Economics 114
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living standards that many countries saw since the 1700s.
Standard of living is typically measured by GDP per capita. GDP per capita is simply
calculated as –
GDP per capita =
GDP for the year
Country s population
Gross domestic product (GDP): the total value of everything produced in a given
period, typically a year. Also referred to as gross domestic income.
When one looks at the trends that GDP per capita has followed over the past
millennium. Economists often describe it as a country’s “hockey stick”, due to the
shape that the GDP per capita trend has followed, as illustrated by the figure below.
From this figure above, it is thus clear that living standards did not grow in any
sustained way, for a very long time. When sustained growth eventually occurred in
countries differ drastically, describes vast differences in living standards in different
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n.
The emergence of capitalism was brought forth by the increases in average
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global spread of a way of organising an economy, which we call capitalism.
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The capitalist revolution: the emergence in the eighteenth century and the eventual
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UNIT 1: THE CAPITALIST REVOLUTION
countries. For some countries, this growth did not occur until they gained
independence from colonial rule or interference by European nations.

The emergence of capitalism led to advances in technology and product
specialisation in products and tasks, which effectively raised daily productivity
figures.
1.1 Income inequality
A thousand years ago, income inequality looked a lot different. It was much “flatter”
than it is currently, as income inequality was not as pronounced. There were
differences in income between the different regions of the world; the differences were
small compared to what we have now.
Economists can say the following two things with certainty –

In every country, the rich have much more than the poor.
A handy measure of inequality in a country is called the 90/10 ratio, which we define
as the average income of the richest 10% divided by the average income of the poorest
10%. More commonly it is also defined as the income of the 90th percentile divided by
that of the 10th percentile.

There is a huge difference in income between countries.
Income distribution is often illustrated as the figure below.
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The countries that took off economically before 1900 are now rich. They, and countries
Once measure of living standards is GDP per capita, as identified above. When using
this measure, one limitation jumps out immediately – to add up the millions of services
and products in a country, economists need to find some measure of how much each
product and service is worth compared to one another. Furthermore, economists must
also decide which products and services should be included in the GDP calculation,
but also how to give a value to each of these things. In practice, the easiest way to do
this is by using their prices. When we do this, the value of GDP corresponds to the
total income of everyone in the country. Which explains why GDP is sometimes
referred to as gross domestic income, as well. The question remains, however, is GDP
per capita the right way to measure living standards, or wellbeing?
Disposable income
Disposable income: an individual’s income (from all sources) received over a given
period, minus any transfers the individual made to others, including taxes paid to the
government.

Disposable income is considered a good measure of living standard, because
it represents the maximum number of products and services a person can
afford without having to borrow—that is, without going into debt or selling
possessions.
Is disposable income a good measure of our wellbeing?
An individual’s income majorly influences wellbeing, because it allows them to buy
goods and services that they need or enjoy. It is, however, an insufficient measure,
because there are aspects of wellbeing that cannot be bought. For example,
disposable income leaves out:

The quality of an individual’s social and physical environment.

The amount of leisure time.

Goods and services that are provided by the government.
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n.
1.2 Measuring income and living standards
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“flatlands” (the lowest columns on the left).
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income distribution. The countries that took off only recently, or not at all, are in the
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like them, are now in the “skyscraper” (the highest columns on the right) part of an
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Goods and services produced within a household, e.g. meals or childcare.
Average disposable income and average wellbeing
The question remains whether average disposable income a good measure of how
well off a specific group is? When considering wellbeing, absolute income matters.
Absolute income: the Rand value that an individual earns, e.g. R3 000.
Research has also shown, however, that individuals care about their relative position
in the general income distribution. Individuals report lower wellbeing if they discover
they earn less than others in their group.
The same average income may result from very different distribution of income
between rich and poor individuals within a group. Accordingly, average income may
fail to reflect how well off a group of individuals are by comparison to another group.
Valuing government goods and services
GDP includes goods and services produced and provided by the government, such as
law enforcement. These services do contribute to the wellbeing of an individual, but it
is not included in disposable income, but it is included in GDP per capita. Therefore,
GDP per capita is a better measure of living standards than disposable income. The
problem is that government products and services are difficult to value. Typically, we
take the prices of goods and services as a rough measure of their value. Seeing as
the goods and services produced by government are typically not sold, the only
measure of their value is how much it costs to produce.
The gaps between what wellbeing means and what GDP per capita measures,
economists should be cautious about the use of GDP per capita to measure how welloff people are. One thing is for sure – GDP per capita is undoubtedly telling us
something about the differences in the availability of goods and services.
Calculation of GDP
When estimating the market value of output in the economy for a given period,
statisticians use the prices at which goods and services are sold in the market.
Nominal GDP is therefore calculated by multiplying the quantities of different goods
and services by their prices. Nominal GDP is therefore given as:
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nominal GDP =
is the quantity of good .
GDP is also called the GDP at constant prices.
Constant prices: the price of a good or service corrected increases and decreased
in prices, enabling a unit of currency to represent the buying power in different periods.
The real GDP considers price changes over time in order to determine whether the
quantity of products and services increased or decreased. It is not possible to measure
real GDP directly. Instead, real GDP is calculated as a derivation of nominal GDP, as
defined above. To determine the real GDP, the first step is selecting a base year, e.g.
2010. The simplistic version of Real GDP is the quantity in the current year, e.g. 2011,
multiplied by the price of that product in the base year (2010). Keeping prices constant
at the base year price, therefore gives an economist the opportunity to determine
whether the overall quantity of goods and services has changed.
Purchasing power parity
To compare information across different countries, it is important to choose a set of
prices and apply those prices to both countries in the comparison. When considering
the prices of different countries, economists typically estimate the GDP per capita
using a common set of prices, known as purchasing power parity (PPP).
Purchasing power parity (PPP): a statistical correction that allows for goods and
services to be compared in different countries that have different currencies, which
attempts to achieve equality in the real purchasing power of different currencies.
1.3 History’s hockey stick: Growth in income
A ratio scale is typically used for comparing growth rates, but it can also be used to
show how GDP per capita doubles over time. When a ratio scale is used, a series that
grows at a constant rate looks like a straight line. This is because the percentage (or
proportional growth rate) is constant. A steeper line in the ratio scale chart means a
faster growth rate. An example of a ratio scale can be seen below, which is an
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n.
of the quantity of goods and services purchased, which is called the real GDP. Real
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However, to gauge whether the economy is growing or shrinking, we need a measure
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is the price of good ,
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Where
adaptation of the first figure in the chapter, which showed levels of GDP per capita
over time.
The data points to the left of the figure is very scarce and far apart. This is because
less information about GDP per capita was available before the 1800s.
A growth rate can be calculated as:
growth rate =
−
Whether an economist wants to compare absolute levels or growth rates, depends on
the question that the economist attempts to answer.
1.4 The permanent technological revolution
It was not until the eighteenth century that each new generation could look forward to
a different life that was shaped by new technology. Remarkable scientific and
technological advances in history often occur at more or less the same time as the
upward kink in the “hockey stick” of countries in the middle of the eighteenth century.
Specifically, important new technologies were introduced in textiles, energy and
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transportation. The cumulative nature of these advancements led to the industrial
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revolution.
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industry, the following technological advancement(s) saw the true emergence of the
Industrial Revolution: the flying shuttle invented by John Kay in 1733, greatly increased
the quantity a weaver could produce in an hour. This led to an increased demand for
yarn to the point where it became difficult for spinsters to produce sufficient quantities
using the wheel technology. James Hargreaves then introduced the spinning jenny in
1764 as a proposed solution to the aforementioned problem.
industrial
revolution
brought
new
ideas,
discoveries,
methods,
technologies and machines, which make the existing standard obsolete. This
process repeats itself often as new ideas and tools are developed.
Technology: a process that takes a set of inputs to produce a specific output.
Based on the economic definition of technology, a recipe for baking cake can be
considered as technology necessary to produce a cake (the output). Alternatively, the
technology necessary to produce a cake can also be large-scale machinery,
ingredients and labour (machine operators).
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allowed the same output to be produced with less labour. Most notably, in the textiles
The
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The revolution started in Britain in the eighteenth century.
The Industrial Revolution saw an extraordinary flowering of radical inventions that
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industrialised countries.
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which changed agrarian and craft-based economies into commercial and
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Industrial revolution: a wave of technological advances and organisational changes
Prior to the Industrial Revolution, technology was updated very slowly.
The industrial revolution saw technological progress become much more frequent and
significant. This is often referred to as the start of the permanent technological
revolution, which saw how the time necessary to produce products reduced from
generation to generation. The permanent technological revolution associated with
capitalism allowed some countries to make a transition to sustained growth in living
standards. (Explained in more details in Unit 2).
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Technological improvements in other areas were equally dramatic, for example James
Watt’s steam engine in 1776. These engines were gradually improved over a long
period of time and were eventually used in industries across the economy. They are
an example of what is termed a general-purpose innovation.
General-purpose technologies: technological advances that can be applied to many
sectors, and spawn further innovations. Computers and electricity are two common
examples.
The permanent technological revolution has produced a connected world, which
everyone is part of. Being “connected” simply means that virtually the entire economy
can be sustained without individuals being physically together. They can still
collaborate and cooperate through the internet.
Technological progress: the change in technology that reduces the inputs required
to produce a set output.
Technological progress is a process that continues to this day. Accordingly, the
process of innovation has also not stopped at the end of the Industrial Revolution. In
a capitalist economy, innovation creates temporary rewards for the innovator, which
provide incentives for improvements in technology that reduce costs. These rewards
are destroyed by competition once the innovation diffuses throughout the economy.
(Explained in more details in Unit 2). Many new industries have seen the
implementation and application of new technologies These technological innovations
change the way that large parts of the economy work which allows for the growth in
living standards. These technological innovations also increase the amount of leisure
time, which increases living standards.
1.6 Capitalism defined: Private property, markets and firms
The capitalist revolution saw the emergence of a new economic system.
Economic system: the institutions that organises the production and distribution of
goods and services within an economy.
An economic system is made up of different institutions, as mentioned above.
Institutions: the laws and social customs that governs the way that individuals interact
with one another in a society.
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The economic system that emerged from the capitalist revolution was capitalism. This
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term has grown in large popularity over the past century.
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Capitalism: an economic system in which private property, markets and firms play an
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important role.
Capitalism saw the prominence of private property.
Private property: the right and expectation that one can enjoy one’s possessions in
ways of one’s own choosing, exclude others from their use, and dispose of them by
gift or sale to others who then become their owners. Also referred to as private
ownership.
Private property made it possible that individuals could enjoy possessions in any way
that they wanted. Furthermore, they could dispose of these possessions as they wish,
as they were the owners of the possessions. Individuals could also exclude others
from using the possession, if they so wished. Private property can be owned by an
individual, a family, a business, or some entity other than the government.
In some economies in the past, key economic institutions included private property,
markets and families, because goods were usually produced by families, rather than
by firms. In other societies, the government controls production, and decided on the
distribution of goods and services. This is called a centrally planned economic
system. Most economies today are capitalist.
Over the course of human history, the extent of private property has varied. In a
capitalist economy, an important type of private property is capital goods.
Capital goods: the equipment, buildings, and other durable inputs used in producing
goods and services. Raw materials, however, is not included under capital goods as
this is referred to as intermediate inputs.
The second important institution in a capitalist economy is markets.
Market: a way of connecting people who may mutually benefit by exchanging goods
and services through buying and selling.
Markets provide a means of transferring goods or services from one person to another,
but it excludes methods of transferring goods such as theft, gifting, or a government
order. Markets differ from these in three respects:
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1. They are reciprocated, i.e. one party receives a good or service and the other
party receives money, or a promise of a later payment, as in the case of credit.
2. They are voluntary, i.e. both parties need to opt in to partake in the process of
buying and selling.
3. Markets are competitive.
Private property and markets alone do not define capitalism. These important
institutions precede capitalism in many countries. The most recent of the three
components of a capitalist economy is the firm.
Firm: a way of organising production by directing employees to produce goods and
services by using sets of capital goods that are owned by one or more individuals
within the economy in exchange for wages and salaries. The produced goods and
services become the property of the firm, which then sells the goods and services on
markets to generate a profit.
Firms that make up a capitalist economy virtually include everything in the economy.
Certain productive organisations, such as family businesses, non-profit organizations,
employee-owned cooperatives, and government-owned entities are not classified as
firms, but they also play lesser roles in a capitalist economy. These organisations are
not classified as firms, because they do not make profits, or because the owners are
not private individuals who own the assets. Even if an organisation takes in unpaid
student interns, it is still classified as a firm.
Prior to firms being the predominant organisation that produces goods and services,
they still existed and played a lesser role than their current role. The current, expanded
role of firms, led to a boom in the labour market, which played a very limited role in the
past.
Labour market: a market that allows employers to offer wages to individuals who
agrees to work under the direction of the employer.

Employers are on the demand side of the labour market, because they require
individuals to perform work for them.
Demand side: the side of a market on which the participants offer money in return for
another good or service.
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
Employees are on the supply side of the labour market, because they are willing
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Supply side: the side of a market on which participants are offering a good or a
Defining capitalism precisely (economically)
Capitalism does not refer to a specific economic system, but rather to a class of
systems sharing specific characteristics. The way in which the institutions of capitalism
(private property, markets, and firms) combine with one another and with other
institutions, also differs greatly across countries.
Various debates exist about the “true” meaning of capitalism. It is, however, often not
the intention to develop a definitive definition of a word. The definition rather acts as a
device that makes it easier for individuals to communicate.
1.7 Capitalism as an economic system
The three parts of a capitalist economic system are all nested concepts. The figure
below illustrates this.
The figure above describes the different resultant systems as we add each of the
institutions of a capitalist economy. The left-hand circle describes an economy that
has private party, which is essentially an economy of isolated families who own their
capital goods and the goods they produce, but there is little to no exchange between
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n.
are successful, and they are typically protected from failure, if they perform poorly.
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A striking characteristic of firms is that they can quickly be born, expand, contract and
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service in return for money.
the families. In the middle, the economy has private property and markets, i.e. families
still produce goods and services, but they exchange these with one another now, using
markets. And finally, on the far right, we have a capitalist economy, where firms are
now the main producers of an economy, rather than family-based organisations.
The following statements explain the interplay that exists among the different
institutions of a capitalist economy:

Inputs and outputs of the production system is private property.

Firms buy inputs on markets, and they sell outputs on markets.
From the above, private property is an essential part of the operations of markets.
Furthermore, the private ownership of capital goods is also a distinctive hallmark of a
capitalist economic system.
Capitalist economies differ from earlier economies in the increased magnitude of
capital goods used in production. Capitalism combines centralisation with
decentralisation. It concentrates power in the hands of owners and managers who
then secures the cooperation of employees in production. It also limits the power of
owners and other individuals, due to the competition that they face to buy and sell in
the markets. It is exactly this combination of competition among firms, and the
concentration of power and cooperation within firms that account for capitalism’s
success as an economic system.
How could capitalism lead to growth in living standards?
The emergence of capitalism brought about two major changes. These changed led
to an enhancement in the production of individual workers within the organisation.
These changes are given below.
Technology
Firms did not cause technological change, but the competition among firms gave firms
strong incentives to adopt and develop new and more productive technologies, and to
invest in capital goods. These technological innovations also increase the amount of
leisure time, which increases living standards.
Specialization
The growth of firms’ number of employees, and the expansion of markets, allowed
specialisation in tasks and products that was historically unprecedented.
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1.8 The gains from specialisation
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Capitalism and specialization
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range of activities. This is true for the following reasons:
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Economies tend to become better at producing things when they focus on a limited

Learning by doing. Employees acquire skills as they produce things.

Difference in ability. Some countries are better at producing certain things due
to skills or natural factors, such as soil quality.

