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Get the most from this book

This textbook has been tailored explicitly to cover the content of the AQA specification for the A-level course. The book is divided into two parts, one covering microeconomics and the other macroeconomics.

The text provides the foundation for studying AQA economics, but you will no doubt wish to keep up to date by referring to additional topical sources of information about economic events. This can be done by reading the serious newspapers, visiting key sites on the internet and reading such magazines as Economics Review.

Special features

Learning objectives
A statement of the intended learning objectives for each chapter.

Key terms
Clear, concise definitions of essential key terms where they first appear and as a list at the end of each section.

Quantitative skills
Worked examples of the quantitative skills that you will need to develop.

Synoptic links
Connections between different areas of economics are highlighted to help improve your overall understanding of the subject.

Test yourself
Exercises to provide active engagement with economic analysis.

Application of economics in the real world
Case studies to show economic concepts applied to real-world situations.

Study tips
Short pieces of advice to help you present your ideas effectively and avoid potential pitfalls.

Extension material
Extension points to stretch your understanding.

Summaries
Bulleted summaries of each topic that can be used as a revision tool.

Questions
Revision questions are provided at the end of each section to help you check your knowledge and understanding of the topics you have covered within each chapter.

Practice questions
There is a section at the back containing exam-style questions for you to practise.

Answers are online at: www.hoddereducation.co.uk/aqa-economics-alevel

1  Economic methodology and the economic problem

Economics is the study of choice and decision making in a world with limited resources. It tries to explain the economic behaviour of both individuals and groups of people, and the economic relationships between individuals and groups. Related to the noun ‘economics’ is the verb ‘to economise’. In large part, economics is the study of economising — the study of how people make choices about what to produce, how to produce and for whom to produce, in a world in which most resources are limited or scarce. How best can people make decisions about how scarce resources should be allocated among competing uses, so as to improve and maximise human happiness and welfare? This is the economic problem, which is the main focus of this introductory chapter.

LEARNING OBJECTIVES

These are to understand:

●  economics as a social science

●  similarities and differences in methodologies from natural and other sciences

●  the difference between positive and normative statements

●  how value judgements influence economic decision making and policy

●  that the central purpose of economic activity is the production of goods and services to satisfy needs and wants

●  the key economic decisions: what to produce, how to produce and who is to benefit from the goods and services produced

●  the economists’ classification of economic resources into land, labour, capital and enterprise, which are known as the factors of production

●  that the environment is a scarce resource

●  that the fundamental economic problem is scarcity resulting from limited resources and unlimited wants

●  scarcity means that choices have to be made about how resources are allocated

●  how production possibility diagrams may be used to illustrate resource allocation, opportunity cost, trade-offs, unemployment, economic growth and efficiency.

1.1 Economic methodology

Economics as a social science

When answering the question ‘What is economics?’, a good place to start is the fact that economics is a social science. Social science is the branch of science that studies society and the relationships of individuals within a society. Psychology, sociology and political science are also social sciences, as are important elements of history and geography.

Psychology studies the behaviour and mental processes of an individual. Sociology studies the social relationships between people in the context of society. By contrast, economics, as the name suggests, studies the economic behaviour of both individuals and groups of people, and the economic relationships between individuals and groups.

Let us give you two examples of what we mean. Our first example (about individual behaviour) is from an important part of economics known as demand theory, which is covered in Chapter 3. The theory addresses consumer behaviour, or how we behave when we go shopping. Why, for example, do people generally buy more strawberries as the price of strawberries falls?

Our second example introduces an important economic relationship. Having explained demand, we must go a stage further and look at how consumers interact with firms or producers. Firms supply and sell the goods that consumers buy, and economists call the ‘place’ in which goods are bought and sold a market. Indeed, before you started this economics course, you may well have heard the phrase ‘supply and demand’ and thought that is what economics is about. Well, in large measure that is true, particularly in the early chapters of this book, which cover Unit 1 of the specification.

TEST YOURSELF 1.1

What is economics the study of?

Economics and scientific methodology

The essentials of scientific methodology, in the context of the demand theory we will look at in Chapter 3, are shown in the flowchart in Figure 1.1. Scientists start off by observing some aspect of the universe (in the natural sciences), or some aspect of human behaviour, in the case of the social sciences. In the case of demand theory, the starting point — shown in the uppermost box of Figure 1.1 — is observations of how individual consumers react to changes in the prices of the goods and services they buy. Demand theory then develops from making a tentative description, known as a hypothesis, of what has been observed. Hypothesis construction is depicted in the second box from the top in the flowchart. In the third box, predictions about human behaviour are deduced from the hypothesis, such as that an individual will always respond to a lower price by demanding more of the good in question.

Figure 1.1 An example of how scientific methodology may be used in economics

This prediction is then tested against collected evidence about how individuals behave in the marketplace (the fourth box from the top). At this stage, the hypothesis becomes a theory. (The difference between the two is that, whereas a hypothesis is a proposed explanation for something, a theory is when a hypothesis is tested and survives the test.)

At this stage, we are in the bottom left-hand box of Figure 1.1. However, this does not mean that the theory is true in all circumstances. All it says is that the hypothesis has survived the test or tests to which it has been exposed. It might not survive stronger tests, which may not yet have been devised. Scientific method is based on the possibility of falsification or refutation of a hypothesis.

If a hypothesis fails to survive the tests to which it is exposed, one of two things can happen. The bottom right-hand box of Figure 1.1 shows the first possibility: outright rejection of the hypothesis. For example, a hypothesis that consumers always respond to price cuts by demanding less would surely be rejected (as would the hypothesis that consumers always respond to a price cut by demanding more of a good). The other possibility, which often occurs in economics, is that the hypothesis is changed, usually by diluting it, so as to make it less deterministic. In the case of demand theory, as the extension material on page 49 in Chapter 3 explains, diluting it means that demand theory predicts that, in most but not all cases, consumers respond to price cuts by demanding more of a good. Diluted in this way, the demand hypothesis survives the tests to which it is exposed, and becomes ‘the first “law” of demand’.

TEST YOURSELF 1.2

Give another example of how a theory can be developed from a hypothesis in economics.

Social sciences and natural sciences

Economic theories often survive only through allowing a significant number of exceptions to their central predictions, which, according to critics, turns the theories into little more than generalisations with low scientific application.

To quote the economist Ha-Joon Chang, economics is not a science like biology is a science. In his book Economics: The User’s Guide, Chang argues that many economists believe, and tell other people, that economics is a ‘value-free’ science, like physics or chemistry. However, Chang argues that economics is a fundamentally political and moral subject in relation to choosing the best option. Whereas the particles and compounds studied by natural scientists do not hold political and moral views, human beings who populate the economy do, and so we cannot fully understand the economy without understanding politics and ethics. No economic argument can be free from politics and ethics: for example, the economic case for trying to persuade people to buy fair-trade products.

Very often economists respond to the criticism that their subject is ‘soft’ by arguing that they are only concerned with ‘positive economics’, which they claim is based on quite strict use of scientific methodology. Positive economics is concerned with ‘what is’ and ‘what will happen’ if a course of action is taken or not taken. In contrast, ‘normative economics’ is concerned with ‘what should or ought to be’.

TEST YOURSELF 1.3

The study of economics can be helped by looking at other relevant social sciences. Can you name three?

The difference between positive and normative statements

A lot of economics is concerned with what people ought to do. This is particularly true of the government. Should the government try to reduce unemployment, control inflation and achieve a ‘fair’ distribution of income and wealth? Most people probably think that all these objectives are desirable. However, they all fall within the remit of normative economics. Normative economics is about value judgements and views, but because people have different views about what is right and wrong, normative statements cannot be scientifically tested.

KEY TERM

normative statement a statement that includes a value judgement and cannot be refuted just by looking at the evidence.

By contrast, a positive statement can be tested to see if it is incorrect. If a positive statement does not pass the test, it is falsified. A positive statement does not have to be true, however. For example, the statement that the Earth is flat is a positive statement. Although once believed to be true, the statement was falsified with the growth of scientific evidence. The key point is that positive statements can in principle be tested and possibly falsified, while normative statements cannot. Normative statements include ethical, or moral, judgements. Words such as ought, should, better and worse often provide clues that a statement is normative.

KEY TERM

positive statement a statement of fact that can be scientifically tested to see if it is correct or incorrect.

To take an economic example, consider the statement ‘If the state pension were to be abolished, a million older people would die of hypothermia.’ This is a positive statement which could be tested, though few if any people would want to do this. By contrast, the statement ‘The state pension ought to be abolished because it is a waste of scarce resources’ is normative, containing an implicit value judgement about the meaning of the word ‘waste’.

STUDY TIP

Make sure you understand fully the difference between a positive and a normative statement. These concepts are often tested as multiple-choice questions in the exam and you will need to be able to select which options are most clearly positive or normative statements. Remember that normative statements often include clues that they are opinions, by using words or phrases such as ‘should’, ‘ought to’ or ‘must’.

TEST YOURSELF 1.4

Which one of the following is an example of a normative economic statement?

A  Increased use of diesel-engine cars will lead to more atmospheric pollution.

B  Higher taxes always lead to higher prices.

C  The government should spend more on roads.

D  Consumers generally act rationally.

How value judgements influence economic decision making and policy

Economists emphasise the distinction between normative and positive economics, but they often forget that the decision to study one over the other is itself a value judgement, and therefore a normative decision. A value judgement is about whether something is desirable or not — if we believe it is more desirable to study what is happening in the economy rather than what ought to happen, we have made a value judgement. Economics necessarily requires that government ministers make value-based judgements when deciding on economic policies. Despite this, economists often wrongly insist that the subject is value-judgement free.

One particular chancellor of the exchequer (the UK government minister in overall charge of economic policy) once said: ‘Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.’ Government ministers are often less frank than this, knowing that their political opponents and the media will immediately seize on the argument that those in power are uncaring and cynical people. However, the quote does serve to illustrate how decision-makers make value judgements when making economic policy decisions.

On occasion, government ministers make decisions on issues such as where a new airport should be located or whether high-speed trains are worthwhile. Before making decisions on issues like these, the policy-makers know in advance that large groups of the population will strongly oppose whatever decision is eventually made. To try and avoid public hostility, government ministers usually create the illusion that the decision-making process is completely scientific and objective. To do this, they hire independent ‘experts’ to provide advice. But the choice of expert in itself involves a value judgement. Do you choose someone you know in advance is sympathetic to the government’s cause, or are you more willing to go for someone more impartial? Whichever way you go, the so-called scientific processes used by the ‘experts’ to reach their conclusions may be full of value judgements. A classic case involved weighing up the costs and benefits of the location of an additional London airport, which ultimately depended on putting money values on an hour of a business person’s time, and an hour of a holidaymaker’s time. It was quickly found that when different values were put on these, the airport location recommended by the experts would have ‘lost out’ under different costing criteria.

STUDY TIP

Make sure you understand fully how value judgements link to normative statements. Value judgements concern the desirability, or otherwise, of things. The fields of politics and economic policy making are based on value judgements. See if you can identify the normative statements made by politicians on news programmes.

Government priorities and spending change — each decision has consequences

The impact of moral and political judgements

Whatever decision is eventually made in the course of framing government economic policy, there will always be winners who gain and losers who suffer as a result of the decision. Governments often claim they have a moral right to make such decisions. They argue that their political manifesto published before the previous general election gives them the mandate, supported by the voters, to carry out their policies, regardless of the fact that among the electorate there will inevitably be some losers.

One example is provided by former US president Donald Trump’s decision in 2018 to implement a ‘zero tolerance’ policy on illegal immigration into the USA. The policy involved splitting adult illegal migrants from their children and keeping them in wire cages along the US border with Mexico. On humanitarian grounds the policy was so unpopular in the USA that it was quickly abandoned in a policy ‘U-turn’, though the other parts of Trump’s anti-immigrant policy remained in place.

SECTION 1.1 SUMMARY

●  Economic methodology involves the application of tested economic theories to explain real-world economic behaviour.

●  It is important to understand the difference between positive and normative statements. A positive statement can be tested to see if it is correct or false; a normative statement is a statement that includes a value judgement which cannot be refuted purely by looking at the evidence.

●  A value judgement is about whether something is desirable or not.

●  Government ministers make value-based judgements when deciding on economic policies.

●  There will always be winners who gain and losers who suffer as a result of government policy decisions.

1.2 The nature and purpose of economic activity

Needs and wants

The production of goods and services to satisfy people’s needs and wants is the central purpose of economic activity. A need is something people must have, something that they cannot do without. Food provides an example. If people starve, they will eventually die. By contrast, a want is something people would like to have, but which is not essential for survival. It is not absolutely necessary, but it is a good thing to have. Books provide an example. Some people might argue that books are a need because they think they can’t do without them. But they don’t need literature to survive. They do need to eat. (It is worth noting that food can be both a need and a want, depending on the type of food. Protein and vitamins are needs, but bars of chocolate are wants. People don’t need to eat chocolate to survive.)

KEY TERMS

need something that is necessary for human survival, such as food, clothing, warmth or shelter.

want something that is desirable, such as a mobile phone, but is not necessary for human survival.

Satisfying people’s needs and wants means improving economic welfare. Welfare is a concept discussed a lot by economists, but often without a clear indication of what the concept means. Welfare is anything that makes a person happier and improves their economic well-being. Short-term happiness may be at the expense of long-term well-being. The consumption of more material goods and services usually improves economic welfare, though, in the long term, consuming more and more food, and the wrong type of food, can lead to health problems.

KEY TERM

economic welfare the economic well-being of an individual, a group within society, or an economy.

STUDY TIP

Make sure you can explain the meaning of the term ‘economic welfare’. This concept is important throughout your studies because, for example, it is the benchmark by which economists judge whether a policy is worth implementing.

There are also important elements of human happiness and welfare that have nothing to do with the consumption of material goods. These include quality-of-life factors, such as the pleasure gained from family and friends or from contemplating a beautiful view.

TEST YOURSELF 1.5

With one example of each, explain the difference between a need and a want.

The key decisions of what and how to produce

We mentioned at the beginning of this chapter that decisions are made about what to produce, how to produce and who is to benefit from the goods and services produced. How these decisions are made depends upon the nature of the economic system within the economy. The set of institutions within which a community decides what, how and for whom to produce is called an economic system. Although the problem of scarcity is fundamental and common to all forms of human society, from the indigenous peoples in the Amazonian rainforest, to wealthy nations such as the United States of America, different economic systems have evolved in different societies.

KEY TERM

economic system the set of institutions within which a community decides what, how and for whom to produce.

SYNOPTIC LINK

The key economic concept of scarcity is explained in section 1.4 of this chapter, and also in section 1.3, in the context of scarce environmental resources. The existence of scarcity means that societies must make sometimes difficult choices about what products are made, how they are made and who will receive them.

Perhaps the most widely used method of defining and classifying economic systems is according to the way or mechanism through which scarce resources reach the people who eventually consume or use them. Although there are varied ways in which wealth and purchasing power can be allocated among individuals, including inheritance and other types of gift, theft and luck or chance, such as winning a fortune on the National Lottery, the two mechanisms by which economic systems are defined are the market mechanism (or price mechanism) and the command mechanism (or planning mechanism). An economic system in which goods and services are purchased through the price mechanism in a system of markets is called a market economy, whereas one in which government officials or planners allocate economic resources to firms and other productive enterprises is called a command economy (or planned economy).

KEY TERMS

market economy an economy in which goods and services are purchased through the price mechanism in a system of markets.

command economy (also known as a planned economy) an economy in which government officials or planners allocate economic resources to firms and other productive enterprises.

Between these extremes, many economies, particularly those in developed economies such as the UK, are called mixed economies. A mixed economy, as the name suggests, is a mixture of different types of economic system. A mixed economy contains both a large market sector and a large non-market sector in which the planning mechanism operates. Figure 1.2 illustrates mixed economies in relation to planned and market economies.

KEY TERM

mixed economy an economy that contains both a large market sector and a large non-market sector in which the planning mechanism operates.

Figure 1.2 Command economies, mixed economies and market economies

TEST YOURSELF 1.6

To what extent is the UK economy a mixed economy?

APPLICATION OF ECONOMICS IN THE REAL WORLD 1.1

Allocating resources through the price mechanism and the planning mechanism

In a pure market economy, the price mechanism performs the central economic task of allocating scarce resources among competing uses through the markets which make up the economy. Transport costs and lack of information may create barriers that separate or break up markets. In past centuries, such barriers often prevented markets from operating outside the relatively small geographical area of a single country or even a small region within a country.

However, while some markets exist in a particular geographical location — for example, a street market or until quite recently the London Stock Exchange — many markets do not. In recent years, modern developments have allowed goods to be transported more easily and at lower cost, and have helped in the transmission of market information via telephone and the internet. This has enabled many markets, especially commodity and raw material markets and markets in financial services, to become truly global or international markets functioning on a worldwide basis.

A complete command economy is an economy in which all decisions about what, how, how much, when, where and for whom to produce are taken by a central planning authority, issuing commands or directives to all the households and producers in the society. Such a system could only exist within a very rigid and controlled political framework because of the restrictions on individual decision making that are implied.

In much the same way as a pure market economy, in which the price mechanism alone allocates resources, is a theoretical abstraction, so no economy in the real world can properly be described as a complete or pure planned economy. Before the collapse of the communist political system around 1990, some countries in eastern Europe were centrally planned economies. However, they were not pure planned economies. Production but not consumption was planned. Consumers often had to queue to get consumer goods, whose prices were fixed by the planners. Shortages resulted, which, together with the generally inferior quality of consumer goods, contributed to the breakdown of the command economies.

Some communist countries still exist, namely the People’s Republic of China, North Korea, Vietnam and Cuba. However, all these countries, with the exception until recently of North Korea, have encouraged the growth of markets to a greater or lesser extent. They have communist political systems, but they have moved away from being pure command economies. In a sense, China is now more capitalist than the USA and the mixed economies of western Europe. The term ‘state capitalism’ is now used to describe much of China’s economy.

Follow-up questions

1  What are the differences between a pure market economy and the market sector of a mixed economy?

2  What is the other name of a planned economy?

3  With the help of Chapter 3, explain how the price mechanism allocates scarce resources between competing uses.

4  Why did the command economies of central and eastern Europe, such as the Union of Soviet Socialist Republics (USSR) break up?

APPLICATION OF ECONOMICS IN THE REAL WORLD 1.2

The UK as a mixed economy

The UK economy developed into a mixed economy after the Second World War ended in 1945, when a number of important industries such as coal, rail and steel were nationalised and taken into public ownership. Previously, the 1944 Education Act had extended state provision of education, and the creation of the National Health Service in 1948 did the same for healthcare.

For about 30 years after the end of the Second World War, from the 1940s to the 1970s, the majority of UK citizens (and the major political parties) agreed that the mixed economy was working well. Most people believed that certain types of economic activity, particularly the production and distribution of consumer goods and services, were best suited to private enterprise and the market economy. But people also accepted that utility industries such as gas and electricity should be nationalised, and that important services such as education, healthcare and roads should in part be provided by government, outside the market, and financed through the tax system. In short, a consensus existed around the belief that the mixed economy was right for the UK.

However, from about 1980 onwards, many economists and politicians began to blame the mixed economy for the UK’s deteriorating economic performance relative to that of its main competitors in western Europe and Japan. Critics argued that the public and non-market sectors of the economy were inefficient and wealth consuming rather than wealth creating. They felt that these sectors had become too big and that their dominance should be weakened. Critics of the mixed economy argued that a concerted effort should be made to change the nature of the UK economy fundamentally, by increasing private ownership and market production.

Successive governments implemented policies that changed the nature of the mix in favour of private ownership and market forces, at the expense of public ownership and state planning. The UK economy is now much closer to being a pure market and private enterprise economy than it was 45 years ago. The three main policies used to change the nature of the UK economy have been privatisation, marketisation and deregulation, policies which collectively can be called ‘economic liberalisation’.

Privatisation involved the sale of state-owned assets such as nationalised industries to private owners. This was often accompanied by marketisation (or commercialisation), whereby prices are charged for goods and services that the state previously provided free of charge. Deregulation, the third aspect of liberalisation, attempts to remove barriers to entry (see Chapter 5) and government red tape and bureaucracy from the operation of markets.

Follow-up questions

1  Critics of the UK economy have called it a ‘mixed-up’ economy rather than a ‘mixed economy’. What do you think they mean?

2  What is meant by the term ‘private enterprise’?

3  What is the difference between privatisation and marketisation?

4  Do you think that there is now a case for increasing rather than reducing state ownership of UK industry? Justify your answer.

SECTION 1.2 SUMMARY

●  A need is something people must have; it is something that they cannot live without.

●  A want is something people would like to have, but which is not essential for survival.

●  How decisions are made about what to produce, how to produce and who is to benefit from the goods and services produced depends upon the nature of the economic system.

●  Market economies, command economies and mixed economies are examples of economic systems, defined in terms of whether or not the price mechanism or the planning mechanism allocates scarce resources among competing uses.

●  Economic systems can also be defined in terms of who owns the means of production.

●  The UK economy is often called a mixed economy, being on the one hand a mix of market and non-market sectors and on the other hand a mix of privately owned and publicly owned sectors.

1.3 Economic resources

For most people, most of the time, increased consumption of material goods is an important part of improving economic welfare. Most of the goods we consume must first be produced. This requires the use of economic resources. These goods are scarce in relation to demand, which gives rise to the need for rationing and economising in their use.

The basic nature of production is shown in Figure 1.3. Production is a process, or set of processes, that converts inputs into outputs. The eventual outputs are the consumer goods and services that go to make up our standard of living, though inputs are of course also used to produce the capital goods that are necessary for the eventual production of consumer goods.