Economies of scale. Producing a large quantity of something is often more
cost-effective than producing smaller quantities.
Economies of scale: the doubling of all inputs of a production process, results in a
more than doubling of the production process’ output. Also known as increasing
returns to scale.
People do not typically produce the full range of goods and services that they use or
consume in their daily life, but instead they specialise in producing one good, while
others produce other goods. But individuals are only willing to specialise if they have
a way to acquire the other goods they need. For this reason, specialisation poses a
problem for society: how are goods and services to be distributed from the producer
to the final user? Capitalism has enhanced the opportunities for specialisation by
expanding and developing the economic importance of markets and firms, which
attempted to provide a solution to the question posed above.
The division of labour in firms
Adam Smith stated that the greatest improvement in the productive powers of labour
has been the effects of the division of labour.
Division of labour: the specialisation of producers to carry out different tasks in the
production process. Also known as specialisation.
Firms employ many individuals, most of which work on specialised tasks under the
direction of the owners/managers of the firm. A firm is also a means by which people,
each with distinct skills and capacities, contribute to a common outcome, the
product(s) or service(s) that the firm delivers. Accordingly, firms facilitate cooperation
among specialised producers (other firms) which in turn increases productivity.
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Markets, specialization, and comparative advantage
When markets are very small, there is no incentive to specialise. Markets allow
everyone to pursue private objectives, to work together in producing and distributing
goods and services in a way that is better than the available alternatives, i.e. markets
facilitate unintended cooperation on a global scale. When individuals differ in their
skills and ability to produce different goods, markets allow them to specialise. All
producers can benefit by specialising and accordingly trading, even if this means a
producer specialises in something that another producer could produce at lower cost.
When economists attempt to establish which producers should specialise in which
goods and/or services, they make use of two concepts: absolute advantage and
comparative advantage that is illustrated with the following example below.
Imagine a world with only two economies and only two goods. Economy A and
Economy B can either produce apples or wheat. They differ in how productive they
are in growing apples and wheat. The following table indicates the quantities of each
good each producer would be able to make, if they dedicated all their available time,
for example 2 000 hours per year, on the production of one good.
Production if all time was spent on one good
Apples
Wheat
Economy A
1 250 apples
50 tonnes of wheat
Economy B
1 000 apples
20 tonnes of wheat
Absolute advantage: when the inputs a producer/country uses to produce a good or
service is less than that of another producer/country.
In this example, the only input into the production process is time. Based on that,
Economy A has an absolute advantage in the production of apples and wheat, as
Economy A can produce more apples and wheat with the input of 2 000 hours per year
than Economy B can. On the flip side then, Economy B has an absolute
disadvantage in the production of apples and wheat.
When referring to the cost of production, it does not have to be stated in monetary
terms. Instead, one can also express the cost of production of one good or service in
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terms of another good or service, for example the cost of producing 1 apple is 0,5
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tonnes of wheat. This is used in calculating the comparative advantage.
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to
determine
comparative
advantage
n.
table
among
producers/countries.
Cost of an additional apple
Cost of an additional tonne of
wheat
50 tonnes of wheat
Economy A
1 250 apples
= 0,04 tonnes of wheat per apple
1 250 apples
50 tonnes of wheat
= 25 apples per tonnes of wheat
Economy B
20 tonnes of wheat
1 000 apples
= 0,02 tonnes of wheat per apple
1 000 apples
20 tonnes of wheat
= 50 apples per tonnes of wheat
Based on the table above, the following observations can be made –

Economy A has a comparative advantage in producing wheat, as an additional
tonne of wheat costs Economy A (25 apples), which is less than it costs
Economy B (50 apples).

Economy B has a comparative advantage in producing apples, as an additional
apple costs Economy B (0,02 tonnes of wheat), which is less than it costs
Economy A (0,04 tonnes of wheat).
Economies have two options for survival – being self-sufficient, i.e. produce both
goods that the economy needs to survive or specialising in the production of one good
and using markets to acquire the other good necessary for survival.
Economy A therefore chooses to use 40% of their time on apple production, and the
rest producing wheat. Economy B spends 30% of their time on apple production, and
the rest producing wheat. The economies can produce the following if they were to be
self-sufficient, i.e. they produce exactly what they need to consume.
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ut
following
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additional unit of the same good or service by another producer/country.
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good or service of a producer/country is lower relative to the cost of producing an
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Comparative advantage: when the cost of producing an additional unit of a specific
Apples
Wheat
Economy A
1 250 apples × 0,40
= 500 apples
50 tonnes of wheat × 0,60
= 30 tonnes of wheat
Economy B
1 000 apples × 0,30
= 300 apples
20 tonnes of wheat × 0,70
= 14 tonnes of wheat
800 apples
44 tonnes of wheat
Total
Suppose there are in fact (barter) markets where apples and wheat can be bought and
sold. 40 apples can be bought for 1 tonne of wheat. If both economies specialise
in the goods in which they have a comparative advantage, Economy A will specialise
in producing wheat, therefore only producing wheat, while Economy B will specialise
in producing apples. Economy A can produce 50 tonnes of wheat. Economy B can
produce 1 000 apples. This gives us the figures for the “production” row of each
economy as put out in the table on the following page.
When both economies specialise, the total production of both crops will be higher than
if it was under self-sufficiency, which means that both economies can sell their surplus
buy some of the good(s) that they cannot produce. Consider the situation in which
Economy A sells 15 tonnes of wheat (the transaction for wheat is indicated in the table
with blue figures) for 600 apples from Economy B (the transaction for apples is
indicated in the table with red figures). This gives us the figures for the “trade” row of
each economy as put out in the table on the following page.
The quantity of a specific good that an economy can consume, can be calculated as
the sum of the quantities of the good that the economy produces, as well as the
quantities of the good that the economy trades on global markets. This gives us the
figures for the “consumption” row of each economy as put out in the table on the
following page.
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600
35
Production
1 000
-
Trade
- 600
+ 15
Consumption
400
15
Consumption
1 000
50
Total
The opportunity to trade benefited both economies. This is because the economies
can produce more apples and wheat of the specialise than under self-sufficiency. One
strange thing to note from the table above – Economy A bought 600 apples even
though the economy could have produced those apples at a lower cost. The reason
why the outcome under specialisation is desirable is because it represents a situation
in which time is better spent for both economies. Markets therefore contribute to
increasing the productivity of labour by allowing producers to specialise in the
production of goods in which they have a comparative advantage!
1.9 Capitalism, causation and history’s hockey stick
The institutions associated with capitalism has the potential to make people better off,
through specialisation and the permanent technological revolution that coincided with
the emergence of capitalism. But can it be concluded that capitalism caused the
upward kink in the hockey stick?
Economists should be sceptical when anyone claims that something ‘causes’
something else, in this capitalism ‘caused’ the upward kink in the historical “hockey
stick”. In science, the statement “X causes Y” is supported by performing experiments
to gather evidence of the relationship among X and Y.
Causality: a direction from cause to effect, which establishes that a change in one
variable brings about a change in another. Correlation is simply an assessment that
two variables move together, but causation is a more restrictive concept that accounts
for the association among variables.
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n.
Economy B
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Consumption
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- 15
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+ 600
Trade
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Economy A
fo
50
ot
-
Production
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Wheat
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Apples
In economics, economists with to make causal statements to understand why things
happen, or to change things so that the economy can work better. This means making
a causal statement that policy X is likely to cause change Y. For example, “If the central
bank lowers the interest rate [policy X – monetary policy], more people will buy homes
and cars [variable Y – luxurious consumer expenditure].”
Unfortunately, an economy is too large to measure and understand all relationships,
and it is rarely possible to gather evidence by conducting experiments. So how can
economists do science? Consider the following real-world example of how economists
gather data.
It has been observed that the emergence of capitalism predated, or coincided with,
the Industrial Revolution and the upward kink in the historical “hockey stick”. This is
consistent with the hypothesis that capitalist institutions (in part) led to the era of
continuous productivity growth. The emergence of a free-thinking cultural environment
(also known as “The Enlightenment”) also predated or coincided with the upward kink
in the historical “hockey stick”. Economists typically tend to narrow the range of things
on which they disagree by using facts. A method for doing this is called a natural
experiment.
Natural experiment: an empirical study exploiting naturally occurring statistical
controls in which researchers do not have the ability to assign participants to treatment
and control groups, as is the case in conventional experiments. Instead, differences in
law, policy, weather, or other events can offer the opportunity to analyse populations
as if they had been part of an experiment. The validity of such studies depends on the
premise that the assignment of subjects to the naturally occurring treatment and
control groups can be plausibly argued to be random.
Because economists cannot change the past, even if it were practical to conduct
experiments on entire populations, economists still typically rely on natural
experiments.
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An English clergyman, Thomas Robert Malthus, believed that a sustained increase in
rs
Revolution, and why it started in Britain.
fo
Economic models help to explain certain phenomena, such as the Industrial
ot
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
Sh
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UNIT 2: TECHNOLOGY, POPULATION, AND GROWTH
income per capita would be impossible. He believed that, even if technology improved
and raised the productivity of labour, people would have more children as soon as they
were better off. This population growth would continue until living standards fell to
subsistence level, which will halt the population increase.
Subsistence level: the level of living standards (measured by consumption or
income) such that the population will not grow or decline.
Malthus’ vicious circle of poverty was widely accepted as inevitable. It is therefore clear
that a combination of population, the productivity of labour, and living standards may
interact to produce a vicious circle of economic stagnation, called the vicious circle of
poverty, as indicated by Malthus.
Malthus did not offer an optimistic vision of economic progress. Even if people
succeeded in improving technology, in the long run the vast majority would earn
enough from their jobs or their farms to keep them alive, and no more. This is more
commonly referred to as the Malthusian trap. The Industrial Revolution (as discussed
in Unit), however, sprung Britain from the Malthusian trap, and continue to do so for
many other countries in the century that followed.
One of the main reasons that the Industrial Revolution was sparked in Great Britain
was due to the large availability of coal and coal played a central role in the Industrial
Revolution. Furthermore, the advances in technology (as descried in Unit 1) and the
increased use of non-renewable resources raised productivity, allowing income to rise
even as the population was increasing, effectively breaking Malthus’ vicious cycle.
Productivity: the amount of something that a person could produce in a given amount
of time.
If technology continued improving quickly enough, it would be able to outpace the
population growth that resulted from the increased income. Living standards, in turn,
could then rise. Eventually, Malthus’ vicious cycle was naturally broken as many
preferred smaller families, even when they earned enough to afford larger families.
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Index of real wages
Index of real wages: a quantitative amount, relative to its value in a reference period
(“index”) of the money wage of a worker, adjusted for changes in prices over time
(“real”). The result represents the real buying power of the money the workers earned.
2.1 Economists, historians, and the Industrial Revolution
Why did the Industrial Revolution happen first in the eighteenth century in Great
Britain? Robert Allen, an economic historian, stated the following two factors drove
the structural changes of the Industrial Revolution:

the relatively high cost of labour

the low cost of local energy sources.
The Industrial Revolution was more than just the breaking of the Malthusian cycle,
rather it was a complex combination of inter-related intellectual, technological, social,
economic and moral changes. Historians and economists have wrestled with
explanations for why the Industrial Revolution started in Great Britain.

Historians tend to focus on peculiarities of time and place. They are more likely
to conclude that the Industrial Revolution happened because of a unique
combination of favourable circumstances. Often a historian’s argument is not
precise enough to make it testable by a model.

Economists are more likely to look for general mechanisms that can explain
success or failure across both time and space. Often an economist’s model is
too simple and ignores important historical facts.
Below are some of the main alternative theories for why the Industrial Revolution took
off in Great Britain.

Joel Mokyr (economist) believed that wages and energy prices merely directed
innovation, but Europe’s scientific revolution and its Enlightenment the century
was the real source of technological change. This is because the period brought
the development of new ways to transfer and transform scientific knowledge
into practical advice to be used to build the machines of that time.

David Landes (historian) emphasises the political and cultural characteristics
of nations. He suggests European countries pulled ahead of China because the
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Chinese state was too powerful and stifled innovation and they favoured
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Kenneth Pomeranz (historian) believed that Europe’s superior growth after the
1800s was due to the abundance of coal in Britain. He also argued that Britain’s
access to agricultural production in its New World colonies fed the expanding
class of industrial workers, which helped them to escape the Malthusian trap.
The European take-off was most likely the result of a combination of scientific,
demographic, political, geographic and military factors. Other scholars also believe
that the take-off was partly due to interactions between Europe and the rest of the
world, not just due to changes within Europe.
This will focus on the economic conditions that contributed to Britain’s take-off, but it
is important to note that each economy that did break out of the Malthus’ vicious cycle
took a different escape route and had their own set of economic conditions that
enabled them to do so. The national trajectories of early followers were largely
influenced by the dominant role that Britain had come to play in the world economy.
The Industrial Revolution did not lead to (equal) economic growth everywhere. The
slow spread of the Industrial Revolution also explains the increase in income inequality
between countries.
David Landes once asked: “Why are we so rich and they so poor?” By “we”, he meant
the rich societies of Europe and North America and by “they” he meant the poorer
societies of Africa, Asia and Latin America. Landes suggested that there were
basically two answers that explains why “we are so rich and they so poor”:

because we are so good and they are so bad, i.e. we are hardworking,
knowledgeable, educated, well governed, efficient, and productive, and they
are the reverse.
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n.

io
sociologist, Max Weber.
ut
as the home of virtues associated with the “spirit of capitalism", based on the
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Protestant countries of northern Europe, where the Industrial Revolution began,
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on to future generations. Clark’s argument follows a long tradition that sees the
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indicated cultural attributes such as hard work and savings, which were passed
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Gregory Clark (economist) also attributes Britain’s take-off to culture. He
fo

ot
stability over change.
o This school of thought believes that the Industrial Revolution started in
Europe because of the Protestant Reformation, Renaissance, scientific
revolution, favourable government policies and/or the development of
superior private property rights.

because we are so bad and they are so good, i.e. we are greedy, ruthless,
exploitative, and aggressive, while they are weak, innocent, virtuous, abused,
and vulnerable.
o This school of thought believes that the Industrial Revolution started in
Europe because of colonialism, slavery and/or the demands of constant
warfare.
These are all non-economic forces that had important economic consequences.
2.2 Economic models: How see more by looking at less
We typically use models to “stand back and look at the big picture”, because it is
impossible to describe every detail of how every economic agents acts and interacts.
Models come in many forms. To create an effective model, we need to distinguish
between the essential features of the economy that are relevant to the question we
want to answer, which should be included in the model, and unimportant details that
can be ignored.
The is a diagrammatic model that illustrates the flows that occur within the economy,
and between the economy and the biosphere. It is unrealistic, because that is not what
the economy or the biosphere looks like, but nevertheless illustrates the relationships
among them. The fact that the model omits many details (is “unrealistic”) is a feature
of the model, not a bug.
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between income and population.
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standards was also based on a model: a simple description of the relationships
fo
Malthus’ explanation of why improvements in technology could not raise living
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Flow: A quantity measured per unit of time, such as annual income or hourly wage.
Some economists have used physical models to illustrate and explore how the
economy works. For example, Irving Fisher designed a hydraulic apparatus that
represents flows in the economy. It consisted of interlinked levers and floating cisterns
of water to show how the prices of goods depend on the amount of each good
supplied, the incomes of consumers, and how much they value each good.
How models are used in economics
Fisher’s study of the economy illustrates how all models are used:
1. He built a model to capture the relevant elements of the economy that mattered
for determining prices.
2. He used the model to show how interactions between elements could result in
a set of prices that did not change.
3. He conducted experiments with the model to discover the effects of changes in
economic conditions.
Fisher’s hydraulic apparatus illustrates an important concept in economics. Fisher’s
hydraulic apparatus represented equilibrium in his model economy by equalising water
levels, which represented constant prices.
Equilibrium: a model outcome that is self-perpetuating. In this case, something of
interest does not change unless an outside or external force is introduced that alters
the model’s description of the situation. Note that equilibrium means that one or more
things in the model remains constant. It does not necessarily mean that nothing
changes.
An income at subsistence level is also an equilibrium because movements away from
subsistence income are self-correcting: they automatically lead back to subsistence
income as the population rises.
When economists build a model, the following steps are involved in the process:
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1. Construct a simplified description of the conditions under which people take
actions.
2. Describe, in simple terms, what determines the actions that people take.
3. Determine how each of their actions affects each other.
4. Determine the outcome of these actions, which often represents an equilibrium.
5. Try to get more insight by studying what happens to certain variables when
conditions change.
Economic models
A good model has four attributes:

It is clear. It helps to better understand something important.