KEY TERMS

production converts inputs or factor services into outputs of goods and services.

capital good (also known as a producer good) a good which is used in the production of other goods or services.

consumer good a good which is consumed by individuals or households to satisfy their needs or wants.

Figure 1.3 The basic nature of production

The factors of production

Economists call the inputs into the production process, which are shown in Figure 1.3, the factors of production. Four factors of production are usually identified. These are land, labour, capital and enterprise, the last often being called the entrepreneurial input.

KEY TERM

factors of production inputs into the production process (e.g. land, labour, capital and enterprise).

Entrepreneurs are different from the other factors of production. They are the people who address the issues introduced earlier, deciding what to produce, how to produce it and for whom to produce it. An entrepreneur decides how much of the other factors of production, including labour, to employ. The costs of employing land, labour and capital, together with the cost of the entrepreneur’s own services, become the firm’s costs of production. In essence, the entrepreneur is a financial risk-taker and decision-maker. Profit, which is the entrepreneur’s financial reward, results from successful decision making. Entrepreneurial profit is the profit left over after the cost of employing the other factors of production is deducted from the sales revenue gained from selling the goods and services the entrepreneur decides to produce.

STUDY TIP

It is important to understand that factors of production are inputs used to produce output of goods and services. The factor of production known as enterprise is usually seen as the factor which coordinates factor inputs of capital, land and labour in pursuit of profit.

The environment as a scarce resource

Environmental resources comprise all the natural resources that are used or can be used in the economic system. These are:

●  physical resources, such as soil, water, forests, fisheries and minerals

●  gases, such as hydrogen and oxygen

●  abstract resources, such as solar energy, wind energy, the beauty of the landscape, clean air and water.

Environmental resources can be split into renewable and non-renewable resources, with the latter further divided into recyclable and non-recyclable resources. Renewable resources, which are reproducible and perpetually maintainable, include forests, animals and water. The availability of these resources depends, however, on their management by humans. By contrast, non-renewable resources, such as oil, gas and minerals, cannot be regenerated or their regeneration is so slow that the stock of resources cannot meaningfully be increased. These are finite resources. Recyclable non-renewable resources such as minerals, paper and glass can be reused in the economic system. In theory, all of these resources can be recycled but it is not always possible and economic to recycle more than a small fraction. Non-recyclable resources such as coal, gas and oil are finite in the sense that, once used, their stock is no longer available for future use.

KEY TERMS

renewable resource a resource (e.g. timber) that with careful management can be renewed as it is used.

non-renewable resource (also known as a finite resource) a resource (e.g. oil) that is scarce and runs out as it is used.

Environmental resources are part of the factor of production, land. Some environmental resources, such as the air we breathe and the water we drink, are often described as the ‘free gifts of nature’. However, this view can be questioned. In most countries and regions where large numbers of people live, clean air and drinkable water are scarce commodities and not the ‘free gifts of nature’. The need to get rid of the effects of pollution created by humankind means that clean air and water are scarce and not free. Resources which could be put to other uses are used instead to produce clean air and water. Production and consumption activities taking place in the economy affect and often damage the natural environment.

Oil is a non-renewable resource

TEST YOURSELF 1.7

Distinguish between a non-renewable and a renewable environmental resource.

SECTION 1.3 SUMMARY

●  Increased consumption of material goods is an important part of improving economic welfare.

●  Most of the goods we consume must first be produced.

●  This requires the use of economic resources.

●  These goods are scarce in relation to demand, which gives rise to the need for rationing and economising in their use.

●  Production is a process, or set of processes, that converts inputs into outputs.

●  Inputs are called factors of production and are economic resources.

●  Land, labour, capital and enterprise (often called the entrepreneurial input) are the factors of production.

●  The entrepreneur is the factor of production that decides what to produce, how to produce and for whom to produce.

●  Inputs are also used to produce the capital goods that are necessary for the eventual production of consumer goods and services.

●  Environmental resources comprise all the natural resources that are used or can be used in the economic system.

1.4 Scarcity, choice and the allocation of resources

Scarcity: the fundamental economic problem

We have already mentioned that we live on a finite planet in which most economic resources are limited. As we have seen, their use usually has to be rationed either by the price mechanism or by the planning mechanism. The fundamental economic problem is therefore scarcity. In a world of scarcity, people (even the very rich) have limited incomes, which means that they face a budget constraint. When the price mechanism is rationing scarce resources between competing uses, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices and their limited income.

KEY TERMS

fundamental economic problem how best to make decisions about the allocation of scarce resources among competing uses, so as to improve and maximise human happiness and welfare.

scarcity results from the fact that people have unlimited wants but resources to meet these wants are limited. In essence, people would like to consume more goods and services than the economy is able to produce with its limited resources.

The need for choice

If goods are scarce and incomes are limited, a choice or choices have to be made. Consider, for example, a family with a weekly income of £1,200. The family currently spends £350 on housing, £350 on food, £300 on other goods and services, including heating and lighting, and £100 on entertainment. The family’s total weekly spending on goods and services is thus £1,100, meaning the family manages to save £100. Suddenly, the cost of housing rises to £550. To avoid getting into debt, and assuming that family income cannot increase, one or more probably unpleasant choices will have to be made. An obvious possibility is to cut down on entertainment, such as visits to the cinema. Other possibilities could be spending less on home heating, buying cheaper food, reducing the purchase of non-essential items and stopping saving. Something will have to be given up. Unless the family gets into debt or its income increases, it will have to economise on its spending and saving decisions.

KEY TERM

choice choosing between alternatives when making a decision on how to use scarce resources.

It is important to appreciate that, even without an increase in house prices, scarcity means that individuals and households are constantly making choices about how to spend their limited incomes and how to make the best use of their time. A decision to spend more on a holiday, for example, means that a family chooses to spend less on other goods, or to save less.

Choices have an opportunity cost

A need for choice arises whenever an economic agent (e.g. an individual, a household or a firm) has to choose between two or more alternatives which are mutually exclusive, in the sense that it is impossible or impractical to achieve both at the same time. In the jargon of economics, an opportunity cost is involved.

KEY TERM

opportunity cost the cost of giving up the next best alternative.

If you ask friends who haven’t studied economics the meaning of the word ‘cost’, typically they will answer that cost is the money cost either of producing a good or of buying a good. Economists, by contrast, focus on opportunity cost. The opportunity cost of any choice, decision or course of action is measured in terms of the alternatives that have to be given up.

TEST YOURSELF 1.8

What is meant by rational economic behaviour?

Economists generally assume that people behave rationally. Rational behaviour means people try to make decisions in their self-interest or to maximise their private benefit. When a choice has to be made, people always choose what they think at the time is the best alternative, which means that the second best or next best alternative is rejected. For rational people, the opportunity cost of any decision or choice is the next best alternative sacrificed or forgone. For example, if you choose to spend half an hour watching a TV programme, the opportunity cost is the lost opportunity to spend this time reading a magazine or book.

SYNOPTIC LINK

The assumption that people are always rational when making choices is questioned in the discussion of behavioural economics in Chapter 2.

TEST YOURSELF 1.9

Can you explain one factor that in real life may prevent a person from making a rational decision?

STUDY TIP

Make sure you can link together the three concepts of scarcity, choice and opportunity cost. As economic resources are finite, society must make choices about how to allocate them. In doing so, there will always be alternatives which are not chosen that would have given some benefit to society; this is the concept of opportunity cost.

Rational behaviour and opportunity cost

Look carefully at the sentence in the previous paragraph about opportunity cost: When a choice has to be made, people always choose what they think at the time is the best alternative, which means that the second best or next best alternative is rejected. The words ‘think at the time’ are quite important. Suppose you decide to see a film, believing at the time you are going to enjoy the film. Two hours later, coming out of the cinema, you say ‘That was a load of rubbish, I wish I hadn’t bothered.’ Nevertheless, at the time the decision was made, deciding to watch the film was a rational decision because you believed you would enjoy watching it. Having left the cinema, irrational behaviour would be going back to the box office and paying good money to see the film again.

Even if the film can be watched freely on television, there is still an opportunity cost, though in this case it only involves time. Time is scarce, and the two hours spent watching the film cannot be spent on some other activity such as reading a book. A choice has to be made between the two activities. Of course, the way the choice is exercised will differ for different people, even if everyone enjoys both watching films and reading. People with plenty of time to spare — for example, retired or unemployed people — value time less highly than a financial trader working in a dealing room from 7 a.m. until 9 p.m.

Going to a cinema to watch a film is, of course, a consumer activity. People have to think carefully about how they spend their limited incomes. In economics this is known as a budget constraint. Money spent on one good cannot be spent on another good. But there is always an opportunity cost when deciding to consume a good, involving time if not money.

TEST YOURSELF 1.10

Give an example of an opportunity cost facing an A-level student when choosing to spend a whole evening playing computer games.

Firms also have to make choices about what and how to produce. Consider a textile manufacturer which can produce either shirts or dresses from the same production line, but not both goods at the same time. In this situation, the opportunity cost of producing more shirts is the number of dresses sacrificed or forgone. Suppose also that both shirts and dresses can be produced using one of two different technologies. These are a labour-intensive technology involving lots of workers but very little capital equipment, and a capital-intensive technology in which there are very few workers but expensive automated capital equipment. Given the budget constraint facing the firm, the opportunity cost of choosing one method of production is the sacrificed opportunity to use the other method.

A further example of opportunity cost arises when a teenager makes a decision about whether to leave school and get a job, or to go to university. Very often this involves the choice between income now and income in the future. Economists call this inter-temporal choice, or choice over time.

QUANTITATIVE SKILLS 1.1

Worked example: calculating an opportunity cost

A small electrical goods manufacturer can produce either TV sets or radio sets using all its available resources. Table 1.1 shows the different combinations of the two goods the firm can produce.

Table 1.1 Production possibilities for TVs and radio sets

TV sets

Radio sets

0

30

1

29

2

27

3

24

4

20

5

15

6

  9

7

  0

What happens to the opportunity cost of TV sets in terms of radios, as TV set production increases from 0 to 7 sets?

If the firm chooses to produce only 1 TV set, its opportunity cost is 1 radio set forgone (30 − 29 radio sets). Performing a similar calculation when TV set production is increased by an extra unit, the opportunity cost of the second TV set is 2 radio sets. All the opportunity costs are set out in Table 1.2.

Table 1.2 Opportunity costs of producing an extra TV set

1st TV set

1 radio set (30 - 29)

2nd TV set

2 radio sets (29 - 27)

3rd TV set

3 radio sets (27 - 24)

4th TV set

4 radio sets (24 - 20)

5th TV set

5 radio sets (20 - 15)

6th TV set

6 radio sets (15 - 9)

7th TV set

9 radio sets (9 - 0)

The data show an increasing opportunity cost in terms of radio sets forgone as production of TV sets increases.

STUDY TIP

Make sure you understand and can distinguish between the words ‘micro’ and ‘macro’. ‘Micro’ means small, whereas ‘macro’ means large. Microeconomics, which is covered in the first eight chapters of this book, looks at the ‘little bits’ of the economy: for example, individual markets, firms and consumers. By contrast, macroeconomics, covered in Chapters 9-15, looks at the ‘aggregate economy’ or the economy ‘as a whole’.