It predicts accurately. Its predictions are consistent with evidence.

It improves communication. It helps to understand what we agree on.

It is useful. It can find ways to improve how the economy works.
Economic models often use mathematical equations and graphs as well as words and
pictures. Mathematics is part of the language of economics and can help communicate
our statements about models precisely to others. The knowledge of economics can
only be expressed by using a combination of mathematics and clear descriptions,
using standard definitions of terms.
A model starts with some assumptions or hypotheses about how people behave, and
often gives predictions about what is likely to occur in the economy. Gathering data on
the economy, and comparing it with what a model predicts, helps to decide whether
the assumptions (what to include and exclude) made when building the model were
justified.
Any institution who makes policies or forecasts uses some type of model. As such,
bad models can result in disastrous policies. To have confidence in a model, it needs
to be consistent with evidence.
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The following are the four key ideas of economic modelling, that will be used
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which new technologies are chosen, both in the past and in contemporary economies.
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In this unit, an economic model will be “built” to help explain the circumstances under
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2.3 Basic concepts, Prices, costs, and innovation rents
n.
throughout:
1. Ceteris paribus and other simplifications help us focus on the variables of
interest. We see more by looking at less.
Ceteris paribus: the literal meaning of the expression is ‘other things equal’. In an
economic model it means an analysis ‘holds other things constant’.
2. Incentives matter, because they affect the benefits and costs of taking one
action as opposed to another.
Incentive: economic reward or punishment, which influences the benefits and costs
of alternative courses of action.
3. Relative prices help us compare alternatives.
Relative price: the price of one good or service compared to another (usually
expressed as a ratio).
4. Economic rent is the basis of how people make choices.
Economic rent: a payment or other benefit received above and beyond what the
individual would have received in his or her next best alternative (or reservation
option).
Ceteris paribus and simplification
Economists often simplify an analysis by setting aside things that are thought to be of
less importance to the question of interest, by using the phrase ceteris paribus. It is
typically used when economists, for example ask: “what would happen if the price
changed, but everything else that might influence the decision stayed the same?”.
These ceteris paribus assumptions, when used well, can clarify the picture without
distorting the key facts.
When studying the way in which a capitalist economic system promotes technological
improvements, it is important to look at how changes in wages affect firms’ choice of
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technology. For the simplest possible model other factors affecting firms will be ‘held
constant’. Therefore, the assumptions are:

Prices of all inputs are the same for all firms.

All firms know the technologies used by other firms.

Attitudes towards risk are similar among firm owners.
Incentives matter
All economic models have something that allows movement to happen, and a
description of the kinds of movements that are possible. People are free to select
different courses of action, rather than simply being told what to do. This is where
economic incentives affect the choices that people make. People are motivated, or
incentivised, not only by the desire for material gain but also by love, hate, sense of
duty, and desire for approval. Material comfort is typically the most important motive,
and economic incentives mostly appeal to this motive. Accordingly, prices are typically
the important factor that determine decisions.
Relative prices
In economic models, the focus is often on the ratios of things, rather than their absolute
level. Relative prices are simply the price of one option relative to another. It is typically
expressed as the ratio of two prices.
Reservation positions and rents
Consider the following: you figured out a way of doing something, cheaper than
anyone else’s method. Your competitors cannot copy you, because they cannot figure
out how to replicate your idea, or because you have a patent on the process. They,
therefore, continue offering their services at a higher price than yours. If you, then,
match their price (charge the same price), or undercut them by just a bit (charge
slightly less), you will be able to sell as much as you can produce, making profits that
greatly exceed those of your competitors.
This is called an innovation rent, which is a form of economic rent. Economic rents
occur throughout the economy. The idea of innovation rents will be used to explain
some of the factors contributing to the Industrial Revolution. And economic rent is a
general concept that will help explain many other features of the economy.
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When taking some action (the option taken; option A) results in a greater benefit to
Reservation option: a person’s next best alternative among all options in a particular
transaction. Also known as a fallback option.
It is “in reserve” in case you do not choose option A. Or, if you are enjoying option A,
but someone excludes you from doing it, your reservation option will be your “Plan B”.
Therefore, it is also called a fallback option.
Economic rent gives us a simple decision rule:

If action A would give you an economic rent, and nobody else would suffer –
Do it!

If you are already doing action A, and it earns you an economic rent – Carry
on doing it!
This decision rule motivates why a firm may innovate by switching from one technology
to another.
2.4 Modelling a dynamic economy: Technology and costs
These modelling ideas will now be used to explain technological progress.
What is a technology?
Different technologies utilise different combinations of inputs in order to produce the
same quantity of output. The table on the page below summarises the different
combinations of input needed to produce 100 metres of cloth that will be used in the
example that follows.
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n.
option.
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“next best alternative”, your “reservation position”, or the term we use, your reservation
ut
The alternative action with the next greatest net benefit (option B), is often called the
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economic rent = benefit from option taken − benefit from next best option
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simply given by the following equation:
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something you would like to get, not something you have to pay. Economic rent is
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as the rent for an apartment. To avoid this confusion, remember, an economic rent is
fo
economic rent. Economic rent is easily confused with everyday uses of the word, such
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yourself than the next best action (option B), we say that you have received an
Technology
Number of workers
Coal required (tonnes)
A
1
6
B
4
2
C
3
7
D
5
5
E
10
1
The five points in the table represent
five
different
technologies
and
graphically illustrated as in the figure
to the right.
We describe the E-technology as
relatively labour-intensive (relying on
labour
the
technology
most)
as
and
the
relatively
A-
energy-
intensive (relying on energy (coal) the
most). If an economy were using
technology E and shifted to using
technology A or B, we would say that
they had adopted a labour-saving technology, because the amount of labour used is
less than with technology E. This is what happened during the Industrial Revolution.
Firms started adopting labour-saving technologies and become more capital-intensive
in their production processes.
When looking at the figure above, is it clear which technology will the firm choose?
The first step in answering this question is to rule out all technologies that are obviously
inferior. A technology is considered inferior when it uses more of both resource inputs
the produce the same quantity of outputs.
Consider the A-technology. The easiest way to determine inferior technologies is to
draw a vertical line upwards from Point A and a horizontal line to the right of point A.
This will give you a shaded area that represents all technologies that are inferior to the
A-technology. This area of inferiority is clearly illustrated in the figure on the following
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page, where the figure shows that
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the C-technology is clearly inferior
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to the A-technology as it uses
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more workers and more coal.
n.
From this, it can be said that the Ctechnology is dominated by the Atechnology.
Dominated:
we
describe
an
outcome in this way if more of
something that is positively valued
can be attained without less of
anything else that is positively valued. In short: an outcome is dominated if there is a
win-win alternative, for example moving from the C-technology to the A-technology.
This process can be repeated with
the B-technology, as shown below,
which
indicates
that
the
D-
technology is dominated by the Btechnology.
Because it has been established
that the C-technology is dominated
by the A-technology, and the Dtechnology is dominated by the Btechnology, it is not necessary to
test whether they dominate any
technologies. This is because any
point that is inferior to the C-technology, will automatically also be inferior to the Atechnology. Accordingly, the last step would be to repeat the process for the Etechnology, as shown in the figure on the following page.
The E-technology does not dominate any of the other available technologies. We know
this because none of the other four technologies are in the area above and to the right
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of point E. Using the information
about the inputs, the choice of
technology can be narrowed down
– the C- and D-technologies will
never be chosen.
But how does the firm choose
between A, B and E? This
decision will require an additional
assumption about what the firm is
trying to do. It can be assumed
that the firm’s goal is to make as
much profit as possible, which
means producing at the least possible cost.
Accordingly, to decide about technology also requires economic information about
relative prices, i.e. the cost of hiring a worker relative to that of purchasing a tonne of
coal. Intuitively, the labour-intensive E-technology would be chosen if labour was very
cheap relative to the cost of coal; the energy-intensive A-technology would be
preferable in a situation where coal is relatively cheap. An economic model helps us
be more precise than this.
Isocost lines
The firm can calculate the cost of any combination of inputs that it might use by
multiplying the number of workers by the wage and the tonnes of coal by the price of
coal. We use the symbol w for the wage, L for the number of workers, p for the price
of coal and R for the tonnes of coal:
cost = (wage × number of workers) + (price of a tonne of coal × number of tonnes)
= (w × L) + (p × R)
The same logic can be extended to any combination of inputs –
cost = (price of input × quantity of input ) + (price of input × quantity of input )
+ ⋯ + (price of input × quantity of input )
Suppose that the wage is £10, and the price of coal is £20 per tonne, we can easily
calculate the cost of the technologies, as shown in the table below.
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130
B
4
2
80
E
10
1
120
could also have a calculated cost of £80, for example employing eight workers and
zero tonnes of coal, which
corresponds
to
price
combination H; or employing
four tonnes of coal and zero
workers, which corresponds to
price combination J. If points J,
B, and H were connected with
a line, the resulting line would
be an isocost line as shown in
the figure to the right.
Isocost line: a line that represents all combinations of inputs that cost a given total
amount.
Iso is the Greek word meaning “same”. Isocost lines are drawn on the assumption that
fractions of workers and of coal can be purchased.
Isocost lines can be drawn through any other set of points within the diagram. They
join all possible combinations of workers and coal that cost the same amount. The
simplest way to construct an isocost line is to determine the intercepts, i.e. how much
workers can £80 employ (eight workers and no tonnes of coal, which represents point
H) and how much tonnes of coal can £80 employ (4 tonnes of coal and no workers,
which represents point J).
Points above an isocost line cost more
All points above an isocost line, will cost more than the cost associated with that
isocost line, and all points below the isocost line costs less. For example, points A and
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n.
as £80, which corresponds to price combination B. Another combination of inputs
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In the table, the cost of employing four workers and two tonnes of coal is calculated
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A
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Total cost (£)
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Coal required (tonnes)
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Number of workers
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Technology
E are above the isocost line JBH, which means that both the A-technology and the Etechnology cost more than the B-technology, which is on the JBH isocost line. From
both the table above, as well as the diagram above, it is clearly that the B-technology
is the least-cost technology, given the resource input prices.
The slope of every isocost line is −
The slope of every isocost lines is negative, because all isocost lines will slope
downward. The slope of the isocost line represents the rate at which the firm is willing
to trade a unit of the resource on the vertical axis, for an additional unit of the resource
on the horizontal axis, i.e. it represents the relative price of the resource on the
horizontal axis. For example, in the case above, if the firm hired one more worker, they
would have to forego 0,5 tonnes of coal. Accordingly, the slope of the isocost line is
represented by the negative of the ratio of the price of the resource on the horizontal
axis to the price of the resource on the vertical axis, i.e. − , the wage divided by the
price of coal.
Equation of the isocost line
The isocost lines for any wage, w, and coal price, p, can be represented as equations.
To do this, we use c for the cost of production. We begin with the cost of production
equation, from above:
=( × )+( × )=
+
This represents one way of writing the equation of the isocost line for any value of c.
To construct the isocost line, it is easier to express it in the typical linear equation form:
=
where
+
is a constant that represents the vertical axis intercept and
is the slope of
the line.
From above, we know that the slop of the isocost line is − , therefore
In this instance,
=− .
refers to the resource on the vertical axis, i.e. coal. Therefore, the
equation needs to be expressed in terms of the quantity of coal that the firm will
employ, . Therefore, the following steps can be taken to rearrange the formula into
the correct format:
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+
ot
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=
e/
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fo
This formula can be rewritten as:
equation of:
=
In this instance, we know when
vertical axis intercept of
=
−
= 10 and
= 20, the isocost line for
= 80 has a
= 4, and a negative slope equal to −
= − . This
means that the isocost line’s equation can be given as:
=4−
.
The generalised equation of any isocost line can be given as follows:
=
where
−
represents the resource on the vertical axis,
resource on the vertical axis,
represents the price of the
represents the resource on the horizontal axis,
represents the price of the resource on the horizontal axis and
represents the total
cost associated with the isocost line.
2.5 Modelling a dynamic economy: Innovation and profit
Any change in the relative price of two inputs will change the slope of isocost lines. If
isocost lines becomes sufficiently steep, it is possible that the firm’s choice of
technology might change. The following example will illustrate how a change in relative
prices could cause this to happen. Suppose that the price of coal falls to £5 while the
wage remains at £10. At these costs, the new total costs will be
Technology
Number of workers
Coal required (tonnes)
Total cost (£)
A
1
6
40
B
4
2
50
E
10
1
105
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n.
Which can be further rearranged to have a generalised formula for an isocost line’s
io
ut
rib
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di
= −
Based on the table on the previous page, the A-technology now becomes the leastcost technology. Cheaper coal makes each method of production (A, B and E)
cheaper, but, intuitively, it makes the most energy-intensive technology the cheapest.
The next step is to calculate the
gains to the firm who first adopts
the least-cost technology (A) when
the relative price of coal falls.
Initially, all firms are using the Btechnology to minimise its costs.
The
initial
indicated
on
B-technology
the
dotted
is
JBH
isocost line, and the new Atechnology is shown on the FAG
isocost line, as shown in the figure
to the right.
The firm’s profits are equal to the
revenue it gets from selling its output minus its costs.
Whether the new or old technology is used, the same prices are paid for labour and
coal, and the same price is received for selling 100 metres of cloth. The change in
profit is thus equal to the fall in costs associated with adopting the new technology,
and profits rise by £10 (the change in the price of a tonne of coal) per 100 metres of
cloth. The change in profit can therefore be calculated as:
Profit change in profit from switching from B to A =
= change in revenue − change in costs = 0 − (40 − 50) = 10
In this case, the economic rent for a firm switching from B to A is £10 per 100 metres
of cloth, which is the cost reduction made possible by the new technology. The
decision rule (if the economic rent is positive, do it!) tells the firm to innovate and
develop/get the new technology if the price of coal falls.
In our example, the A-technology was available, but not in use until a first-adopter firm
responded to the incentive created by the increase in the relative price of labour. The
first adopter is called an entrepreneur.
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organisational forms, and other opportunities.
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Entrepreneur: a person who creates or is an early adopter of new technologies,
Schumpeter, identified the adoption of technological improvements by entrepreneurs
as a key part of his explanation for the dynamism of capitalism. Therefore, innovation
rents are also often called Schumpeterian rents.
Innovation rents will only last as long as it takes for other firms to adopt the new
technology, which will also reduce their costs and increase their profits. In this case,
with higher profits, the lower-cost firms will thrive. They will be able to increase their
output. As more firms introduce the new technology, the supply of cloth to the market
will increase and the price will start to fall. This process will continue until all firms
adopted the new technology, at which stage prices will have declined to the point
where no firm is earning innovation rents. Firms that did not adopt the new technology
will be unable to cover their costs at the lower price, and they will go bankrupt.
Schumpeter called this creative destruction.
Creative destruction: Schumpeter’s name for the process by which firms who do not
adopt new technologies, along with the old technologies are swept away by the new
technology and those who adopt it, because they cannot compete in the market. In his
view, the failure of unprofitable firms is creative because it releases labour and capital
goods for use in new combinations.
For Schumpeter, creative destruction was an essential fact about capitalism.
Furthermore, Schumpeter developed one of the most important concepts of modern
economics: creative destruction. He brought to economics the idea of the entrepreneur
as the central actor in capitalism. The entrepreneur is the agent of change who
introduces new products, new methods of production, and opens new markets,
generating innovation rents. Imitators follow, and the innovation is diffused through the
economy. A new entrepreneur and innovation launch the next upswing. This
decentralised process mentioned above, generates a continued improvement in
productivity, which leads to growth, so Schumpeter argued it is virtuous. The slowness
of this process creates upswings and downswings in the economy. The branch of
economic thought is known as evolutionary economics that has its origins in
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n.
io
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out new technologies and to start new businesses. The economist, Joseph
e/
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When we describe a person or firm as entrepreneurial, it refers to a willingness to try
Schumpeter’s work and is contained in most modern economic modelling that deals
with entrepreneurship and innovation.
Evolutionary economics: an approach that studies the process of economic change,
including technological innovation, the diffusion of new social norms, and the
development of novel institutions.
2.6 The British Industrial Revolution and incentives for new technologies
The table below indicates the major changes that happened during the Industrial
Revolution.
Old technology
New technology
Many workers
Few workers
Little machinery
Lots of capital goods
Machinery required only human energy
Machinery required requires energy
Labour-intensive
Labour-saving
Capital-saving
Capital-intensive
Energy-saving
Energy-intensive
Looking at how relative prices differed among countries, and how they changed over
time, can help us understand why certain technologies, such as the spinning jenny,
were invented in Great Britain rather than in another country, and why it happened in
the eighteenth century, rather than at another time in history.
In England, labour was more expensive relative to the cost of energy than other
countries. Wages relative to the cost of energy were high in England, because English
wages were just typically higher than elsewhere, and because coal was cheaper in
coal-rich Britain than in other countries. Furthermore, wages became steadily more
expensive relative to the cost of capital goods in after the mid-seventeenth century. In
other words, the incentive to replace workers with machines was increasing in England
during this time, which was not the case for many other countries.

Wages relative to the cost of energy and capital goods rose in the eighteenth
century in Britain compared with earlier historical periods.
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
Wages relative to the cost of energy and capital goods were higher in Britain
ot
.N
op
during the eighteenth century than elsewhere.
n.
io
ut
rib
st
di
e/
al
in the era of permanent technological change.
rs
fo
Britain was also a very inventive country. There were many skilled workers who aided
The relative prices of the
1600s are shown by dotted
isocost line JH in the figure to
the right, which means that the
B-technology was used. At
those relative prices, there was
no incentive to develop a
technology like A, which is
above the isocost line JH.
In the 1700s, the isocost lines,
such
as
FG,
were
much
steeper, because the relative
price of labour to coal was
higher, which means that the A-technology was used.
To summarise the two scenarios that can take place in the figure above:

Where the relative price of labour is high, the energy-intensive technology A, is
chosen.

Where the relative price of labour is low, the labour-intensive technology B, is
chosen.
The relative prices of labour, energy and capital can explain why these labour-saving
technologies were first adopted in England (during the Industrial Revolution), and why
technological advancement occurred more rapidly in Great Britain than elsewhere.
The eventual adoption of the technologies in other countries can be explained by
further technological progress, because new technology was developed that
dominated the existing technology in use.
The aforementioned can easily be introduced into the model from before – initially the
A-technology was replaced by the B-technology when the relative price of coal
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increased. When a new labour- and energy-saving technology, A′, was developed, it
dominated both the A- and B-technologies, as can be seen in the figure to the right.
The new A’ technology would be adopted in both economies.
As mentioned before, the other major
factor that promoted the diffusion of
new
technologies
into
other
countries was wage growth and
falling energy costs. This made
isocost lines steeper, which provided
countries with an incentive to switch
to labour-saving technology, such as
the A-technology.
The two aforementioned factors led
to
the
spread
of
the
new
technologies. The divergence in
technologies and living standards was eventually replaced by convergence, especially
among the countries where the capitalist revolution took off. Nevertheless, certain
countries still use the technologies that were replaced during the Industrial Revolution,
most likely due to the relative price of labour being very low, making the isocost line
very flat. This could create an alternative situation where HJ isocost line is so flat that
the B-technology (labour-intensive technology) could be preferred to the A′technology.
2.7 Malthusian economics: Diminishing average product of labour
Malthus provided a model predicted a pattern of economic development that is
consistent with (can explain) the flat part of the GDP per capita “hockey stick”. The
Malthusian model introduces many important concepts that are widely used in
economics, as explained below.
Production functions
Suppose an agricultural economy that only produces grain. In this hypothetical
example, the only factors of production necessary to produce grain is labour and land.
Ignore all other things that you know are necessary to produce grain.
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Factors of production: the labour, machinery and equipment (usually referred to as
ot
capital), land, and other inputs to a production process.
n.
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production are energy and labour.
e/
al
rs
fo
In the model of technological change that has been used this far, the factors of
To understand what will happen to the production of grain when the inputs (labour and
land) become variable, a production function for farming is necessary.
Production function: expresses a graphical or mathematical relationship describing
the amount of output that can be produced by any given amount or combination of
input(s). The function describes differing technologies capable of producing the same
thing.
For illustrative purposes, the production function will calculate the amount of grain
produced by only considering the number of farmers working on a given amount of
land (farm), holding all other inputs constant.
A production function indicates a relationship between two quantities, the inputs and
outputs. A function is typically expressed mathematically as:
= ( )
This
labour.
means
that
“ is
a
function
of ”.
represents
the
quantity
of
represents the grain output that results from the labour inputs. The function
( ) describes the relationship between
and . In the previous sections, there has
already been a simple production function – for example, the production function for
technology A gives us the typical “if-then” statement that is indicative of mathematical
functions: if 1 worker and 6 tonnes of coal are the inputs, then 100 metres of cloth will
be the output. The grain production function is a similar “if-then” statement, indicating
that if there are
farmers, then they will harvest
grain.
A production function can be represented graphically by a production function curve,
by plotting the labour input (on the horizontal axis) to the grain output (on the vertical
axis). The combinations of labour inputs and grain outputs can be seen in the table
below.
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Labour input (number of workers)
Grain output (kg)
200
200 000
400
330 000
600
420 000
800
500 000
1 000
570 000
1 200
630 000
1 400
684 000
1 600
732 000
1 800
774 000
2 000
810 000
2 200
840 000
2 400
864 000
2 600
882 000
2 800
894 000
3 000
900 000
Based on the table
above, the following
production function can
be constructed.
Another concept that
needs to be considered
regarding
functions
production
is
the
average product of specific input.
Average product: total output divided by a particular input, for example per worker
(divided by the number of workers) or per worker per hour (total output divided by the
total number of hours of labour put in).
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To demonstrate, the average product of labour for this example, for point A, for
.N
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ot
example, can be calculated as:
= 458. This is the slope of the ray from the point (0,0)
to the point B on the production function. This essentially means that an average
product of 458kg of grain is produced per farmer when there are 1 600 farmers working
the land.
As the figure above illustrates, the slope of the ray to point A (625) is steeper than the
slope of the ray to point B (458). A pattern can be observed if we calculate the average
product of labour for more points along the production function as illustrated in the
table on the following page.
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n.
point B is calculated as
io
point. For example, in the figure below shows that the average product of labour at
ut
Graphically, the average product is the slope of the ray from the origin to a specific
rib
The slope of the ray is the average product
st
di
= 625 kg per farmer
e/
al
total output
500 000kg
=
total number of farmers 800 farmers
rs
fo
average product of labour =
Labour input (number of workers)
Grain output (kg)
Average product of
labour (kg/worker)
200
200 000
1 000
400
330 000
825
600
420 000
700
800
500 000
625
1 000
570 000
570
As more farmers work on a fixed amount of land, the average product of labour falls.
Stated otherwise, as the quantity of labour increases, quantity of land kept constant,
the average product of labour fails. This feature is called the diminishing average
product of labour and is one of the two foundations of Malthus’ model.
Diminishing average product of labour: a situation in which, as more labour is used
in a given production process, the average product of labour typically falls.
The diminishing average product of labour worried Malthus. This worried Malthus
because of the real-world negative consequences that it could have on future
generations of farmers. One could argue that if the population grows in the real world,
more land can be used for farming. But Malthus pointed out that earlier generations of
farmers would have picked the best land, so new land would be less productive, which
would reduce the average product of labour further.
In summary, diminishing average product of labour can be caused by:

An increased quantity of labour devoted to a fixed quantity of land; and/or

An increased quantity of inferior land bought.
Essentially, as the average product of labour diminishes, the incomes of farmers also
inevitably fall.
2.8 Malthusian economics: Population grows when living standards rise
The diminishing average product of labour cannot be solely responsible for the long,
flat portion of the “hockey stick”. This just means that living standards depend on the
size of the population. It does not indicate why living standards and population didn’t
change much over long periods of time. For this, the other part of Malthus’s model is
needed: his argument that increased living standards led to a population increase.
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This is based on Richard Cantillon’s (economist) theory that stated that, “men multiply

There is a law of diminishing average product of labour; and

The population increases if living standards increase.
Malthus reasoned that the human population living in a country with a fixed supply of
agricultural land, will be well-fed and would eventually multiply like Cantillon’s mice in
a barn; but eventually the population would fill the country. Further population growth
would therefore push down the incomes of most people as a result of diminishing
average product of labour. The resulting fall in living standards would slow population
growth as the mortality rate increases and the birth rates fall. Due to the
aforementioned, incomes would ultimately settle at the subsistence level of the
economy’s population.
The Malthusian model that has been descried thus far results in an equilibrium in
which there is an income level just enough to allow a subsistence level of consumption.
The variables that stay constant in this Malthusian model equilibrium are:

the size of the population; and

the income level of the people.
If the conditions within the economy change, the population and their incomes may
change too, but eventually the economy’s population’s income will equilibrate at the
subsistence level.
Malthusian economics: The effect of technological improvement
Over the centuries prior to the Industrial Revolution, improvements in technology
occurred in many countries, but living standards remained constant. The question
arises whether the Malthusian model can explain this?
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n.
The main ideas (foundations) of the Malthusian model is therefore:
io
ut
rib
st
di
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al
rs
intellectually).
fo
Malthus’ belief that people are not that different from other animals (excluding
ot
.N
op
like mice in a barn, if they have unlimited means of subsistence” combined with
The figure above illustrates how the diminishing average product of labour and the
effect of higher incomes on population growth mean that in the very long run,
technological improvements will not result in higher income for farmers. In the figure,
concepts in the box on the left are causes for concepts in the box on the right.
A textual explanation of this figure follows:
1. Beginning in equilibrium, with income at the subsistence level, a new
technology raises the income per person on the existing fixed quantity of land.
2. Higher living standards lead to an increase in population.
3. As more people are added to the land, diminishing average product of labour
means average income per person falls.
4. Eventually income equilibrates at the subsistence level, with a higher
population.
Now the question arises why the population is higher at the new equilibrium? This is
because the output per farmer is higher for each farmer. The population cannot return
to the original level, because then income would be above the subsistence level. A
better technology can therefore provide subsistence income for a larger population.
Essentially, the Malthusian model predicts that improvements in technology will not
raise living standards if:

the average product of labour diminishes as more labour is applied to a fixed
amount of land; and
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population grows in response to increases in real wages.
st
di
e/
al
rs
larger population but will not result in higher wages. This conclusion was called
fo
Due to the aforementioned, in the long run, an increase in productivity will result in a
ot
.N
op
Sh
s.
ie

The Malthusian model can be represented graphically as explained below.
 The downward-sloping line in the left-hand figure on the following page shows
that as the population increases, the level of wages decreases, due to the
diminishing average product of labour.
 The upward-sloping line on the right (below) shows the relationship between
wages and population growth: as the level of wages increase, the population
grows, because of higher living standards that lead to more births and fewer
deaths.
o This figure shows that when the wages are high, the population growth
is positive; while population growth is negative, when wages are low.
In the figure on the left (below), the wage’s subsistence level occurs at point A where
the population is medium-sized. If this point A is traced across to the figure on the
right, it shows a point A′ where population growth is equal to zero. Point A is therefore
an equilibrium position where the population stays constant and wages remain at
subsistence level. Similarly, point B (from the left) can also be traced to the figure on
the right (point B’) which shows that at that higher wage and smaller population, the
population will in fact be rising as the population growth rate is positive.
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n.
io
ut
rib
Malthus’ Law.
The economy always returns to equilibrium
It has been established that as the population rises, the economy moves down the line
in the left diagram, while wages fall until they reach the subsistence level at point A.
The two figures together explain the Malthusian population trap. Population will be
constant when the wage is at subsistence level, it will rise when the wage is above
subsistence level, and it will fall when the wage is below subsistence level. Bearing
this in mind, the following figure shows how the Malthusian model predicts that even
if productivity increases, living standards will not increase in the long run.
1. Initially the economy is in equilibrium in point A, with a medium-sized population
and wage at subsistence level.
2. The economy then implements an advance in technology. A technological
improvement will raise the average product of labour, and accordingly, the
wage will be higher for any level of population. The real wage line shifts
(parallel) upward. At the initial population level (point A), the wage increases,
and the economy moves to point D.
3. If we trace point D over the figure to the right to point D’, it is clear that as the
wage is now high, the population will begin to rise (as population growth is
positive).
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4. The population will then start to increase, which sees a fall in the wage, due to
ot
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the diminishing average product of labour.
a. At C, the wage has reached subsistence level again. The population
remains constant (point C′). The population is higher at equilibrium C
than it was at equilibrium A.
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n.
io
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Reaching the new equilibrium at point C with the new technology
rs
fo
5. The economy therefore starts to move down the real-wage curve again.
UNIT 3: SCARCITY, WORK, AND CHOICES

Decision making under scarcity is a common problem because we usually have
limited means available to meet our objectives.
In the modern economy, time is the scarcest resource. Accordingly, the biggest
scarcity decision pertains to the division between time spent on leisure and time spent
on work.

Economists attempt to model these situations by defining all feasible action
combinations, then evaluating which combination is the best, given the
objectives.
When modelling these situations, it is important to consider opportunity costs, which
describe the unavoidable trade-offs that occur in the presence of scarcity. From the
opening statement, it is clear that an individual therefore has to make a trade-off
decision between working more or having more leisure time.

This economic model also attempts to explain the differences in the hours that
people work in different countries, and the changes in the hours of work
throughout history.
The appropriate question to ask is therefore whether people have used economic
progress to consume more goods, enjoy more free time, or both? The answer is both,
but in different proportions in different countries. Some of the trends that have been
observed in this regard are given below. In the late nineteenth and early twentieth
century, average income approximately trebled, and hours of work fell substantially.
During the rest of the twentieth century, income per head rose four-fold, for example

A more than six-fold increase in hourly earnings for twentieth century
Americans, and a fall in their average annual work time by a little more than
one-third.

Hours of work continued to fall in the Netherlands and France (albeit more
slowly) but levelled off in the US, where there has been little change since 1960.
Many countries have experienced similar trends, but there are still vast differences in
different countries. Higher-income countries seem to have lower working hours and
more free time, but there are also some striking differences between the higher-
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income countries, as well. These differences lead to different scenarios playing out in
.N
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ot
different countries. Some of these scenarios are:
st
di
consumed more.