SECTION 1.4 SUMMARY

●  The economic problem is how limited resources are used in relation to people’s desires and wants.

●  The economic problem results from relative scarcity.

●  Scarcity results in the need for choice.

●  Whenever a choice has to be made, there is an opportunity cost.

●  The opportunity cost of any decision is the next best alternative forgone.

●  Economists generally assume that people are rational, choosing the best alternative available.

1.5 Production possibility diagrams

So far, we have focused mainly on how scarcity and choice may affect firms, families and individuals at the microeconomic level. In much the same way, but on a far grander scale, the economy of the nation as a whole faces a similar need for choice. To explain how the economic problem affects the whole economy, we will use a diagram which you will come across again and again in your economics course — a production possibility diagram.

The key feature of a production possibility diagram is a production possibility frontier (PPF) or production possibility curve. A PPF illustrates the different combinations of two goods, or two sets of goods, that can be produced with a fixed quantity of resource, providing we assume that all available resources are being utilised to the full. The PPF in Figure 1.4 illustrates the different combinations of capital goods and consumer goods that the whole economy can produce when all the economy’s resources are employed, with no spare capacity. To put it another way, the PPF shows what the economy can produce, assuming that all the labour, capital and land at the country’s disposal are employed to the full, and assuming a given state of technical progress.

KEY TERMS

production possibility frontier a curve depicting the various combinations of two products (or types of product) that can be produced when all the available resources are fully and efficiently employed.

technical progress new and better ways of making goods and new techniques for producing more output from scarce resources.

Figure 1.4 Using a production possibility frontier diagram to illustrate the economic problem

Given that resources and capacity are limited, a choice has to be made about the type of good to produce. Look closely at points X and Y on the diagram. Point X shows the maximum possible output of consumer goods, assuming that the economy only produces consumer goods (i.e. no capital goods are produced). Likewise, point Y shows the maximum possible output of capital goods, assuming that the economy only produces capital goods. In fact, points X and Y show the two extreme production possibilities, since all goods are either consumer goods or capital goods. Finally, the line drawn between points X and Y in Figure 1.4 is the economy’s production possibility frontier. The PPF shows all the different combinations of consumer goods and capital goods that can be produced, given the assumptions mentioned earlier about full employment of available resources and the state of technical progress. Point A, for example, shows K1 capital goods and C1 consumer goods being produced. An increase in capital goods production to K2, shown at point B, means that consumer goods production falls to C2. C1 − C2 is the opportunity cost of producing K2 − K1 additional capital goods. Whichever combination of capital and consumer goods is actually chosen reflects decisions made in society about allocating scarce resources between competing uses.

STUDY TIP

You must learn to draw and interpret production possibility diagrams, which are important in both microeconomics and macroeconomics. At the micro level they can be used to illustrate scarcity, choice, opportunity cost and productive efficiency. At the macro level, they can be used to illustrate economic growth, full employment and unemployment.

QUANTITATIVE SKILLS 1.2

Worked example: calculating opportunity cost: apples and pears

Figure 1.5 Production possibilities for apples and pears

A country is currently producing 3.2 million tons of apples and 3.5 million tons of pears. Calculate the opportunity cost in terms of apples of increasing pear production to 5 million tons.

The opportunity cost of increasing pear production by 1.5 million tons is the sacrifice of 1.2 million tons of apples.

SYNOPTIC LINK

As we explain below, production possibility diagrams can also be used to illustrate economic growth. This is revisited in Chapter 11. Chapter 10 explains another way of illustrating economic growth, in terms of aggregate demand and aggregate supply or AD/AS analysis. AD/AS analysis is one of the key models in macroeconomics, which is concerned with the performance of the entire economy. In contrast, microeconomics is concerned with individual markets within an economy.

Macroeconomic PPF diagrams

The production possibility frontier in Figure 1.4 shows the economy as a whole, which means that the PPF depicts the macroeconomy. Before we look at some microeconomic production possibility frontiers, we will explain two important ways in which macroeconomic PPF diagrams can be used.

Figure 1.6 Long-run and short-run economic growth

Using a PPF diagram to show economic growth

Figure 1.6 shows how a PPF diagram can be used to illustrate economic growth. There are two forms of economic growth, which are explained in detail in Chapter 11. These are long-run economic growth and short-run economic growth.

KEY TERM

economic growth the increase in the potential level of real output the economy can produce over a period of time.

Economic growth is defined as the increase in the potential level of real output the economy can produce over a period of time: for example, a year. Strictly, this is long-run economic growth, which is not the same as short-run economic growth. If the economy’s production possibility frontier is PPF1 initially, short-run economic growth is shown by the movement from point C inside the frontier to a point, such as point A, on the frontier.

Long-run economic growth is shown by the outward movement of the frontier to PPF2. The movement from point A to point B depicts long-run economic growth. Short-run growth makes use of spare capacity and takes up the slack in the economy, whereas long-run growth increases total productive capacity.

Using a PPF diagram to show full employment and unemployment

As mentioned earlier, all points on a production possibility frontier show full employment of available resources. For a macroeconomic production possibility frontier, this means full employment of labour as well as other resources that can be used in the course of production. Thus, points A and B in Figure 1.7 show full employment when the economy’s production possibility frontier is in the position indicated.

KEY TERM

full employment when all who are able and willing to work are employed.

Figure 1.7 Using a production possibility curve diagram to show full employment and unemployment in the economy

By contrast, a point inside the PPF, such as point X, shows that some resources, including labour, are not being employed. There is unused capacity in the economy. (Note that if long-run economic growth were to move the PPF outwards to a new position, points A and B on the ‘old’ production possibility frontier would now be points of unemployment, as they would be located inside the new ‘further out’ frontier.)

KEY TERM

unemployment when not all of those who are able and willing to work are employed.

TEST YOURSELF 1.11

Illustrate full employment and unemployment on a production possibility frontier diagram.

SYNOPTIC LINK

PPF diagrams can be used to illustrate a range of macroeconomic concepts such as full employment and unemployment. These concepts feature in Chapters 11, 12 and 13, where they are also illustrated with aggregate demand and aggregate supply (AD/AS) diagrams.

Microeconomic PPF diagrams

Look carefully at the microeconomic production possibility frontier in Figure 1.8. We can tell this is a microeconomic diagram because of the labels on the two axes of the graph. The diagram depicts a situation in which a firm can produce both mobile phones and laptop computers from the resources it has available. As in Figure 1.4, points X and Y show the extreme possibilities facing the firm. Point X on the horizontal axis shows the maximum possible output of laptop computers when no mobile phones are produced. This means that all available resources are devoted to the production of laptop computers.

Figure 1.8 The production possibility frontier facing a firm producing mobile phones and laptop computers

Conversely, point Y on the vertical axis shows the opposite situation: the maximum possible output of mobile phones when zero laptop computers are produced. As was the case in the macroeconomic production possibility diagrams, all points on the PPF between X and Y show different combinations of the two goods being produced between the two extreme possibilities.

We can use Figure 1.8 to explain a number of important economic relationships.

Scarcity, resource allocation and choice (revisited)

A PPF diagram such as Figure 1.8 shows different possible ways in which scarce resources can be allocated between competing uses. This involves choice. Compared to the resource allocation at point A, point B shows the effect of shifting more resources into the production of mobile phones, with fewer resources being allocated to laptop computer production.

KEY TERM

resource allocation the process through which the available factors of production are assigned to produce different goods and services (e.g. how many of society’s economic resources are devoted to supplying different products such as food, cars, healthcare and defence).

Opportunity cost (revisited)

Production possibility diagrams provide a very good way of illustrating opportunity cost. Suppose, for example, that the firm in Figure 1.8 initially produces MP1 mobile phones and LC1 laptop computers. This combination of the two goods is shown at point A in the diagram. A decision by the manufacturer to increase production of mobile phones from MP1 to MP2 means that computer production falls by LC1 − LC2. Moving from point A to point B on the curve, the fall in computer production is the opportunity cost of the increase in phone production.

Look now at the shape of the PPF in Figure 1.8. You can see that the slope of the curve falls, moving up the curve from point A to point B, and indeed to all other points further up the curve. There is a reason for this. The slope shows the opportunity cost of producing more mobile phones in terms of the laptop computers that have to be sacrificed. When mobile phone production increases from MP1 to MP2 laptop computer production falls by LC1 − LC2. This is the opportunity cost involved. But suppose mobile phone production increases again by the same amount as before (which means that MP3 − MP2 is the same as MP2 − MP1). In this situation, shown at point C on the curve, more laptop computers than before have to be given up. LC3 − LC2 is larger than LC2 − LC1. The slope of the curve of the production possibility frontier shows that the opportunity cost of producing mobile phones increases as more mobile phones are produced. A greater number of laptop computers have to be sacrificed whenever an extra mobile phone is produced.

A large company such as Apple must decide how to allocate its resources

TEST YOURSELF 1.12

Provide another example of a production possibility frontier diagram illustrating a microeconomic idea or concept.

SYNOPTIC LINK

Link the microeconomic use of production possibility frontier diagrams to the coverage of the price mechanism in Chapter 3 and to production, costs and revenue in Chapter 4. All of these models can be used to illustrate the concepts of efficiency and choice.

Productive efficiency and production possibility diagrams

You will come across the concept of economic efficiency on numerous occasions as you proceed through the course and this book. There are a number of different measures of economic efficiency, one of which is productive efficiency. Chapter 5 explains productive efficiency in terms of a firm minimising the average cost of producing a good. In this chapter, we focus on two other ways of explaining the concept, both of which are illustrated by the production possibility curve in Figure 1.9.

KEY TERM

productive efficiency for the economy as a whole occurs when it is impossible to produce more of one good without producing less of another. For a firm it occurs when the average total cost of production is minimised.

Figure 1.9 Productive efficiency and the economy’s PPF

Productive efficiency occurs when output is maximised from available inputs. But we know already that a PPF shows maximisation of output from available inputs at every point on the curve, though the combination of the two goods (in this case, capital goods and consumer goods) varies at different points on the curve. This means that all points on the economy’s production possibility frontier shown in Figure 1.9, including points A and B, are productively efficient. By contrast, all points inside the PPF are productively inefficient, including point Z. Productive inefficiency occurs when output is not maximised from available inputs. At point Z, the economy is not employing all the available resources, including, of course, labour. Productive inefficiency is often associated with unemployment.

Consider now a movement along the PPF from point A to point B. The diagram is telling us that, when on the PPF, more capital goods can be produced only by giving up the production of some consumer goods. This is another way of explaining productive efficiency. Productive efficiency occurs when producing more of one good involves reducing production of other goods. By contrast, when the economy is productively inefficient at point Z, more capital goods and consumer goods can be produced by taking up the slack in the economy and making use of idle resources.

TEST YOURSELF 1.13

A production possibility frontier can be used to show all the following except:

A  all the different combinations of two goods that can be produced from available inputs

B  all the productively efficient combinations of output that can be produced from available inputs

C  the opportunity cost of producing more of a particular good

D  the economic welfare a consumer gains from different combinations of goods

SYNOPTIC LINK

As noted, there are various types of economic efficiency you need to learn and understand as you proceed through the course. One type is productive efficiency, first introduced in this chapter, which can be illustrated on a production possibility frontier diagram. Other types of efficiency are best learnt later in the course. One of these is allocative efficiency. Chapter 5 explains in some detail the meaning of allocative efficiency (and productive efficiency) in the context of two market structures known as perfect competition and monopoly. Chapter 8 also considers allocative efficiency, this time in the context of market failure. Allocative efficiency is a welfare concept rather than a production concept.

QUANTITATIVE SKILLS 1.3

Worked example: drawing a PPF from given data

Draw a production possibility frontier using the data in Table 1.3.

Table 1.3 Production possibility schedule for producing tanks and military aircraft

Tanks

Military aircraft

100

    0

  90

  10

  80

  20

  70

  30

  60

  40

  50

  50

  40

  60

  30

  70

  20

  80

  10

  90

    0

100

The PPF drawn from these data is shown in Figure 1.10.

Figure 1.10 PPF for tanks and military aircraft

Unlike all the PPFs shown earlier in this chapter, this one shows a constant opportunity cost of 10 military aircraft whenever 10 extra tanks are produced. This means that the PPF is a straight line, positioned between the two production possibility extremes of zero tanks and 100 military aircraft, and 100 tanks and zero military aircraft.

TEST YOURSELF 1.14

Suppose the opportunity cost of producing 1 extra unit of a good in terms of another good sacrificed fell as more of the good was produced. In what way would the shape of the PPF differ from those shown in this chapter?

QUANTITATIVE SKILLS 1.4

Worked example: interpreting statistical data and performing simple percentage calculations

Table 1.4 shows the proportion of total output exported in selected industries, in January 2010 and January 2019.

Table 1.4 Export proportions for selected manufacturing industries in the UK

Industry

Percentage of total industry output exported, January 2010

Percentage of total industry output exported, January 2019

Alcoholic drinks

14.5

28.6

Petrochemicals

52.9

68.1

Furniture

  5.5

10.0

Motor vehicles

39.5

50.6

Computers and electronic and optical products

48.2

58.7

Weapons

  9.2

28.1

Source: ONS

(a)  Which industry enjoyed the greatest percentage growth in the proportion of its output exported between January 2010 and January 2019?

The percentage growth in the proportion of its output exported over the year were: for alcohol drinks 97.2%; petrochemicals 28.7%; furniture 81.8%; motor vehicles 28.1%; computers etc. 21.8%; weapons 205.4%. The greatest percentage growth was in weapons exports.

(b)  Is it possible to calculate the actual amount by which petrochemical output changed between January 2010 and January 2019? Explain your answer.

No. We can calculate the percentage growth but not the actual growth. We need the money value of total output of petrochemicals in January 2010 to enable this calculation to be made.

SECTION 1.5 SUMMARY

●  Key economic concepts such as scarcity, choice, opportunity cost, economic growth, and full employment and unemployment, can be illustrated on a production possibility diagram.

●  A production possibility frontier illustrates the different combinations of goods that can be produced with a fixed quantity of resources.

●  Different economic systems allocate resources between different uses in different ways.

●  In a market economy, the price mechanism performs the allocative task.

●  The UK economy is a mixed economy, containing a mix of market and non-market sectors, and private and public sectors.

●  The nature of the UK mixed economy has changed during the last 40 years.

Questions

1  With one example of each, explain the difference between a positive and a normative statement.

2  What is the fundamental or central economic problem?

3  Relate scarcity to the need to make economic choices and to opportunity cost.

4  Briefly describe the four factors of production.

5  What is a production possibility frontier?

6  Draw a production possibility frontier to illustrate the choice between producing capital goods and consumer goods.

7  Draw a production possibility frontier which illustrates economic growth taking place.

2  Individual economic decision making

This chapter introduces two extremely significant aspects of individual economic decision making. 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 chapter, behavioural economics. Behavioural economics is a relatively new part of the subject which provides significant insights into how individuals make economic decisions.

LEARNING OBJECTIVES

These are to understand:

●  the significance of utility maximisation for individual economic decision making

●  the importance of the margin when making choices

●  how imperfect information and asymmetric information affect choice decisions

●  the emergence of behavioural economics as an important recent development in economic theory

●  important elements of behavioural economics such as bounded rationality, biases in individual decision making and the role of altruism

●  how behavioural economics relates to government economic policy.

2.1 Consumer behaviour

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 behaviour means people try to make decisions in their self-interest or to maximise their private benefit. When a choice has to be made, people always choose what they think at the time is the best alternative, which means that the second best or next best alternative is rejected. For households and the individuals within them, rational behaviour means attempting to maximise the welfare, satisfaction or utility gained from the goods and services consumed.

KEY TERM

rational behaviour acting in pursuit of self-interest, which for a consumer means attempting to maximise the welfare, satisfaction or utility gained from the goods and services consumed.

SYNOPTIC LINK

Chapter 3 will look at how traditional economic theory explains price determination. At the heart of this approach is the assumption that individuals make rational decisions and seek to maximise utility.

TEST YOURSELF 2.1

Which one of the following provides the best reason why consumers become early adopters of a new innovation such as a smart watch, even though they know that they will be paying a high price for the good?

Early adopters are people who:

A  like technological gadgets

B  get up early to buy in a sale

C  base their consumption decisions on the reviews submitted online by existing users

D  want to be the first to get new types of product as they come onto the market

Explain your answer.

Utility theory: total and marginal utility, and diminishing marginal utility

What is utility?

Consumers attempt to maximise the welfare or utility they gain from the goods and services they decide to consume. We will explore this further in the next section, on utility maximisation. In economics, utility is usually defined as the pleasure or satisfaction obtained from consumption, and marginal utility is the additional pleasure or satisfaction obtained from consuming one more unit of something. Although it is difficult to compare the utility obtained by each individual, we can assign nominal values to different levels of utility.

KEY TERMS

utility the satisfaction or economic welfare an individual gains from consuming a good or service.

marginal utility the additional welfare, satisfaction or pleasure gained from consuming one extra unit of a good or service.

TEST YOURSELF 2.2

A family’s typical weekly shopping basket might include ‘pleasure items’ such as packets of crisps and cans of Coca-Cola and other items which fulfil a need and without which life would be more uncomfortable. Are each of the following ‘pleasure items’ or ‘need-fulfilment items’?

(a)  medicine

(b)  chocolate

(c)  daffodil bulbs

(d)  electric light bulbs

(e)  washing-up liquid

The relationship between total utility and marginal utility

Let us imagine a thirsty teenager who drinks 6 glasses of lemonade on a hot sunny afternoon, deriving successively 8, 6, 4, 2, 0 and −2 ‘units of utility’ from each glass consumed. This information is shown in the total and marginal utility schedules in Table 2.1, from which the total and marginal utility curves in Figure 2.1 are plotted. Note that marginal utility is plotted at ‘halfway’ points.

Table 2.1 Total and marginal utility schedules for lemonade

Glasses of lemonade

Total utility (units of utility)

Marginal utility (units of utility)

0

  0

 –

1

  8

  8

2

14

  6

3

18

  4

4

20

  2

5

20

  0

6

18

−2

It is important to realise that the total and marginal utility schedules and, likewise, the total and marginal utility curves show exactly the same information, but they show it in different ways. The total utility schedule and the total utility curve show the data cumulatively — for example, when drinking two glasses of lemonade, the thirsty teenager gains 14 ‘units of utility’ in total. After three glasses, total utility rises to 18 ‘units of utility’, and so on.

Figure 2.1 An example of total utility and marginal utility curves

In contrast, the marginal utility schedule and the marginal utility curve plot the same data as separate observations, rather than cumulatively. The last unit consumed is always the marginal unit and the utility derived from it is the marginal utility. So, after two drinks, the second glass of lemonade is the marginal unit consumed, yielding a marginal utility of 6 ‘units of utility’. But when three glasses of lemonade are consumed, the third glass becomes the marginal unit, from which the still partially thirsty teenager gains a marginal utility of just 4 ‘units of utility’.

In Figure 2.1, 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 would be irrational for our teenager who is no longer thirsty to drink a sixth glass of lemonade. He or she would experience negative marginal utility (or marginal disutility), which is shown by the downward slope of the total utility curve and by the negative position of the lower section of the marginal utility curve.

QUANTITATIVE SKILLS 2.1

Worked example: calculating marginal utility

An 8-year-old boy decides to enter a competition to see how many jam doughnuts can be eaten in 15 minutes. Table 2.2 shows how many he ate and his total utility schedule.

Table 2.2 Total utility for doughnuts

Jam doughnuts

Total utility (units of utility)

Marginal utility (units of utility)

0

  0

1

  6

2

10

3

12

4

12

5

  8

6

  3

Complete the boy’s marginal utility schedule.

The boy’s marginal utility schedule is shown in Table 2.3.

Table 2.3 Total and marginal utility for doughnuts

Jam doughnuts

Total utility (units of utility)

Marginal utility (units of utility)

0

  0

  –

1

  6

  6

2

10

  4

3

12

  2

4

12

  0

5

  8

−4

6

  3

−5

The hypothesis (or ‘law’) of diminishing marginal utility

The numerical examples in Tables 2.1–2.3, and the graph in Figure 2.1, illustrate a famous economic hypothesis, which some would call an economic law: the hypothesis of diminishing marginal utility. This simply states that as a person increases consumption of a good — while keeping consumption of other products constant — there is a decline in the marginal utility derived from consuming each additional unit of the good.

KEY TERM

hypothesis of diminishing marginal utility for a single consumer, the marginal utility derived from a good or service diminishes for each additional unit consumed.

TEST YOURSELF 2.3

Explain how traditional economic theory assumes a rational individual will make decisions: for example, when deciding how to respond to a change in a good’s price.

SYNOPTIC LINK

In the context of economic methodology, Chapter 1 explained the difference between a hypothesis and a theory. To remind you, whereas a hypothesis is a proposed explanation for something, a theory is when a hypothesis is tested and survives the test.

APPLICATION OF ECONOMICS IN THE REAL WORLD 2.1

Adam Smith’s diamonds and water paradox

In 1776 the great classical economist Adam Smith wrote about the diamonds and water paradox (or the paradox of value) in his famous book The Wealth of Nations. Smith wrote:

Nothing is more useful than water: but; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

In most countries, water has a low price, but a piece of diamond jewellery has a high price. Why does an economy put a much lower value on something vital to sustaining life compared to something that simply looks good? Smith pointed out that practical things that we use every day have a value in use, but often have little or no value in exchange. On the other hand, some of the things that often have the greatest value in the market or in exchange, such as a drawing by Picasso, have little or no practical use other than, in this case, as ornamentation.