While in other countries people now have much more free time.
Countries therefore see a variation of these three aspects depending on the economic
conditions within the country.
3.1 Labour and production
Labour is work. Work activity is often difficult to measure, which is a concern as
employers find it difficult to determine the exact amount of work that employees are
doing. Economists also cannot measure the effort required by different activities in a
comparable way. Therefore, economists often measure labour simply as the number
of hours worked by individuals engaged in production and assume that as the number
of hours worked increases, the amount of goods produced also increases. For this
unit, we will consider the choices of a student: how many hours to spend studying.
There are many factors that influence this choice. Part of the motivation to devote time
to studying could come from the belief that more time spent studying, results in higher
grades. For the model that will be constructed in this Unit, we will assume a positive
relationship between hours worked (studied) and the final grade.
Consider the hypothetical student, whom we will call Alex. The positive relationship
noted earlier is clearly represented in the table below.
Study hours
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14 15+
Grade
0
20
33
42
50
57
63
69
74
78
81
84
86
88
89
90
The table shows how Alex’s grade will vary if he changes his study hours, if all other
factors – his social life, for example – are held constant. It is possible that the final
grade might also be affected by unpredictable events, which can be called “luck’”, but
these figures refer to studying under normal conditions, i.e. the effect of “luck” is
removed.
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n.
In other countries, people have carried on working just as hard as before but
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1870.

e/
al
In many countries there has been a huge increase in living standards since
rs
fo

The combinations from the
table on the previous page,
can be plot on a graph, to
illustrate Alex’s production
function, as seen to the
right.
Alex can achieve a higher
grade by studying more, so
the curve slopes upward.
The production function shows that the positive relationship only lasts if Alex studies
less than 15 hours, because the maximum grade that Alex is capable of is 90%, which
he can obtain if he studies for 15 hours or any amount of time in excess thereof. This
is graphically illustrated on the right-side of the production curve where it plateaus (the
curve becomes flat) past 15 hours of study per day.
As in Unit 2, Alex’s average product of labour can be calculated again, which indicates
the slope of a ray from the origin to the curve at any point on the curve. Another
important concept is Alex’s marginal product, which refers to the increase in his grade
from increasing study time by one hour.
Marginal product: the additional amount of output that is produced if a particular input
was increased by one unit, while holding all other inputs constant. The marginal
product represents the slope of the production function.
Comparing average product and marginal product
When Alex studies four hours per day, his average product is
= 12,5 percentage
points, which represents the slope of the ray from that point to the origin.
If Alex were to increase his study time from 4 to 5 hours, Alex’s grade raises from 50
to 57. Therefore, at 4 hours of study, the marginal product of an additional hour is
approximately 7. More precisely, the marginal product is the slope of the tangent (the
rate of change) at that point, which is approximately 7.
Tangency: when two curves share one point in common but do not cross. The tangent
to a curve at a given point is a straight line that touches the curve at (only) that point
but does not cross it.
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In order to get a more precise approximation, the calculation needs to be repeated
he studies, i.e. the marginal product of an additional hour of studying falls as Alex
studies more. The marginal product is therefore diminishing.
Diminishing returns: A situation in which the use of an additional unit of a factor of
production results in a smaller increase in output than the previous increase. Also
known as diminishing marginal returns in production.
The model captures the idea that an extra hour of study helps a lot if you are not
studying much, but if you are already studying a lot, then studying even more does not
help very much. Especially when Alex reaches his maximum grade (90%) in which
case an additional hour of studying would cause no change in his grade, i.e. his
marginal product is zero (0).
To generalise the, at each point on the production function the marginal product (the
slope of the curve) will always be lower than the average product (the slope of the
ray), as can be seen below by the tangent at the point (marginal product) being less
steep than the ray from the
origin to the point (average
product).
The
figure
indicates
increases
to
that
as
the
the
the
right
output
input
increases, but the marginal
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n.
As seen in the figure above, Alex’s production function becomes flatter the more hours
io
accurate marginal product.
ut
second of study per day, for example), we would be able to calculate an even more
rib
If we looked at even smaller changes in study time (the rise in grade for each additional
st
di
0,124
= 7.44
0,016667
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estimate of the marginal product (the rate of change) would therefore be:
rs
to the graph, his grade will rise by a very small amount – about 0.124. A more precise
fo
and studies for 1 minute longer each day (a total of 4,016667 hours). Then, according
ot
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op
with much smaller increments. Suppose Alex has been studying for 4 hours a day,
product falls, which means that the function becomes gradually flatter. A production
function with this shape is described as concave.
Concave function: a function of two variables for which the line segment between
any two points on the function lies entirely below the curve representing the function
(the function is convex when the line segment lies above the function).
3.2 Preferences
If Alex were to know his production, how many hours would he choose to study per
day? His decision depends on his preferences for the things that he cares about.
Preferences: a description of the benefit or cost we associate with each possible
outcome.
If he cared only about his grades, he would study for 15 hours a day. But if Alex also
cares about his free time, he faces a trade-off: how many percentage points is he
willing to give up in order to spend time on things other than study?
If the combinations of time studying and
Alex’s final grade are plotted on a set of
axes, where free time is on the horizontal
axis and Alex’s final grade is on the
vertical
axis,
the
downward-sloping
result
will
curve,
be
a
called
an indifference curve, which joins all the
combinations that provide equal utility or
“satisfaction”.
Indifference curve: A curve of the points which indicate the combinations of goods
that provide a given level of utility to the individual.
Utility: A numerical indicator of the value that one places on an outcome, such that
higher valued outcomes will be chosen over lower valued ones when both are feasible.
From this figure the following assumptions (that can be generalised) can be made:

For a given grade, say 84%, Alex would prefer a combination that gives him
more free time. Therefore, even though both point A and B corresponds to a
grade of 84%, Alex will prefer A because it gives him more free time.
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
Similarly, if two combinations have the same amount of free time, Alex will
provides Alex with more utility than points B and C. Therefore, higher indifference
curves represent higher utility for the individual. To describe preferences, the
indifference curve does not have to quantify the exact utility of each option; it only
needs to illustrate which combinations an individual provides more or less utility in
relation to the others.
Typically, indifference curves are drawn for various consumption goods, and we refer
to the individual as a consumer. In our model, the consumption goods are Alex’s final
grades and his free time.
Consumption good: a good or service that satisfies the needs of consumers over a
short period.
The following are more important characteristics of indifference curves:

Indifference curves slope downward due to the trade-off decisions that
consumers have to make.

Higher indifference curves correspond to higher utility levels.

Indifference curves are typically smooth, i.e. small changes in the amounts of
goods do not cause big jumps in utility.

Indifference curves never cross.

As you move to the right along an indifference curve, it becomes flatter.
The slope of an indifference curve is determined similar to the way in which we
calculated the marginal product. It demonstrates how much of the consumption good
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n.
and point C. The higher indifference curve that point A and point D are on, therefore
io
C. This is because point A and point D are on a higher indifference curve to point B
ut
above, we know that Alex prefers point A to point B; and Alex prefers point D to point
rib
Alex is indifferent between A, E, F, G, H and D. Furthermore, from the two assumptions
st
di
points along the same indifference curve. From the figure above, it is thus clear that
e/
al
same amount of utility. Accordingly, an individual is therefore indifference between all
rs
In general, the indifference curve joins all possible outcomes that will give Alex the
fo
point C), as it gives him the higher grade with the same amount of free time.
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prefer the one with a higher grade. For example, Alex would prefer point D (to
on the vertical axis the consumer is willing to forgo for an additional unit of the good
on the horizontal axis. This is called the marginal rate of substitution (MRS).
Marginal rate of substitution (MRS): the trade-off that a person is willing to make
between two goods. At any point, this is the slope of the indifference curve.
Intuitively, this makes sense, because it is reasonable to assume that the more free
time Alex has, and the lower his grades are, the less willing he will be to sacrifice
further percentage points in return for free time, so therefore his MRS will be lower.
3.3 Opportunity costs
Alex wants to have the maximum amount of free time and the highest possible final
grade, but because of his production function that is not completely possible. He
therefore has an opportunity cost to get more free time –the opportunity cost of more
time is getting a higher grade.
Opportunity cost: when taking an action implies forgoing the next best alternative
action, this is the net benefit of the foregone alternative.
Opportunity costs need to be considered when consumers make a choice. In the
choice to take action A, we cannot take action B. Accordingly, “not taking action B”
becomes part of the cost of doing A, which we call the opportunity cost.
When determining the cost of taking a particular action, accountants only consider the
“out-of-pocket” cost, which means that they do not consider the opportunity cost as a
concrete monetary value that is considered a cost. Economists, however, considers
the economics cost of a particular action as the “out-of-pocket” cost plus the
opportunity cost.
Economic cost: the out-of-pocket cost of an action, plus the opportunity cost.
Now, the opportunity cost must be considered when deciding whether or not to
undertake an action or not. There are two concerts – concert A with an admission cost
of R25 and concert B, which is free. These concerts happen at the same time and the
consumer will have to make a decision. The following table shows whether a consumer
should choose to attend concert A.
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R40
R40
Economic benefit
R50
R30
Economic rent
R10
-R10
b)
The most you would be willing to pay to go to concert B (if it was not free) is R15,
which is the cost of the “next best alternative” (concert B).
In scenario I, the consumer makes a judgement that the economic benefit (pleasure)
they would receive from attending concert A is equal to R50. This would mean that the
benefit exceeds the economic cost of attending the concert, which results in a positive
economic rent. Accordingly, the consumer should attend concert A. In scenario II, the
consumer believes their economic benefit would only be equal to R30. This will result
in a negative economic rent. Accordingly, the consumer should not attend concert B.
3.4 The feasible set
In Alex’s situation, he does not have an infinite amount of combinations, because there
are only 24 hours in a day. If Alex chooses to study for 24 hours, he will receive a final
mark of 90%. If he were to spend 24 hours on free time, we can assume that his final
mark will be 0%. Based on this, we can construct the following convex feasible frontier,
which indicates the highest grade Alex can achieve given the amount of free time he
takes.
Feasible frontier: the curve made of points that defines the maximum feasible
quantity of one good for a given quantity of the other.
The feasible frontier graphically illustrates all possible combinations that constitute the
feasible set, which is the area inside of the frontier and the frontier itself.
Feasible set: all the combinations of the things under consideration that a decisionmaker could choose given the economic, physical or other constraints that he faces.
Alex’s feasible frontier can be illustrated by the figure on the following page.
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n.
The monetary cost of attending the concert.
io
a)
ut
rib
st
di
Total cost
e/
al
R15 b)
rs
R15 b)
Opportunity cost
fo
R25
ot
R25
Out-of-pocket cost a)
.N
op
Scenario II
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Scenario I
As mentioned before, all combinations (points) on and under the feasible frontier, are
combinations that are possible for Alex to attain, for example point A, E, C, F and D.
Furthermore, the feasible frontier shows the maximum final grade Alex can obtain
given the time that he spends studying, for example, if Alex has 20 hours of free time
per day, he obtains a final mark of 50%, as indicated by point F. With this amount of
free time, it would be impossible for Alex to obtain a final mark of 70%, as indicated
by point B.
To generalise, any combinations outside (above/to the right) the feasible frontier, such
as point B above, are said to be infeasible given Alex’s resource constraints.
Furthermore, even though a combination inside of the frontier is feasible, they
represent inferior combinations, because at any point inside of the frontier, Alex can
either have more free time or obtain a higher final grade without having to make a
trade-off decision. By choosing a combination inside the frontier, Alex would therefore
be giving up something that is freely available – something that has no opportunity
cost.
The feasible frontier represents the trade-off he must make between grade and free
time. At any point on the frontier, taking more free time has an opportunity cost in terms
of grade points foregone, corresponding to the slope of the frontier. In economic terms,
the feasible frontier shows the marginal rate of transformation (MRT).
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sacrificed to acquire one additional unit of another good. At any point, it is the slope of
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Marginal rate of transformation (MRT): The quantity of some good that must be
fo
the frontier. To be more precise, the slope of the feasible frontier at any point can be
calculated as the slope of the tangent at that point, which represents the MRT and the
opportunity cost at that point.
3.5 Decision making and scarcity
To finally determine which combination Alex will choose, we must combine the feasible
frontier and the indifference curves from before. Indifference curves indicate what Alex
prefers, and their slopes represent the trade-offs that Alex is willing to make; while the
feasible frontier is the constraint on his choices, and its slope represents the trade-off
he is constrained to make. Accordingly, Alex will want to choose a combination that is
on the highest possible indifference curve (to give him the highest amount of utility),
while still being on the feasible frontier (to show a combination of free time and final
grade that is obtainable). He will make his decision based on the figure below.
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n.
io
ut
rib
The slope of any given ray, for example AE, is only an approximation to the slope of
st
di
e/
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rs
the feasible frontier.
Alex cannot choose IC4 because no point on IC4 represents a feasible combination.
Any combination on the indifference curves IC1 and IC2 will be non-optimal choices,
as Alex will be able to increase his utility by switching to a higher indifference curve,
IC3. On IC3 the only feasible combination, however, is point E, which represents the
feasible combination with the highest attainable utility. To generalise, this is the (only)
point where the slope of the indifference curve and the slope of the feasible frontier
are equal. In order for a consumer to maximise their utility, is therefore at the point
where MRS = MRT. To maximise his utility, the model predicts that Alex will choose
to spend 5 hours each day studying, and 19 hours on other activities (free time), while
obtaining a final grade of 57%.
Alex’s situation that was just studied can also be called a constrained choice problem
where a decisionmaker pursues an objective subject to a given constraint.
Constrained choice problem: this problem is about how we can do the best for
ourselves, given our preferences and constraints, and when the things we value are
scarce.
3.6 Hours of work and economic growth
We will now apply the model of constrained choice problems to Angela, a self-sufficient
farmer. She only produces enough grain for her to eat. Her choice on how to spend
her time is therefore divided between producing grain and having free time. Angela
therefore faces a problem of scarcity: she must make a choice between consuming
grain (to eat) and having free time. To understand her choice, we need to model her
production function, and her preferences.
Her production function, given her current technology and conditions, is constructed
from the table below, and can be seen in the figure on the next page, labelled as PF.
Working hours 0
1
2
Grain
9
18 26 33 40 46 51 55 58 60 62 64 66 69 72
0
3
4
5
6
7
8
9
10 11 12 13 18 24
If a technological improvement were to occur, such as better equipment that makes
harvesting quicker, the amount of grain produced in a given number of hours will
increase and will be reflected in her production function. The new production function
is also shown in the figure on the following page, labelled as PFnew.
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fo
Notice that the new production function is steeper than the original one for every given
number of hours. Furthermore, the new technology also increased Angela’s marginal
product of labour, i.e. at every point, an additional hour of work produces more grain
than under the old technology.
The figure below shows Angela’s feasible frontier for the original technology (FF), and
the new one (FFnew), along with her indifference curves.
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From the figure on the previous page, it is clear that the technological improvement
expands the feasible set. Furthermore, it also gives Angela access to indifference
curves that were previously not possible, i.e. increases the maximum utility that she
can receive. Under the original technology, her optimal choice at point A was to work
for 8 hours a day, giving her 16 hours of free time and producing 55 units of grain.
After the technological improvement, her optimal choice at point E increased both her
consumption of grain (61 units of grain) and her free time (17 hours per day).
Technological change makes the production function steeper, i.e. it increases Angela’s
marginal product of labour. This also means that the opportunity cost of free time is
higher, which gives her a greater incentive to work. But now, since she can have more
grain for each amount of free time, she may be more willing to give up some grain for
more free time, i.e. reduce her hours of work. These are the two effects that
technological improvements have, and clearly it works in opposite directions. In
Angela’s case, the second effect dominates, i.e. she chooses to reduce her hours of
work, which resulted in more grain.
3.7 Income and substitution effect on hours of work and free time
The two effects of technological improvements that we saw work in opposite directions
in the previous example, is indicative of the income and substitution effect. Consider
the following situation to explain the difference in these effects: you are looking for a
job after college and you expect to earn a wage of $15 per hour. The wage and the
hours of work will effectively determine how much free time you will have, and your
total earnings. We will define the wage as w, and the hours of free time you have as
t hours per day, which means you work (24 − t) hours per day. Because your
consumption cannot exceed your total earnings, your maximum level of
consumption, c, will be given by your number of hours worked multiplied by your wage:
=
(24 − )
This equation is called your budget constraint and shows what you can afford to buy.
Budget constraint: an equation that represents all combinations of goods and
services that one could acquire that exactly exhaust one’s budgetary resources.
Since we know that the wage is $15, the equation of the budget constraint is:
= 15(24 − )
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We can construct this budget line by simply drawing the straight line graph, or by
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plotting the respective combinations of free time and consumption as indicated in the
fo
4
6
8
10
12
14
16
Free time, t
24
22
20
18
16
14
12
10
8
Consumption, c
0
$30
$60
$90
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2
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0
rib
Hours of work
st
di
e/
al
rs
table below.
The
constructed
$120 $150 $180 $210
$240
budget
constraint is illustrated in the
figure to the right.
The
slope
of
the
budget
constraint corresponds to the
wage: for each additional hour
of free time, consumption must
decrease by $15. The shaded
area
under
the
budget
constraint represents your feasible set. The budget constraint acts very similar to a
feasible frontier, except now it is a straight line. Accordingly, your MRT, and therefore
the opportunity cost of free time, will be constant and equal to your wage, which is the
slope of the budget constraint – $15. Your preferred combination of free time and
consumption will therefore still be at the point where your budget constraint is
tangential to your highest indifference curve, as this is where MRS = MRT, as before,
i.e. point A in the figure above.
If you were to receive, say an additional $50 a day for life it will affect your decision.
The equation of your new budget constraint will now be:
= 15(24 − ) + 50
The extra income will not change your opportunity cost of time, but it will shift your
budget constraint parallel to the original budget constraint. This will allow you to
consume more per day, for every amount of hours worked, which essentially expand
the feasible frontier and enables you to consume on a higher indifference curve,
enabling you to increase your maximum utility. Your new ideal combination will be at
point B, which increases your consumption, but your hours of free time remains
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constant. The new budget constraint, relative to the original budget constraint is shown
below.
The effect of the additional income on your choice of free time is called the income
effect.
Income effect: the effect that the additional income would have if there were no
change in the price or opportunity cost.
In this case, your income effect was zero, as the extra income did not lead to an
increase in free time. An alternative scenario, based on preference, could have also
resulted in an income effect that is positive, in which case the additional income does
lead to an increase in your free time, as well, as illustrated below.
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It is important to note that the income effect can be positive or zero, but never negative.
n.
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= 25(24 − )
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equation of your new budget constraint will then be:
ot
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op
Consider the alternative scenario where the wage rate increases to $25 per hour. The
Your new budget constraint will now be steeper as the wage rate (slope) increased.
Similarly, your feasible set will be expanded, and you will be able to achieve a highest
level of utility as indifference curves that were previously infeasible, have now become
feasible. Your new optimal combination will therefore be point D, as illustrated in the
figure on the next page. This results in an increase in your consumption, but you will
have fewer hours of free time per day.
This is called the substitution effect, which decreases the hours of free time, but
increases consumption.
Substitution effect: the effect that is only due to changes in the price or opportunity
cost, given the new level of utility.
When the wage rate increases, two things happen – the opportunity cost of free time
increases, but you also have increased income, resulting in an income and substitution
effect, as illustrated in the figure on the following page. Initially your optimal
combination was at point A on IC₂. The higher wage enables you to reach point D on
IC₄. The increase in the wage, will result in a steeper budget constraint and will make
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your new optimal choice
point D on IC4. The dotted
line shows how you could
reach
IC4
without
an
increase in the wage rate,
i.e. an exogenous increase
an income. The shift from
point A to point C shows
the income effect of the
wage rise, which would
increase consumption and
free time. The shift from point C to point D shows the substitution effect of the wage
increase, which would increase consumption, but decrease free time. The total effect
of the wage increase would therefore be from point A to point D.
The substitution effect will always be negative – with a higher opportunity cost of free
time you choose a point on the indifference curve with a higher MRS, which is a point
with less free time (and more consumption). But, tThe overall effect of the wage rise
will therefore depend on the sum of the income and substitution effects. In this case,
the substitution effect was bigger than the income effect, which explains why you have
increased consumption, but less free time.
Technological progress
If you look back at Section 3.6, you will see that Angela’s response to a rise in
productivity was also determined by these two opposing effects: an increased
incentive to work produced by the rise in the opportunity cost of free time, and an
increased desire for free time when her income rises.
In general, the income effect of a higher wage makes workers want more free time,
while the substitution effect provides an incentive to work longer hours. If the income
effect dominates the substitution effect, workers will prefer to have more free time.
3.8 Is this a good model?
This model might seem unrealistic. But, remember from Unit 2 that models help us
“see more by looking at less”. The lack of realism in this model is therefore an
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intentional feature, rather than a shortcoming. The question is then: can a model that
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ignores thought, possibly be a good model of how we choose?
rs
fo
think through these calculations each time they decide. Instead, individuals try various
choices and then adopt to habits or change our choice, accordingly. Economic theory
rather posits that individuals will try different combinations, until they find that a
particular combination yields the best results for them, after which they will stick to that
combination. This is ultimately the “human” method of trial and error to find the
combination that maximises utility, as the model attempts to do mathematically.
The influence of culture and politics
The second unrealistic aspect of the model is that employers choose working hours,
not individuals. Employers will also typically impose longer working days than workers
prefer. As a result, working hours are mostly regulated by law, so that beyond some
number of hours, neither employee nor employer can choose to work. Effectively, the
government has imposed a limitation to the feasible set.
Although individual workers often have little freedom to choose their hours, the
changes in working hours over time, and differences between countries, may in fact
partly reflect the preferences of workers. If many individual workers in a democracy
wish to lower their hours, they may “choose” this indirectly as voters. Or, they may
bargain as members of a trade union for contracts that pay higher overtime wages for
longer working hours.
This explanation stresses culture, the changes in preferences or differences in
preferences among countries, and politics, the differences in laws, or trade union
strength and objectives, as possible explanation to the differences in working hours
between countries:
But, even on an individual level, we may influence the hours we work. For example,
employers who advertise jobs with the working hours that most people prefer may find
they have more applicants than other employers offering too many (or too few) hours.
Remember, we also judge the quality of a model by whether it provides insight into
something that we want to understand.
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n.
io
ut
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Milton Friedman (economist) explained that economists do not claim that individuals
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Trial and error replace calculations
UNIT 4: SOCIAL INTERACTIONS