Understanding the diamonds and water paradox comes through first understanding the economic terms ‘marginal utility’ and ‘scarcity’. Scarcity relates to how little of a good there is compared to what people are demanding. Marginal utility is the additional welfare a person gains from using or purchasing an additional unit of the good. People are willing to pay a higher price for goods with greater marginal utility.

Relating this to water and diamonds, water is not scarce in most of the world, which means people can consume water up to the point at which the marginal utility they gain from the last drop consumed is very low. They aren’t willing to pay a lot of money for one more drink of water. Diamonds, by contrast, are scarce. Because of their limited supply, the marginal utility typically gained from adding one more diamond to a person’s collection is much higher than for one extra drink of water. However, if one is dying of thirst, this paradox breaks down. In this situation, the marginal utility gained from another drink of water would be much higher than the additional satisfaction of owning an extra diamond — at least until the thirst was quenched.

Follow-up questions

1  Define the terms ‘scarcity’ and ‘marginal utility’.

2  Can you think of two other goods which generally illustrate the paradox of value?

3  Why are a bottle of water and a diamond priced differently?

4  Is it rational for an individual to trade a diamond for a bottle of water?

SYNOPTIC LINK

This chapter focuses on the individual choices made by consumers or members of households when they decide how much of a good to consume in the economy’s goods or product market. In Chapter 6, by contrast, we explain the choices made by members of the same households about how much labour to supply and how much leisure time to enjoy when making decisions in the economy’s labour market. In both sets of markets, utility maximisation (explained below) is central to individual economic decision making. In the labour market we assume that workers attempt to maximise the utility derived from the wage and the utility gained from job satisfaction.

Utility maximisation

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

EXTENSION MATERIAL

Maximising versus minimising behaviour

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

EXTENSION MATERIAL

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 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 marketplace. The 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 cannot 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’.

●  The budget constraint. Taken together, limited income and the set of prices faced impose a budget constraint on consumers’ freedom of action in the marketplace. 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 the 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 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 will see in later chapters in Part 1 of this book, in traditional economic theory, the margin is equally important in other areas of economic choice. For example, we will 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 will explain how, in order to maximise a desired objective, an economic agent must undertake the activity involved up to the point at which the marginal private benefit received equals the marginal private cost incurred. For example, a utility-maximising consumer must choose to consume or demand a good up to the point at which MU = P. Marginal utility or MU is, of course, the marginal private benefit derived from consuming the last unit of the good, while the good’s price, P, is its opportunity cost in consumption, at the margin.

STUDY TIP

The margin is one of the key concepts in A-level microeconomics. You have already encountered the concept of marginal utility in this chapter. In Chapters 4, 5 and 6 you will come across concepts such as marginal cost, marginal revenue and marginal returns. Make sure you understand and can define ‘the margin’ and apply the concept in its different forms in your exam.

EXTENSION MATERIAL

Can utility be measured?

On several occasions we have referred to ‘units of utility’ as a unit of measurement for the happiness, pleasure, satisfaction or fulfilment of need which an individual derives from consuming a good or service. However, in real life there is no way in which an individual can mathematically work out the utility to be gained from every unit of a good consumed. Economists have found it impossible to measure directly units of satisfaction, pleasure or fulfilment through which comparisons can be made across individuals.

To get around this problem, the famous economist Paul Samuelson introduced the concept of ‘revealed preference’. What revealed preference theory does is work backwards from observing how consumers actually behave to observing their preferences. Consumers reveal their preferences by choosing, at given prices and for given levels of income, the bundles or combinations of goods they end up buying.

SECTION 2.1 SUMMARY

●  The starting point for understanding individual economic decision making is understanding the nature of rationality and maximising behaviour.

●  Economists have traditionally assumed that individuals wish to maximise utility.

●  Utility can be thought of as satisfaction, pleasure or fulfilment of need.

●  It is important to distinguish between total utility and marginal utility.

●  The hypothesis (or ‘law’) of diminishing marginal utility lies behind the derivation of an individual’s demand curve.

●  Utility cannot be measured directly.

2.2 Imperfect information

The importance of information for decision making

So far in this chapter, we have assumed that consumers possess perfect information: for example, about the goods that are available to buy, their prices and quality, and about the utility which will be derived from their consumption. Traditional economic theory assumes that if individuals possess perfect information, they will make decisions that maximise their welfare. However, when attempting to maximise total utility, more often than not consumers possess imperfect information. As a result, they make ‘wrong’ decisions.

A student may spend £100 on a ticket for a rock concert, believing in advance that she will thoroughly enjoy the entertainment. However, she may come out of the stadium in which the event was held believing that she had wasted her hard-earned money and would be far better off if she had spent the £100 on other goods, such as a meal in an expensive restaurant. This is an example of a ‘wrong’ choice, but it was also a rational choice because she believed in advance that the concert would be good.

In Chapter 8, section 8.5, we will study how consumers may choose to under-consume a merit good such as education and over-consume a demerit good such as tobacco because they possess imperfect information about the long-term consequences of their choices. We will investigate the contribution of behavioural economics in the next section of this chapter.

SYNOPTIC LINK

In Chapter 8 we analyse merit goods and demerit goods by examining the information failures that households experience when deciding how much to consume of a merit good such as education, or a demerit good such as tobacco.

The significance of asymmetric information

Sometimes, one party to a market transaction, either the buyer or the seller, suffers from imperfect information about the nature of the transaction. Asymmetric information arises when either the buyer or the seller involved in a potential transaction knows something that is not observable to the other party. One of the ways in which asymmetric information can manifest itself is through the process known as adverse selection, which is a feature of many market transactions. For example, in the sale and purchase of a second-hand computer, the seller of the good knows more about the computer’s defects than a potential purchaser. However, to avoid paying too high a price for an inferior product which has lots of defects, potential purchasers often offer low prices on all second-hand computers, regardless of the fact that some of the computers are good.

KEY TERM

asymmetric information when one party to a market transaction possesses less information relevant to the exchange than the other.

The problem of asymmetric information possessed by buyers and sellers is described in a classic article by George Akerlof on the market for ‘lemons’ — a ‘lemon’ being American slang for a poor-quality second-hand car.

TEST YOURSELF 2.4

Why does asymmetric information give a salesperson an advantage in the market for used cars or in the market for private pensions?

APPLICATION OF ECONOMICS IN THE REAL WORLD 2.2

The market for ‘lemons’

In 2001 George Akerlof was awarded the Nobel prize in economics, largely in response to a 13-page academic paper he published in 1970 titled ‘The market for lemons’. Back in 1970, Akerlof found it difficult to get his paper published. Two leading academic journals rejected it on the grounds that asymmetric information in the market for second-hand cars was too trivial an economic issue. However, by 2001 things had changed.

On receiving his Nobel prize, Akerlof said:

‘Lemons’ deals with a problem as old as markets themselves. It concerns how horse traders respond to the natural question: ‘if he wants to sell that horse, do I really want to buy it?’ Such questioning is fundamental to the market for horses and used cars, but it is also at least minimally present in many market transactions.

Here is an extract from what Akerlof wrote in his 1970 paper:

From time to time one hears either mention of or surprise at the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a ‘new’ car.

We offer a different explanation. Suppose that there are just four kinds of cars. There are new cars and used cars. There are good cars and bad cars (which in America are known as ‘lemons’). A new car may be a good car or a ‘lemon’, and of course the same is true of used cars.

The individuals in this market buy a new automobile without knowing whether the car they buy will be good or a ‘lemon’. After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine.

An asymmetry of information has developed: for the sellers have more knowledge about the quality of a car than the buyers. But good and bad used cars must still sell at the same price, since it is impossible for a buyer to tell the difference between a good and a bad car.

It is apparent that a used car cannot have the same valuation as a new car — if it did, it would clearly be advantageous to trade a lemon at the price of a new car, at a high probability of the new car being a good car. Most used cars traded will be ‘lemons’, and good used cars may not be traded at all. The ‘bad cars tend to drive out the good (in much the same way that bad money drives out the good)’.

Follow-up questions

1  Define the term ‘asymmetric information’.

2  Explain why a buyer with a good knowledge of car mechanics has an advantage in the market for second-hand cars.

3  Explain, using examples other than cars, which markets are most affected by the problem of asymmetric information.

4  Discuss to what extent you believe that, if the price of a good is too good to be true, you are buying a ‘lemon’ rather than taking advantage of an opportunity.

SECTION 2.2 SUMMARY

●  Traditional economic theory assumes individuals will make rational choices.

●  In reality, individuals have to make decisions based on imperfect information, which makes them prone to making a ‘wrong decision’.

●  In real-world markets, the problem of asymmetric information arises when either the buyer or the seller knows something not observable to the other party.

2.3 Aspects of behavioural economic theory

Emergence of behavioural economics

Behavioural economics is a field of study that has attracted a great deal of attention since the beginning of the twenty-first century. Most of the research in the field has come from universities in the USA, but in recent years UK university economics departments have been offering courses in the subject. Behavioural economics is built on the insights of psychologists seeking to understand human behaviour and decision making. In 2008, economist Richard Thaler and legal scholar Cass Sunstein published Nudge: Improving Decisions about Health, Wealth and Happiness, which is a highly accessible overview of behavioural economics. In 2010, the UK government set up the Behavioural Insights Team (BIT), which was initially based in the Cabinet Office in Downing Street. The creation of the BIT, and of a similar body advising the then US president, Barack Obama, marked the growing influence that behavioural economics was having on government policy-makers.

KEY TERM

behavioural economics a method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions.

On its website, the BIT writes:

We coined the term ‘behavioural insights’ in 2010 to help bring together ideas from a range of inter-related academic disciplines (behavioural economics, psychology, and social anthropology). These fields seek to understand how individuals take decisions in practice and how they are likely to respond to options. Their insights enable us to design policies or interventions that can encourage, support and enable people to make better choices for themselves and society.

The BIT’s website is worth reading to find out about projects that the team runs in government. You might also access a BIT publication, Better Choices: Better Deals, otherwise known as the UK government’s consumer empowerment strategy, which recommends how government policy can attempt to influence consumer behaviour. It can be found at www.gov.uk/government/publications/better-choices-better-deals-behavioural-insights-team-paper.

STUDY TIP

Try to read Thaler and Sunstein’s Nudge: Improving Decisions about Health, Wealth and Happiness, and also some of the Behavioural Insight Team’s publications, which can be accessed on the internet. Both will give you a deeper understanding of how behavioural economics can help to encourage choices intended to increase the overall welfare of society. This will help you to address questions about how governments could correct instances of market failure — for example, presenting meal options in school canteens in ways which promote healthier choices.

TEST YOURSELF 2.5

Which one of the following statements is true about how the use of the internet affects consumer behaviour?

A  It facilitates the use of price comparison websites.

B  It stops consumers comparing prices in stores.

C  It always adds to consumer confusion.

D  It eliminates the need for consumer choice.

Explain your answer.

EXTENSION MATERIAL

Squaring the circle between traditional and behavioural economic theory

In his excellent book Predictably Irrational, Dan Ariely stated that traditional economics is about creating a theory and using it to explain actual behaviour, whereas behavioural economics is about observing actual behaviour and then coming up with a theory.

Traditional theories are often attacked by behavioural economists on the grounds that the simplifying assumptions on which the theories are built are unrealistic. In particular, in the context of what traditional economists call the ‘theory of the firm’, behavioural economists query the ‘profit-maximising assumption’. This is the assumption that entrepreneurs make business decisions solely on the basis of whether the decisions will lead to larger profits.

However, in the essay, ‘The methodology of positive economics’, published in 1953, the free-market economist Milton Friedman defended the traditional approach. Friedman wrote: ‘Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions.’

Friedman rejected testing a theory solely on the realism of its assumptions. He agreed that assumptions such as utility maximisation and profit maximisation are unrealistic. Friedman argued that a theory should be tested and then accepted or rejected on the basis of the validity and fruitfulness of its predictions. If unrealistic assumptions led to wrong conclusions, he would have argued that the theory should be rejected or modified. But if assumptions are unrealistic because of the need to abstract from a complex reality, but still lead to sound predictions which survive scientific testing, they can be justified. In summary, if members of households act ‘as if’ they are utility maximisers and likewise the entrepreneurs who run firms act ‘as if’ they are profit maximisers, the predictive power of traditional theories can still be good.

In the traditional theory of the firm, entrepreneurs are assumed to produce and sell output up to the point at which marginal revenue equals marginal cost, yet real-world business people seldom make such decisions when running their businesses. Friedman argued that this does not matter. If Friedman had lived to the present day (he died at the age of 94 in 2006), he might be using similar reasoning to defend traditional economic theory from the attacks of behavioural economists.

SYNOPTIC LINK

The traditional theory of production, known as the theory of the firm, assumes that rational producers always seek to maximise profit as their reward for taking a risk in starting a business. The traditional theory of the firm and profit maximisation are explained in depth in Chapters 4 and 5.

STUDY TIP

Make sure you understand the key differences between traditional economic theory and behavioural economics. Each of these makes important assumptions about how individuals and firms behave. Note too, however, that each set of theories can complement the other. This is an important consideration when tackling questions that ask about the ‘best’ methods of tackling economic problems. A good approach is to explain how more mainstream policies may be augmented by those which take into account an appreciation of behavioural economics.

APPLICATION OF ECONOMICS IN THE REAL WORLD 2.3

In the April 2010 edition of the Economic Review, published by Philip Allan for Hodder Education, David Gill presented an overview of interesting developments in behavioural economics. This case study summarises the introduction of David Gill’s article.

Beyond Homo economicus

Economists like to simplify the world; in particular they like to simplify people. Most of twentieth-century economics makes a number of standard assumptions about how people behave, which comprise our view of Homo economicus or ‘economic man’. Homo economicus is self-interested: he only cares about himself. He knows the consequences of everything he does. He is rational: he knows what he wants and always acts on these preferences.

This simple model has proved to be exceptionally useful in gaining insights into economic behaviour, especially when consumers and firms interact in large markets. However, the new science of behavioural economics seeks to move beyond Homo economicus to a more realistic representation of how people choose and behave. It does so in a number of ways.

First, data collected by economists show a number of so-called ‘anomalies’ — that is, behaviour which deviates in a consistent manner from that predicted by the model of Homo economicus. For example, people appear to be altruistic: they tend to put at least some weight on the well-being of others. Another point is that we are generally impatient and lack self-control. Most of us find it difficult to resist immediate temptation, whether it be a chocolate bar or an extra hour in bed. Finally, we dislike change. The so-called ‘status quo bias’ means that we generally like to stick with what we have, unless the incentive to change course is compelling.

Second, research from the field of cognitive psychology paints a picture at odds with that of Homo economicus. This research shows that humans often make decisions using simple rules-of-thumb — called heuristics — and suffer from many biases when choosing what to do, such as over-confidence, confirmation bias (the tendency to search for, and put greater weight on, information that confirms one’s preconceptions) and recency bias (the tendency to weight recent information and experience more heavily than older information and earlier experiences). Also psychological findings emphasise the fundamental role of emotions in decision making, including, for example, anger, regret, guilt, shame and disappointment.

Third, humans clearly face quite substantial limitations of computation and reasoning. These are particularly important when the environment is complex: for example, when people are interacting strategically, my best action will depend on what others choose to do. In production, firms in markets known as oligopolies, when deciding what price to set, will have to start thinking about what their competitors are going to do.

Follow-up questions

1  How does ‘economic man’ make decisions?

2  Define the term ‘altruism’.

3  Is it rational for an individual to give money to charity or to donate blood?

4  To what extent is the UK mortgage market a complex market?

SYNOPTIC LINK

Oligopolistic pricing behaviour is explained in Chapter 5, pages 145–50. This gives several explanations of how firms in concentrated markets pursue an optimal strategy to reduce uncertainty.

Bounded rationality

So far in this chapter, we have assumed that when exercising choice, individuals are perfectly rational, in the sense that they make decisions in a context of being fully informed, with perfect logic and aiming to achieve the maximum possible economic gain. However, in real life, individuals are seldom if ever perfectly rational.

In the world in which we live, decisions are made in conditions of bounded rationality, which means that individuals, however clever they are, make decisions subject to three unavoidable constraints: imperfect information about possible alternatives and their consequences; limited mental processing ability; and a time constraint which limits the time available for making decisions. In complex choice situations, bounded rationality often results in satisficing rather than maximising choices. Satisficing means accepting outcomes which are sub-optimal, or second-best.

KEY TERM

bounded rationality when making decisions, individuals’ rationality is limited by the information they have, the limitations of their minds, and the finite amount of time available in which to make decisions.

SYNOPTIC LINK

The difference between firms profit satisficing and maximising is explained in Chapter 5, pages 127–29. In practice, although firms may wish to maximise their profits, there may be several reasons why they are unable to. Therefore, they may settle for a sub-optimal, satisficing level of profit.

Bounded self-control

Bounded rationality is closely linked to the related concept of bounded self-control. Traditional economic theory implicitly assumes that when making choices, individuals have complete self-control. Behavioural economists, by contrast, believe that some individuals have bounded (or limited) self-control. Such people may set out with good intentions to act rationally, but find themselves slipping into less rational behaviour as more appealing alternatives are encountered. For example, a healthy-eating regime may give way to fast food after a few days.

KEY TERM

bounded self-control where individuals have limited self-control to act rationally in their own interests.

Thinking fast and thinking slow

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

The second, which Kahneman called System 2, is ‘thinking slow’. In this method of thinking, which is also known as reflective thinking, concentration and mental effort are required to work through a problem before a decision can be made.

For example, when learning a new skill such as skateboarding, an individual will ‘think slow’ when practising the appropriate skill. Because the decision making is relatively slow, involving careful, logical thought about every decision, the process can be tiring. However, the more often the skills are practised, the less skateboarders have to think about minor decisions. Automatic thinking takes over. Skateboarding experts often act quickly and instinctively. Through years of repetitive training, their automatic systems have learnt to respond to situations promptly and effectively. In high-pressure situations they can, of course, suffer if they stop to think. When this happens, they switch back to System 2 or the reflective system, over-thinking the situation, which can mean that bad decisions have disastrous consequences.

Many of our everyday economic decisions are taken by our automatic system. Buying a coffee at a train station, buying groceries in a supermarket and buying a sandwich from a snack bar will often be quick, intuitive decisions. Bigger and more important decisions tend to be taken by our reflective system. Deciding whether to buy a car or a house, and choosing an insurance policy, will normally result from reflective decisions.

Biases in decision making

Behavioural economics argues that quick decisions that people make when exercising choice (automatic thinking) are often heavily biased. This is because decisions are made on the basis of one’s own likes, dislikes and past experiences. Psychologists use the term cognitive bias to describe this situation. A cognitive bias is a mistake in reasoning or other thought process, often occurring as a result of holding onto one’s preferences and beliefs regardless of contrary information. Many kinds of cognitive bias exist, such as confirmation bias, which is the tendency to seek only information that matches what one already believes.

KEY TERM

cognitive bias a systematic error in thinking that affects the decisions and judgements that people make.

Rules of thumb

Rules of thumb are thinking shortcuts used by humans to help them make sensible decisions based on limited information, but the decisions are prone to cognitive bias. The two common rules of thumb that lead to biases are availability and anchoring.

KEY TERM

rules of thumb thinking shortcuts, or informed guesses, that individuals use to make decisions in order to save time and effort.

The availability bias

The availability bias occurs when individuals place too much weight on the probability of an event happening because they can recall vivid examples of similar events. For example, after reading several news reports about car thefts, an individual may judge that vehicle theft is much more common than it really is in the local area.

KEY TERM

availability bias occurs when individuals make judgements about the likelihood of future events according to how easy it is to recall examples of similar events.

The availability bias often leads to decisions that are not based on logical reasoning. The media report stories that stick in our mind and affect our reasoning process. Humans often believe that the probability of an extreme weather event, such as a hurricane or severe flooding, is more likely than empirical statistical analysis bears out. The market research company Ipsos has 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, many citizens believed that 24% of the population were immigrants when the real figure was 13% and, likewise, that 24% of the working age population was unemployed when in fact at the time of the research it was less than 7%.

Anchoring

Anchoring is an example of a predictable bias in individual decision making. Most people have a tendency to compare and contrast only a limited set of items. This is called the anchoring effect. A good example is provided by restaurant menus, which sometimes feature very expensive main courses, while also including more (apparently) reasonably priced alternatives. We are lured into choosing the cheaper items, even though their prices are still quite high. When given a choice, we often tend to pick the middle option, believing it is not too expensive, but also not too cheap.

KEY TERM

anchoring a cognitive bias describing the human tendency when making decisions to rely too heavily on the first piece of information offered (the so-called ‘anchor’). Individuals use an initial piece of information when making subsequent judgements.

Biases based on social norms

Human beings are social animals and as a result the behaviour of other people influences our own behaviour. By unconsciously learning from the behaviour of other people, social norms are established.

KEY TERM

social norms forms or patterns of behaviour considered acceptable by a society or group within that society.

TEST YOURSELF 2.6

Explain how individuals use ‘rules of thumb’ when making decisions.

Negative social norms include attitudes towards drinking alcohol. Many young 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 don’t engage in regular heavy drinking, behavioural economists would seek to nudge young drinkers into different patterns of behaviour.

Positive social norms can be seen in the way in which social attitudes have altered towards smoking in the last 30 years. In the 1980s it was socially acceptable to smoke in all public places including libraries, trains and the London Underground. Concerted health campaigns, which provided the general public with better information about the risks of smoking, have altered social attitudes. As a result, people became much more willing to accept laws which restricted their right to smoke. The laws banning smoking in public places are economic sanctions (used by government policy-makers) and not nudges. Economic sanctions include restrictions imposed by regulations and/or laws that restrict an individual’s freedom to behave in certain ways. Breaking a sanction can lead to punishment.