Game theory is a way of understanding how people interact based on the
constraints that limit their actions, their motives, and their beliefs about what
others will do.
Game theory: a branch of mathematics that studies strategic interactions, meaning
situations in which each actor knows that the benefits they receive depend on the
actions taken by all.

In most interactions there is some conflict of interest between people, but also
some opportunity for mutual gain.
The tools of game theory allow economists to model these social interactions.
Social interaction: situations in which the actions taken by each person affect other
people’s outcomes as well as their own.

Self-interest, a concern for others, and a preference for fairness are all
important motives that explain how people interact.
The pursuit of self-interest can sometimes lead to results that are considered good by
all participants, or outcomes that none of the participants would prefer. A concern for
others and for fairness allows us to internalise the effects of our actions on others and
can also contribute to good social outcomes.
This unit will specifically look at situations that result in social dilemmas and how
people can sometimes solve them, but sometimes not (or not yet), as in the case of
climate change.
Social dilemma: a situation in which actions taken independently by individuals in
pursuit of their own private objectives result in an outcome which is inferior to some
other feasible outcome that could have occurred if people had acted together, rather
than as individuals.
Not all social interactions lead to social dilemmas, even if individuals act in pursuit of
their own interests. Social dilemmas, like climate change, occur when people take
inadequate account of the effects of their decisions on others, whether the effects are
positive or negative. Social dilemmas occur frequently in our lives.
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A typical example of a social dilemma is something that is common to all of us. If, as
Altruism: the willingness to bear a cost in order to benefit somebody else.
Altruistic self-sacrifice is not the most important way that societies resolve social
dilemmas and reduce free riding. Sometimes the problems can be resolved by
government policies. Local communities can also create institutions to regulate
behaviour.
4.1 Social interactions: Game theory
On which side of the road should you drive? In South Africa, we drive on the right. But
suppose we just left the choice to every driver to pursue their self-interest and to select
a side of the road. If everyone else was already driving on the right, the self-interest of
avoiding a collision could be enough to motivate a driver to drive on the right, as well.
In this example, self-interest can promote general wellbeing, but there are cases in
which the pursuit of self-interest leads to undesirable results. To analyse this, we will
introduce game theory, a way of modelling how people interact.
Social and strategic interactions
The following four concepts is important throughout this unit:

Strategic interactions
Strategic interaction: a social interaction in which the participants are aware of the
ways that their actions affect others (and the ways that the actions of others affect
them).
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n.
called altruistic.
io
The actions of these individuals willing to do the hard work on behalf of the group, are
ut
without contributing oneself.
rib
Free ride: benefiting from the contributions of others to some cooperative project
st
di
sometimes called free riders.
e/
al
work, bears the cost of having to work. The “others” that did not do the work are
rs
work for the group, everyone benefits, but it is hard work. Whoever does the most
fo
effort is individual, yet the benefits go to the whole group. When one person does the
ot
.N
op
a student, you have ever done a group assignment, you understand that the cost of

Strategy
Strategy: an action (or a course of action) that a person may take when that person
is aware of the mutual dependence of the results for herself and for others. The
outcomes depend not only on that person’s actions, but also on the actions of others.

Games
Game: a model of strategic interaction that describes the players, the feasible
strategies, the information that the players have, and their payoffs.
The players of a game refer to who is interacting with whom; the feasible strategies
refer to which actions are available to the players; the information refers to what each
player knows when making their decision; and the payoffs refer to what the outcomes
will be for each player for each of the possible combinations of actions.

Game theory
To see how game theory can clarify strategic interactions, imagine two farmers – Anil
and Bala. Both of them face the same problem – should they grow rice or cassava?
We assume that both farmers can grow both types of crop, but each can only grow
one crop at a time. Anil’s land is better suited for growing cassava, while Bala’s is
better suited for rice. The two farmers must determine who will specialise in which
crop, but they do so independently, i.e. they do not meet to discuss a course of action.
They both sell whatever crop they produce in a nearby village market. On market day,
if they bring less rice to the market, the price will be higher. The same goes for
cassava.
To simplify the model, we assume that:

There are no other people involved or affected in any way.

The selection of which crop to grow is the only decision that Anil and Bala need
to make.

Anil and Bala will interact just once (which is called a “one-shot game”).

They decide simultaneously. When a player decides that player doesn’t know
what the other person has decided to do.
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This interaction can be represented by the table on the following page. Anil’s choices
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are the rows of the table, which is called the “row player” and Bala’s are the columns,
fo
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rs
which is called the “column player”.
in
such
a
n.
represented
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When an interaction is
table, each cell describes
the
outcome
of
a
hypothetical situation, for
example, the upper-left cell
should be interpreted as:
Suppose Anil and Bala
planted rice, what would
we see? In this game, there
are
four
situations:
hypothetical
both
players
plant rice, Anil plants rice
and Bala plants cassava,
Anil plants cassava and Bala plants rice, or both players plant cassava.
Now that we know what the different outcomes are, we need to assign payoffs to each
hypothetical situation, which represents each player’s incomes they would receive if
the hypothetical actions were taken.
Payoff: the benefit to each player
associated with the joint actions of all
the players.
The payoffs of a game are typically
represented in a payoff matrix, as
indicated to the right. A matrix is just
any rectangular array of numbers.
The first number in each box is the
reward received by the row player
(whose name begins with A as a
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reminder that his payoff is first). The second number is the column player’s payoff.
Since the players’ income depends on the market prices, which in turn depend on their
decisions, this is called an “invisible hand” game.
4.2 Equilibrium in the invisible hand game
Game theory may also be able to provide predictions about what will happen. To
predict the outcome of a game, we need another concept, which is the best response
of each player.
Best response: in game theory, the strategy that will give a player the highest payoff,
given the strategies that the other players select.
Finding best responses
Suppose Anil considers the hypothetical case in which Bala has chosen to grow rice.
Anil would decide to grow cassava, as Anil would get a payoff of 4, compared to a
payoff of 1 if you decided to grow rice. We indicate this choice by means of a solid
black dot in the corresponding block, which represents the row player’s best response.
Similarly, if Bala chooses to grow cassava,
Anil’s best response would also be to grow
cassava, because the payoff will be 3,
rather than 2 (if Anil chose to grow rice).
Place
a
solid
black
dot
in
the
corresponding block. This will yield a
payoff matrix that looks like this, thus far.
The payoff in this game refers to units of
income that the player would receive when
they take their crops to sell on the markets.
Due to the fact that Anil will choose to grow
cassava, regardless of what choice Bala makes, it can be concluded that Anil’s
dominant strategy is to grow cassava.
Dominant strategy: action that yields the highest payoff for a player, no matter what
the other players do.
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the
column
player’s best response. If Anil instead
decided to grow cassava, Bala’s best
response will again be to grow rice,
because Bala will receive a payoff of 4
rather than 3. Place a circle in the corresponding block. Accordingly, Bala also has a
dominant strategy – he will choose to grow rice, regardless of what Anil chooses to
do.
From the final payoff matrix to the right, it is clear that a row player has a dominant
strategy if both solid black dots are in the same row; and a column player has a
dominant strategy if both circles are in the same column. This is the case in the game
that we just studied.
Because both players have a dominant strategy, we have a simple prediction about
what each player will do – each player will play their dominant strategy: Anil will grow
cassava, and Bala will grow rice. If we find that both players in a two-player game have
dominant strategies, the game has a dominant strategy equilibrium.
Dominant strategy equilibrium: an outcome of a game in which every player plays
his or her dominant strategy.
Anil choosing Cassava and Bala choosing Rice is an equilibrium because neither of
them would want to change their decision after seeing what the other player chose. In
the dominant strategy equilibrium Anil and Bala have specialised in producing the
good for which their land is better suited. Simply pursuing their self-interest resulted in
an outcome that was:

the best of the four possible outcomes for each player; and

the strategy that yielded the largest total payoffs for the two farmers combined.
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n.
represents
io
which
ut
block,
rib
means of a circle in the corresponding
st
di
best responses. We indicate this choice by
e/
al
2. Circles represent the column player’s
rs
because they payoff will be 3 rather than
fo
response will be to also grow Rice,
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Anil chooses to grow rice, Bala’s best
Sh
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Now we consider Bala’s best responses. If
In this example, the dominant strategy equilibrium is the outcome that each would
have chosen if they had a way of coordinating their decisions. Although they
independently pursued their self-interest, they were guided “as if by an invisible hand”
to an outcome that was in both of their best interests.
Real economic problems are never this simple, but the basic logic is the same. The
pursuit of self-interest without regard for others is sometimes considered to be morally
bad, but the study of economics has identified cases in which it can lead to outcomes
that are in fact socially desirable. There are other cases, however, in which the pursuit
of self-interest leads to results that are not in the self-interest of any of the players, for
example the Prisoner’s dilemma.
Homo economicus
Homo economicus (economic man) is the nickname that is given to the selfish and
calculating character that you find in economics textbooks. Have economists been
right to imagine homo economicus as the only actor on the economic stage?
Adam Smith believed that we were not homo economicus. But most economists since
Smith have disagreed. Since the 1990s, in an attempt to resolve the debate on
empirical grounds, economists have performed various experiments across the world
in which the behaviour of individuals can be observed as they make real choices about
sharing, using economic games. In these experiments, we almost always see some
self-interested behaviour. But we also observe altruism, reciprocity and aversion to
inequality, and other preferences that are different from self-interest. In many
experiments, homo economicus is the minority.
Reciprocity: a preference to be kind or to help others who are kind and helpful, and
to withhold help and kindness from people who are not helpful or kind.
Is the debate resolved? Many economists think so and now consider people who are
sometimes altruistic, sometimes inequality averse, and sometimes reciprocal, in
addition to homo economicus. They point out that the assumption of self-interest is
appropriate for many economic settings, but it might not be as appropriate in other
settings.
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4.3 The prisoners’ dilemma
players choose to use Terminator, the water contamination becomes a serious
problem, and they need to purchase an additional costly water filtering system. The
hypothetical scenarios that describe their interactions are shown in the table below.
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n.
If only one of the players choose to use Terminator, the damage is limited, but if both
io
farm that eats the pests.
ut
To use integrated pest control (IPC) that introduces beneficial insects to the
rib
st
di
e/
al
To use an inexpensive chemical called Terminator that kills every insect for
miles around, but also leaks into the water supply they both use.

rs

fo
to deal with pests that destroy their crops. Each has two feasible strategies:
ot
.N
op
Imagine that Anil and Bala are now facing a different problem – having to decide how
Now that both players are aware of the outcomes, they must know their payoffs to
make a decisions, which is in part dependent on the other player’s choice. This is an
example of a strategic interaction. The
payoff matrix for this strategic interaction
is illustrated in the payoff matrix to the
right. The payoff in this game refers to
units of income that the player would
receive when they take their crops to sell
on the markets, minus the cost of the
chosen form of pest control.
Using the same method as before (black
solid dots and circles), but omitting the
illustration thereof, the best responses of
both players are given below.
Anil’s best responses:

If Bala chooses IPC: Anil will choose Terminator.

If Bala chooses Terminator: Anil will choose Terminator.
Therefore, Anil has a dominant strategy – choose to use Terminator.
Bala’s best responses:

If Anil chooses IPC: Bala will choose Terminator.

If Anil chooses Terminator: Bala will choose Terminator.
Therefore, Bala has the same dominant strategy – choose to use Terminator.
In this game, both players using insecticide (Terminator) is the dominant strategy
equilibrium of the game. Both players will receive a payoff of 2. The problem is that
both players would be better off if they both used IPC instead. The predicted outcome
is therefore not the best feasible outcome. The pest control game is an example of a
game called the prisoners’ dilemma.
Prisoners’ dilemma: a game in which the payoffs in the dominant strategy equilibrium
are lower for each player, and lower in total, than if neither player played the dominant
strategy.
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The name of this game comes from a story about two prisoners (for example Thelma
game is given to the right.
In a prisoners’ dilemma, both players
have a dominant strategy which, when
played by both, results in an outcome that
is worse for both than if they had both
adopted a different strategy.
This example might be hypothetical, but
the concept of prisoners’ dilemma games applies to many real problems. In economic
examples, the mutually beneficial strategy is generally termed Cooperate, while the
dominant strategy is called Defect. Cooperate does not mean that players discuss the
decisions they will make together. The rules of the game are always that each player
decides independently on a strategy.
The contrast between the invisible hand game and the prisoners’ dilemma shows that
self-interest can lead to a favourable outcome or an outcome that nobody would
endorse.
Three aspects of the interaction between Anil and Bala caused us to predict an
unfortunate outcome in their prisoners’ dilemma game:

They did not place any value on the payoffs of the other person, and so did not
take account of the costs that their actions inflicted on the other.

There was no way anyone could make either player pay for the harm that they
caused.
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n.
lower payoff. The payoff matrix for this
io
means that each player would prefer a
ut
payoff is the number of years, which
rib
both get a jail sentence. In this game, the
st
di
whereas the other person gets a long jail sentence. If both chooses to Accuse, they
e/
al
Accuse the other and one chooses to Deny, the accuser will be freed immediately,
rs
If both Deny, they are freed after a few days of questioning. If one person chooses to
fo
prisoners may have committed together or Deny that the other prisoner was involved.
ot
.N
op
and Louise) whose strategies are to Accuse (implicate) the other in a crime that the

They were not able to make an agreement beforehand about what each would
do.
If we can overcome one or more of these problems, the outcome preferred by both
would sometimes be the result.
4.4 Social preferences: Altruism
When students play one-shot prisoners’ dilemma games in experiments, it is common
to observe many participants playing the Cooperate strategy, despite mutually
choosing Defect being the dominant strategy for players who care only about their own
monetary payoffs. One interpretation of these results is that players are altruistic.
The economic models we used in Unit 3 assumed self-interested preferences. People
generally do not care only about what happens to themselves, but also what happens
to others. Then we say that the individual has social preferences.
Social preferences: preferences that place a value on what happens to other people,
even if it results in lower payoffs for the individual.
Altruism is an example of a social preference. Spite and envy are also social
preferences, which indicates that social preference can be negative or positive.
Altruistic preferences as indifference curves
In previous units, we used indifference curves and feasible sets to model consumer’s
behaviour. We can do the same to study how people interact when social preferences
are part of their motivation. Imagine the following situation. Anil was given some tickets
for the national lottery, and one of the tickets won a prize of 10 thousand rupees. Anil
can keep all the money for himself, or he can share some of with his neighbour Bala.
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The figure to the right illustrates the situation graphically. The horizontal axis
ut
rib
st
di
e/
al
rs
combination of amounts of
fo
and the vertical one the amount that he gives to Bala. Each point represents a
ot
.N
op
represents the amount of money (in thousands of rupees) that Anil keeps for himself,
n.
io
money for Anil and Bala in
thousands of rupees. The
shaded triangle depicts the
feasible choices for Anil. At
the corner (10, 0) on the
horizontal axis, Anil keeps it
all. At the other corner (0, 10)
on the vertical axis, Anil gives
it all to Bala.
The boundary of the shaded area is the feasible frontier. If Anil divides up his prize
money, he chooses a point on that frontier, because being inside the frontier would
mean throwing away some of the money. The choice among points on the feasible
frontier is called a zero sum game because, when choosing point B rather than point
A, the sum of Anil’s losses and Bala’s gains is zero, for example, Anil has 3 thousand
fewer rupees at B than at A, and Bala has 3 thousand rupees more at B than at A.
Zero sum game: a game in which the payoff gains and losses of the individuals sum
to zero, for all combinations of strategies they might pursue.
If Anil is self-interested, his indifference curves are straight vertical lines, as illustrated
in the figure above, because he is indifferent to whether Bala gets a lot or nothing.
Given his feasible set, Anil’s best option would be point A, where he keeps all of the
money. If Anil were somewhat altruistic, he has downward-sloping indifference curves,
as indicated above. This is because Anil will derive utility from Bala’s consumption. In
this instance, his best feasible option in this case, is therefore point B.
If Anil is self-interested, the best option given his feasible set is A, where he keeps all
the money. If he derives utility from Bala’s consumption, he has downward-sloping
indifference curves so he may prefer an outcome where Bala gets some of the money.
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4.5 Altruistic preferences in the prisoners’ dilemma
When Anil and Bala wanted to get rid of pests, they found themselves in a prisoners’
dilemma. One reason for the unfortunate outcome was that they did not account for
the costs that their actions inflicted on the other. The choice of pest control regime
using the insecticide implied a free ride on the other farmer’s contribution to ensuring
clean water. If either player cared for the wellbeing of both players, the outcome can
be different.
In the figure below, the two axes represent Anil and Bala’s payoffs. The diagram shows
all feasible outcomes. However, now there are only four feasible combinations of
Terminator (T) and IPC (I).
If Anil does not care about Bala’s wellbeing, Anil’s indifference curves are vertical, so
(T, I) is his most preferred outcome. When Anil cares about Bala’s wellbeing, Anil’s
indifference curves will be downward-sloping and (I, I) is his most preferred outcome.
This figure demonstrates that when Anil is completely self-interested, his dominant
strategy is Terminator, but if Anil cares sufficiently about Bala, his dominant strategy
is IPC. If Bala feels the same way, then the two would both choose IPC, resulting in
the outcome that both prefer the most. The lesson here is therefore that if people care
about the wellbeing of one another, social dilemmas are easier to resolve.
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UNIT 5: PROPERTY AND POWER: MUTUAL GAINS AND CONFLCIT
ot
5.1 Institutions and power
e/
al
rs
fo
what people do when they interact in a joint project

the distribution of the products of their joint effort
Institutions provide both constraints and incentives. In the terminology of game theory,
institutions are the “rules of the game”, specifying who can do what, when they can do
it, and how the players’ actions determine their payoffs. The terms “institutions” and
“rules of the game” can be used interchangeably. Unit 4 illustrated that the rules of the
game affect:

how the game is played;

the size of the total payoff available to those participating; and

how this total is divided.
Since institutions determine who can do what, and how payoffs are distributed, they
determine the power individuals must get what they want in interactions with others.
Power
Power: the ability to do and get the things we want in opposition to the intentions of
others.
Power in economics takes two main forms:

Power can set the terms of an exchange by making a take-it-or-leave-it offer.

Power can impose or threaten to impose heavy costs upon a party, unless
the other party acts in a way that benefits the person with power.
A quick summary of an ultimatum game to understand the terminology used
below:
A two-person one shot game known as the ultimatum game is often used to study
social preferences. It observes the choices of players to investigate their preferences
and motives. A typical example is as follows: the players are invited to play a game
where they can win some money. How much money they win will depend on how all
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
io
Institutions are written and unwritten rules that govern:
ut
rib
st
di
Institutions
players choose to play the game. The rules are explained, and each player is randomly
assigned to be the Proposer or the Responder. The Proposer is given an amount of
money and is instructed to offer the Responder a portion of the money. It is a “take-itor-leave-it offer” hence the name – ultimatum game: the Responder can choose to
accept an offer and get some money, or reject the offer and get nothing.
The rules of the ultimatum game determine the ability that the players has to obtain a
high payoff, which is a form of power called bargaining power.
Bargaining power: the extent of a person’s advantage in securing a larger share of
the economic rents made possible by an interaction.
The power to make a take-it-or-leave-it offer gives the Proposer more bargaining
power than the Responder, and usually results in the Proposer getting more than half
of the “money”. The Proposer’s bargaining power is still limited because the
Responder has the power to refuse. If there are two Responders, the power to refuse
of each Responder is weaker, which means the Proposer has increased bargaining
power.
In real economies, unlike in the ultimatum game, the assignment of power is not
random. In the labour market, the power to set the terms of the exchange typically lies
with those who propose the wage and other terms of employment. Those seeking
employment are like Responders, and since there are many employment seekers,
their bargaining power may be low. Also, because the place of employment is the
employer’s private property, the employer may be able to exclude a worker by firing
them.
The power to say no
Suppose we allow a Proposer to split the money in any way and the Responder takes
whatever he gets, if anything. Under these rules, the Proposer has all the bargaining
power and the Responder none. There is an experimental game like this, and it is
called the dictator game. In a capitalist economy in a democratic society, institutions
exist to protect people against violence and coercion, and to ensure that most
economic interactions are conducted voluntarily, which means a dictator game is not
likely to occur.
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Allocation: a description of who does what, the consequences of their actions, and
who gets what as a result.
In the ultimatum game, the allocation describes the proposed division of the money by
the Proposer, whether it was rejected or accepted, and the resulting payoffs to the two
players.
The Pareto criterion
According to the Pareto criterion, allocation A dominates allocation B if at least one
party would be better off with A than B, and nobody would be worse off. We say that
A Pareto dominates B.
Pareto dominant: allocation A Pareto dominates allocation B if at least one party
would be better off with A than B, and nobody would be worse off.
Can we say which allocation is better when we compare two possible allocations, A
and B, that may result from an economic interaction? This criterion for judging between
A and B is called the Pareto criterion after Vilfredo Pareto (economist; sociologist).
Pareto criterion: according to the Pareto criterion, a desirable attribute of an
allocation is that it be Pareto efficient.
Note that when we say an allocation makes someone “better off” we mean that they
prefer it, which does not necessarily mean they get more money (wellbeing vs wealth).
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We call the outcome of an economic interaction an allocation.
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and have a means of evaluating it – is it better or worse than other potential outcomes?
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When individuals make a decision, we want to be able to both describe what happens
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5.2 Evaluating institutions and outcomes: The Pareto criterion
Pareto dominance
The figure to the right compares the four
allocations from the pest control game from
Unit 4 by the Pareto criterion. It is important
to note that we assume that Anil and Bala are
self-interested, so they prefer allocations with
a higher payoff for themselves.
Now, we use the exact same process to
determine Pareto dominance as the process
we used in Unit 2 to determine which
technology dominated another. The blue
rectangle with its corner at allocation (T, T)
shows that (I, I) Pareto dominates (T, T),
because it lies northeast of the allocation
(T,T). Using the shaded areas in the figure
to the right, it is possible to make the
following conclusions –

No allocation Pareto dominates (I,I),
but it Pareto dominates (T,T).

No allocation Pareto dominates
(I,T), but it also does not Pareto dominate any other allocations.

No allocation Pareto dominates (T,I), but it also does not Pareto dominate any
other allocations.
This example illustrates that the Pareto criterion may be of limited help in comparing
allocations, as it can only tell us which allocations Pareto dominates other allocations,
but it cannot tell us which allocation is better.
The diagram also shows that three of the four allocations are not Pareto dominated by
any other. An allocation with this property is called Pareto efficient.
Pareto efficient: an allocation with the property that there is no alternative technically
feasible allocation in which at least one person would be better off, and nobody worse
off.
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Pareto efficiency
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efficiency is very widely used in economics, but economists should take caution with
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least one party would be better off and nobody worse off. The concept of Pareto
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If an allocation is Pareto efficient, then there is no alternative allocation in which at
n.
the following:

There is often more than one Pareto efficient allocation.

The Pareto criterion does not tell us which of the Pareto efficient allocations is
better.

If an allocation is Pareto efficient, this does not mean we should approve of it.

The Pareto criterion tells us which allocation is Pareto efficient and Pareto
inefficient, but not which is better.
There are many Pareto efficient allocations that we would not evaluate favourably.
This is due to the existence of the concept of “fairness” that influences a decision.
5.3 Evaluating institutions and outcomes: Fairness
Although the Pareto criterion can help us to evaluate allocations, we will also want to
use another criterion: justice. We will ask, is it fair?
First and foremost, we can apply the criterion of justice (or the standard of fairness) to
the outcomes of the game. Suppose in the ultimatum game, the Proposer offered the
Responder one cent from a total of R100. This is clearly an unfair outcome towards
the Responder.
Consider now the Proposer lost their job and was homeless while the Responder was
well off. Now it seems more fair for the Proposer to keep R99.99. Thus, we might apply
a different standard of justice to the outcome when we know all the facts.
We could also apply a standard of fairness to the rules of the game. Suppose the
Proposer offers an equal offer of R50 each to the Responder. It might appear fair, but
what if this only occurred because the Responder had a gun to the Proposer’s head?
We would probably judge this to be unfair then.
The example makes a basic point about fairness. Allocations can be judged unfair
because of:
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
How unequal they are, in terms of, for example income or subjective
wellbeing. These are called substantive judgements of fairness.
Substantive judgements of fairness: judgements based on the characteristics of the
allocation itself, not how it was determined.

How they came about, for example, by force, or by competition on a level
playing field. These are called procedural judgements of fairness.
Procedural judgements of fairness: an evaluation of an outcome based on how the
allocation came about, and not on the characteristics of the outcome itself, (for
example, how unequal it is).
Substantive and procedural judgements
To make a substantive judgement about fairness, you only need to know the allocation
itself. However, for procedural evaluations you also need to know the rules of the game
and other factors that explain why the allocation occurred.
Substantive judgements
Substantive judgements are based on inequality in some aspect of the allocation, such
as:

Income: The reward in money (or some equivalent measure) of the individual’s
command over valued goods and services.