KEY TERM

nudges factors which encourage people to think and act in particular ways. Nudges try to shift group and individual behaviour in ways which comply with desirable social norms.

Critics of behavioural economics point out that sanctions, such as the smoking ban, may be more effective at changing behaviour and improving public health than nudges, which only alter the behaviour of some people. Nevertheless, government reports in Ireland claim that since smoking in public places was banned, people are also less likely to smoke in other people’s houses because it is now considered socially unacceptable.

TEST YOURSELF 2.7

Explain how a social norm can lead to less litter and chewing gum being dropped on a street.

The economist Esther Duflo has won a Nobel prize for, among other things, her work on using social aspects of behavioural economics to help reduce poverty and improve economic development. One example, from 2003, involved reducing teacher absenteeism in India by encouraging teachers in 120 schools to have their photograph taken with their students each day in order to reinforce the bond between teacher and learner.

French-American economist Esther Duflo has used behavioural economics to improve economic development in India

TEST YOURSELF 2.8

Which one of the following provides the best definition of norms?

Norms are:

A  laws that attempt to discourage excessive consumption

B  informal rules that govern human behaviour

C  formal rules that govern human behaviour

D  formal rules about how to buy goods and services

Explain your answer.

SYNOPTIC LINK

Nudges are a good example of how policies that take behavioural economics into account can complement ‘traditional’ policies, such as indirect taxation, to correct market failures. See Chapter 8 for a discussion of nudges in relation to environmental market failures.

Altruism and fairness

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

KEY TERM

altruism concern for the welfare of others.

Altruistic behaviour often results from people’s perceptions of fairness. Fairness is a normative term incorporating value judgements, as different people have a range of different views on the meaning of fairness. A popular view is that fairness involves treating people equally or in a way that is right or reasonable.

KEY TERM

fairness the quality of being impartial, just, or free of favouritism. It can mean treating people equally, sharing with others, giving others respect and time, and not taking advantage of them.

SYNOPTIC LINK

Go back to Chapter 1 to remind yourself of the meaning of normative statements. The notion of fairness is a normative issue because different societies will have a range of opinions about, for example, what degree of inequality is fair.

SECTION 2.3 SUMMARY

●  In recent years, behavioural economics has emerged to question many of the assumptions of traditional economic theory.

●  Behavioural economists believe that individuals in the real world have bounded rationality.

●  An individual’s economic decision making may be biased.

●  Humans use rules of thumb to help them make decisions based on limited information.

●  The two most common rules of thumb that lead to bias are availability and anchoring.

●  Social norms can lead people into positive and negative behaviour.

●  People are often altruistic and instinctively cooperate rather than compete.

●  Most individuals believe in fairness and are concerned with the welfare of others.

2.4 Behavioural economics and economic policy

As we mentioned at the beginning of section 2.3, UK and US governments have recently been introducing the insights of behavioural economics into practical policy making. In assessing the impact of behavioural economics on government economic policy making, you need to consider how it might influence the design 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 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.

As we have seen, behavioural economics argues that individuals are not fully rational in the way traditional economic theory assumes. As a result, they regularly suffer from behavioural biases that make it difficult for them to achieve the results they actually prefer. In this situation, government intervention should aim at helping individuals to achieve an outcome that is in their own best interest.

Choice architecture and framing

Choice architecture

Choice architecture is the term used by behavioural economists to describe how government policy-makers can guide people into making better choices. Government can use behavioural insights to design choice architectures so that citizens are nudged to opt for choices that are deemed to be in their best interest, so as to achieve a socially desirable outcome. For example, the layout and design of a canteen affects the menu choices of some individuals when purchasing a meal. Behavioural studies have found that when fruit and salads are placed at the front of a canteen more are bought than when they are placed on the back counters. Consumers are free to choose their meals but the choice architecture nudges individuals into buying healthier food.

KEY TERM

choice architecture a framework setting out different ways in which choices can be presented to consumers, and the impact of that presentation on consumer decision making.

TEST YOURSELF 2.9

Explain how well-designed choice architecture can help to solve the problem of imperfect information: for example, when designing the layout of a school canteen to encourage the eating of healthier foods.

SYNOPTIC LINK

You can find details of automatic pension enrolment in Chapter 7, page 221. This is a good example of how governments have used choice architecture to encourage individuals to make desirable choices about saving for the future.

Default choice

The default choice is a key aspect of choice architecture in which one option is automatically selected unless an alternative is specified. For example, when framing policy on the issue of organ donation, individuals who might donate body organs such as hearts or livers in the event of their death can be asked whether to ‘opt in’ or ‘opt out’ of organ donation. In this context, an ‘opt-in’ default choice is illustrated by the use of a tick box which, if filled in by a member of the general public, indicates positively that they would like to donate their body organs after their death. Unless the user ticks the box, however, healthcare organisations cannot make use of their organs. This is in contrast with an ‘opt-out’, where the default position is that the organs can be used to help others survive unless a box has been ticked to indicate that the body parts should not be used. England adopted an opt-out system in 2020. Countries that require people to opt out of organ donations generally have a much higher proportion of the population registered to donate than countries that ask people to opt in. For a behavioural economist, the benefits of opt-out over opt-in are clear: the supply of donated organs rises to be closer to the demand for them and the nation’s public health improves.

KEY TERM

default choice an option that is selected automatically unless an alternative is specified.

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

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

Framing

People are influenced by how information is presented. Framing is the tendency for people to be influenced by the context in which the choice is presented when making a decision. Advertisers have for many years presented consumers with choices in a manner that frames their products in a favourable light. Consider the label on a food product that reads: ‘90% fat-free’. Would it sell as well if the label read: ‘10% fat’?

KEY TERM

framing how something is presented (the ‘frame’) influences the choices people make.

Politicians often frame (or spin) economic statements in a manner that is favourable to the argument they are trying to make. For example, in the run-up to the EU Referendum in 2016, often referred to as ‘Brexit’, politicians supporting the Vote Leave campaign presented certain statistics in ways which made it appear the UK was significantly disadvantaged by its membership of the European Union. One of these was that the UK sends £350 million per week to the EU, which could have been spent on the NHS. Critics pointed out that this figure failed to take into account the substantial financial support the UK received from the EU for regional aid and agriculture.

Vote Leave’s campaign bus makes a hotly contested claim

Mandated choices

A variant of default choice is mandated choice. This is where people are required, often by law, to make a decision. A mandated or required choice occurs when a choice architect designs a system that forces individuals to make an explicit decision and not merely go ahead with a default position.

KEY TERM

mandated choice people are required, often by law, to make a decision.

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

Restricted choice

Restricted choice means offering people a limited number of options, on the basis that offering too many choices is unhelpful and leads to poor decisions. Most people cannot, or cannot be bothered to, evaluate a large number of choices. The policy of requiring the energy companies to simplify their pricing structures and restrict the number of options offered to consumers is an example of ‘restricted choice’ in action.

KEY TERM

restricted choice offering people a limited number of options so that they are not overwhelmed by the complexity of the situation. If there are too many choices, people may make a poorly thought-out decision or not make any decision.

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 emails to remind people to complete requests. Evidence from the BIT shows that personalised letters increase response rates, while asking respondents to sign forms at the top of the page and not the bottom results in more honest answers.

Revisiting nudge theory

As explained earlier, a nudge tries to alter people’s behaviour in a predictable way without forbidding any options or significantly changing economic incentives. A nudge is not a legal requirement. Neither is it an economic sanction. Fines, taxes and subsidies are not nudges.

When used as a part of government policy, nudges must be open and transparent to the general public. Governments should be honest with the public and ensure that they explain why they have introduced a nudge, but still allow individuals to make a choice.

Nudges versus shoves

‘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 by responding to financial incentives and disincentives that reward or punish different decisions (see Table 2.4).

Government policies based on traditional economic theories have generally sought to shove people into altering their behaviour rather than to nudge them in the desired direction.

TEST YOURSELF 2.10

To what extent are fines and penalty points the most effective way of reducing the speed of motorists on the roads?

Table 2.4 Nudges versus shoves

Nudge

Shove

●  Provides information for people to respond to.

●  Creates positive social norms.

●  Opt-out schemes rather than opt-in schemes and default choices.

●  Active choosing by individuals.

●  Uses taxation and subsidies to alter incentives and on occasion, in the case of taxes, to punish people.

●  Uses fines, laws banning activities and regulations.

SYNOPTIC LINK

When studying the conditions of demand and supply in Chapter 3, and the problem of merit and demerit goods in Chapter 8, consider how ‘nudge’ policies could be more effective than the traditional ‘shove’ policies of taxation and subsidy.

APPLICATION OF ECONOMICS IN THE REAL WORLD 2.4

This case study has been extracted from a paper published by the UK cabinet’s Behaviour Insights Team (BIT), published in 2013.

Applying behavioural insights to charitable giving

This paper explores new and innovative ways of increasing charitable giving. It recognises the important indirect benefits of charitable giving that recent behavioural research has begun to explore. This research shows that giving both time and money has large benefits for the well-being of the giver as well as the receiver.

Experiments have shown, for example, that individuals are happier when given the opportunity to spend money on others. Similarly, volunteering is associated with increased life satisfaction — not only among volunteers, but also in the wider community. Charitable giving is good for donors, for beneficiaries, and for society at large.

Four behavioural insights

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

●  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 schemes (with a clear option to decline)

●  using prompted choice to encourage people to become charitable donors.

Insight 2 is to ‘attract attention’. Making charitable giving more attractive to an individual can be a powerful way of increasing donations. This can include:

●  attracting individuals’ attention, for example by using personalised messages

●  rewarding the behaviour you seek to encourage, for example through matched funding schemes

●  encouraging reciprocity with small gifts.

Insight 3 is to ‘focus on the social’. We are all influenced by the actions of those around us, which means we are more likely to give to charity if we 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:

●  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.

3  Why is December a better month than January to ask for charitable donations?

4  To what extent can a positive social norm affect the willingness of an individual making a charitable donation?

SECTION 2.4 SUMMARY

●  Nudge theory, choice architecture and framing lie at the heart of the ways in which behavioural architecture can influence economic policy making.

●  Well-designed choice architecture can guide individuals towards making better decisions.

●  Governments can improve social welfare by designing government programmes that select a default choice which is seen to be in an individual’s best long-term interest.

●  Decision making can be influenced when framed in a context.

●  Nudge policies seek to lead individuals into making decisions whereas shove policies instruct using the power of the law.

Questions

1  Explain the hypothesis (or law) of diminishing marginal utility.

2  How does traditional economic theory seek to influence individual decision making?

3  Explain how, in traditional economic theory, a rational individual can make a ‘wrong’ decision.

4  Explain why rational individuals may make satisficing rather than maximising choices.

5  Is it irrational to give money to charity? Discuss.

6  Explain, using examples, how government officials can use framing techniques to make policies more effective.

7  How can governments intervene in markets to help individuals make better choices?