Happiness: Economists have developed indicators by which subjective
wellbeing can be measured.

Freedom: The extent that one can do (or be) what one chooses without socially
imposed limits.
Procedural judgements
The rules of the game that brought about the allocation may be evaluated according
to aspects, such as:

Voluntary exchange of private property acquired by legitimate means:
Were the actions resulting in the allocation the result of freely chosen actions
by the individuals involved, or was fraud or force involved?
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
Equal opportunity for economic advantage: Did people have an equal

Proposers and Responders are chosen randomly;

The game is played anonymously;

Discrimination is not possible; and

All actions are voluntary.
A substantive judgement would differ per outcome, but if the Proposer took 90%, for
example, most would agree that the allocation is unfair.
Evaluating fairness
The rules of the game in the real economy are a long way from the fair procedures of
the ultimatum game, and procedural judgements of unfairness are very important to
many people. People’s values about what is fair differ. John Rawls (philosopher)
devised a way to clearly evaluate the fairness of an allocation:
1. We adopt the principle that fairness applies to all people. If the roles were
to be revered, would each player still think that it is fair?
2. Imagine a veil of ignorance. For example, you do not know if you will be the
Proposer or the Responder.
3. From behind the veil of ignorance, we can make a judgement. The veil of
ignorance essentially give players an objective lens to view an allocation from.
The veil of ignorance invites you, in making a judgement about fairness, to put yourself
in the shoes of others quite different from yourself. Rawls argued that you would then
be able to evaluate the constitutions, laws, inheritance practices, and other institutions
of a society as an impartial outsider.
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n.
procedurally fair, because:
io
game. The experimental rules of the game will appear to most people’s minds as
ut
We can apply these differing judgements to evaluate the outcome of an ultimatum
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social norms?
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account of the extent to which an individual worked hard, or otherwise upheld
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Deservingness: Did the rules of the game that determined the allocation take
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
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some kind of discrimination or other disadvantages?
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opportunity to acquire a large share of the total to be divided up, or were there
There are many disagreements about the questions of value, but economics can
clarify the following:

How the dimensions of unfairness may be connected. For example, how
will special advantages of one group affect the degree of inequality of another.

The trade-offs between the dimensions of fairness. For example, do we
have to compromise on the equality of income if we also want equality of
opportunity?

Public policies to address concerns about unfairness. Do the policies
compromise other objectives?
5.4 A model of choice and conflict
As before, Angela’s harvest depends
on her hours of work, through the
production function. She works the
land and enjoys the remainder of the
day as free time. Angela values both
grain and free time, which means
that she needs to make trade-offs.
Angela’s indifference curves and her
feasible frontier are shown in the
figure to the right. Angela’s optimal
combination is at point C.
In this unit, we make an assumption
about Angela’s preferences that you can see in the shape of her indifference curves
that we call quasi-linearity. As she gets more grain, her MRS does not change. So, the
curves have the same slope as you move up the vertical line at 16 hours of free time.
More grain does not change her valuation of free time relative to grain. Why might this
be? Perhaps she does not eat all the grain, but sells some and uses the proceeds to
buy other things she needs.
Remember: when drawing indifference curves for the model in this unit, simply shift
them up and down, keeping the MRS constant at a given amount of free time.
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A new character appears
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Now, Bruno, who is not a farmer, but will
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claim some of Angela’s harvest, enters
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the situation. The figure to the right
n.
indicates Angela and Bruno’s combined
feasible frontier. The frontier indicates
how many bushels of grain Angela can
produce given the amount of free time
she takes. The figure also indicates a
possible allocation between Angela and
Bruno – both receive 5,25 bushels of
grain. Point F, G and H also show feasible allocations of this situation. Intuitively,
however, point H is an impossible allocation, because at this point Angela gets no
bushels of grain, which means she will starve. Of the allocations that are at least
possible (Point E, F and G), the one that will occur depends on the rules of the game.
5.5 Technically feasible allocations
Initially Angela could consume (or sell) everything she produced. But now Bruno has
arrived, and, for example, has a gun with the power to implement any allocation that
he chooses (dictator game). Bruno can determine the amount of grain Angela should
produce, as well as the grain will be shared among the players. In this model, we
assume that Bruno and Angela are entirely self-interested.
We now make another important assumption. If Angela does not work, there are no
other prospective farmers that Bruno can exploit. This means his reservation option is
zero, which means he will consider the future – he has to give Angela some of the
crops, otherwise she will die, and he will get nothing thereafter.
The first step will now be to determine the set of technically feasible combinations of
Angela’s hours of work and the amount of grain she receives. These combinations
consider the limitations of technology and biology.
Technically feasible: an allocation within the limits set by technology and biology.
The technological limitations are easy to determine, because they are introduced by
the production function, which is represented by the feasible frontier. Angela’s
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biological survival constraint, however, shows the minimum amount of grain that she
needs for each amount of work to survive. Points below this line (biological survival
constraint) would leave her undernourished or overworked that she would not survive.
This constraint shows what is biologically feasible. The question of biological feasibility
only arises because Bruno claims a portion of the output.
Biologically feasible: an allocation that can sustain the survival of those involved is
biologically feasible.
The figure to the right illustrates the
feasible
frontier,
as
well
as
the
limitations imposed upon production.
Angela’s chances at survival are limited
by the productivity of her labour, as well
as how much of what she produces is
taken by Bruno. If Angela does not work
at all, she needs 2,5 bushels of grain to
survive, represented by point Z. If she
gives up some free time and expends
energy working, she needs more food,
so the curve is higher when she has less free time. This is the biological survival
constraint. The slope of the biological survival constraint is the MRS between free time
and grain in securing Angela’s survival. Points below the biological survival constraint
are biologically infeasible, while points above the feasible frontier are technically
infeasible. This means that the technically feasible set is the intersection of the
biologically feasible and the technically feasible set, i.e. the points in the lens-shaped
area bounded by the feasible frontier and the biological survival constraint, including
the points on the feasible frontier. We can now ask which allocation will occur, and
how it depends on the institutions governing the interaction.
5.6 Allocations imposed by force
With the help of his gun, Bruno can choose any point in the technically feasible set of
allocations. But which will he choose? Bruno’s reasoning is that he should let Angela
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survival
constraint at any given number of hours of
free time. Using the figure to the right, it is
clear that the vertical distance is the
greatest when Angela works for 11 hours,
in which case Angela will produce 10
bushels and Bruno will get to keep 6
bushels for himself, after feeding Angela.
This figure can be used to determine how
much
Bruno
would
get
for
every
technically feasible allocation. The figure
to the right indicates that the vertical
distance is maximised at exactly the point where:
ℎ
=
ℎ
New institutions: Law and private property
Now we move from a scenario of coercion (slavery) to one in which there is a legal
system that prohibits slavery and protects private property and the rights of
landowners and workers. We can therefore expect the outcome of the interaction to
change. Bruno owns the land, which means that he can exclude Angela if he chooses.
How much grain he will get as a result of his private ownership of the land will depend
on the extent of his power over Angela in the new situation.
When people participate voluntarily in an interaction, they do so expecting economic
rents where the outcome is better than their reservation option. Economic rents are
also sometimes called gains from exchange.
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biological
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vertical distance between the feasible
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level of output that Bruno gets is the
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to give to Angela for her to survive. The
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him the maximum level of output, taking
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work for the amount of hours that gives
Gains from exchange: the benefits that each party gains from a transaction
compared to how they would have fared without the exchange. Also known as gains
from trade or economic rent.
The sum of the economic rents is termed the surplus, or joint surplus to emphasize
that it includes all the rents.
Joint surplus: the sum of the economic rents of all involved in an interaction. Also
known as total gains from exchange or trade.
How the joint surplus will be dividing among the players depend on their bargaining
power, which in turn depends on the institutions governing the interaction.
5.7 Economically feasible allocations and the surplus
Suppose a new situation where there is now a government with laws administered by
courts, and professional enforcers called the police. Bruno now owns the land, and
Angela must have permission to use his property. He can offer her a contract that
allows her to farm the land and give him part of the harvest in return, but the law
requires that the exchange between the players is voluntary – Angela can therefore
refuse the offer (contract).
In this situation, Bruno makes a take-it-or-leave-it offer, like the Proposer in the
ultimatum game. Furthermore, he also knows that Angela is entirely self-interested,
which means that she will not punish an unfair offer, i.e. if Bruno makes an offer slightly
better for Angela than not working and getting subsistence rations, she will accept it.
What the offer should be is determined the same way as in the previous example, but
now the limitation is not Angela’s survival, but rather her agreement. A consulting
economist know that Angela values free time, so the more hours Bruno offers her to
work, the more he will have to pay her. The economist therefore suggests that Bruno
considers her indifference curve that passes through the point where she does not
work at all and barely survives, which will tell him how much is the least he can pay
her for each of the hours of free time she would give up to work for you. This point is
illustrated by point Z in the figure on the following page.
Point Z indicates the allocation in which Angela does no work and gets only survival
rations (from an exogenous source). This is her reservation option. If Angela refuses
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Bruno’s offer, she has the option of not working and receiving survival rations as a
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that are as highly (equally) valued as one’s reservation option.
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Reservation indifference curve: a curve that indicates allocations (combinations)
Below or to the left of the reservation
indifference curve, Angela is worse off
than in her reservation option. Above
and to the right of the curve she is better
off.
The
economically
feasible
allocations are represented by the
points in the shaded area bounded by
the reservation indifference curve and
the feasible frontier, including the points
on the frontiers.
The biological survival constraint and the reservation indifference curve have a
common point (Z), because at that point, Angela does no work and gets the
subsistence rations from the government, which means that she can still survive. Other
than that, the two curves differ. The reservation indifference curve is uniformly above
the biological survival constraint. The reason is because

However hard Angela works along the survival constraint, she barely survives;
and the more she works the less free time she has, so she is unhappier.

Along the reservation indifference curve, by contrast, she is just as well off as
at her reservation option, meaning that being able to keep more of the grain
that she produces compensates exactly for her lost free time.
We can see that both Angela and Bruno may benefit if a deal can be made. Their
exchange makes it possible for both to be better off than if no deal had been struck.
All the allocations that represent mutual gains are shown in the economically feasible
set in the figure above. Each of these allocations Pareto dominates the allocation that
would occur without a deal. In other words, Bruno and Angela could achieve a Pareto
improvement.
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Pareto improvement: a change that benefits at least one person without making
anyone else worse off.
Again, Bruno maximises the amount
of grain he can get at the maximum
vertical distance between Angela’s
reservation indifference curve and
the feasible frontier. This will be
where the MRT on the feasible
frontier is equal to the MRS on the
indifference curve, as shown in the
figure to the right.
Using
coercion,
Bruno
chose
allocation B. He forced Angela to
work 11 hours and received grain equal to the distance of the line segment AB. With
the voluntary exchange from this situation, allocation B is not available. The best that
Bruno can do under the voluntary exchange is allocation D, where Angela works for 8
hours, giving him grain equal to the distance of the line segment CD, i.e. 4,5 bushels
of grain. He must therefore make a take-it-or-leave-it offer of a contract allowing
Angela to work the land, in return for a land rent of 4,5 bushels per day.
If Angela must pay 4,5 bushels of grain, then she will choose to produce at point C,
because that is where MRS = MRT where she works for 8 hours (irrespective of the
land rent), otherwise she would have lower utility if she still had to give Bruno 4,5
bushels of grain, because she would be below her reservation indifference curve. She
can achieve her reservation utility by working for 8 hours, so she will accept the
contract. Since Angela is on her reservation indifference curve, only Bruno benefits
from this exchange, i.e. the joint surplus goes to Bruno.
The surplus that Bruno gets will vary with the amount of Angela’s hours worked. You
will see that the surplus falls as Angela works more or less than 8 hours. It is humpshaped, like Bruno’s rent in the case of coercion. In this case, the peak is lower when
Bruno needs Angela to agree to the proposal than what it was under coercion, in the
previous example. This can be seen in the figure on the next page.
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5.8 The Pareto efficiency curve and the distribution of the surplus
Angela chose to work for 8 hours, producing 9 bushels of grain, resulting in a surplus
of 4.5 bushels when she had to pay land rent and when she did not have to. The two
cases differ in who gets the surplus. When Angela had to pay land rent, Bruno took
the whole surplus, but when she did not have to pay land rent, she obtained all the
surplus. Both allocations have two important properties:

All the grain produced is shared between Angela and Bruno.
This means that no Pareto improvement can be achieved by changing the amounts of
grain each player consume.

The MRT on the feasible frontier is equal to the MRS on Angela’s indifference
curve.
This means that no Pareto improvement can be achieved by changing Angela’s hours
of work and hence the amount of grain produced.
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This means that the allocations are Pareto efficient, because Pareto efficiency means
that no Pareto improvement is
possible.
The
figure
on
the
following page shows that there
are many other Pareto efficient
allocations in addition to these
two. Point C is the outcome when
Angela pays no land rent. Point D
is the outcome when Angela has
to pay land rent. Point G is a
hypothetical allocation, at which MRS = MRT. Angela works for 8 hours, and 9 bushels
of grain are produced. Bruno gets grain equal to the distance of CG, and Angela gets
the rest (equal to the distance of GD). Allocation G is Pareto efficient.
All points making up the line between C and D are in fact Pareto efficient allocations,
at which MRS = MRT, in which the surplus of 4,5 of grain is shared between Angela
and Bruno. The set of all these Pareto efficient allocations is the Pareto efficiency
curve.
Pareto efficiency curve: the set of all allocations that are Pareto efficient. Often
referred to as the contract curve, even in social interactions in which there is no
contract, which is why we avoid the term. Also known as the contract curve.
Figure 5.8 shows that in addition to the two Pareto efficient allocations we have
observed (C and D), every point between C and D represents a Pareto efficient
allocation. CD is called the Pareto efficiency curve. At each allocation on the Pareto
efficiency curve Angela works for 8 hours and there is a surplus of 4.5 bushels, but the
distribution of the surplus is different ranging between point D where Angela gets none
of the surplus, to point C where Angela gets all of the surplus. At any allocation
between C and D, both players receive an economic rent, which add up to the joint
surplus.
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
Through firms, the components of goods are produced by different people in
the firm and assembled to produce the finished good; or

Components are produced by groups of workers in different firms may be
brought together through market interactions between firms.

By buying and selling goods on markets, the finished good gets from the
producer into the pocket of the consumer.
The coordination of work
The way that labour is coordinated within firms is different to coordination through
markets:

Firms represent a concentration of economic power.
The power is placed in the hands of the owners and managers, who regularly issue
directives with the expectation that their employees will carry them out.

Markets are characterized by a decentralization of power.
Purchases and sales result from the buyers’ and sellers’ autonomous decision.
The prices that motivate and constrain people’s actions in a market are the result of
the actions of many, not a decision by someone in authority. The idea of private
property specifically limits the things a government or anyone else can do with your
possessions. In a firm, by contrast, owners or their managers direct the activities of
their many employees. The owners, through the board of directors, decide the longterm strategies of the firm concerning how, what, and where to produce. They then
direct the manager(s) to implement these decisions. Each manager assigns workers
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n.
The division of labour is coordinated in two major ways: firms and markets.
io
The economy is made up of people doing and specialising in different things.
ut
6.1 Firms, markets, and the division of labour
rib
may involve outsourcing production to other firms.
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boundaries in which it operates. It can take place within a multinational company or
e/
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Offshoring: the relocation of part of a firm’s activities outside of the national
rs
that are not the main market for the goods produced.
fo
Many firms, such as Apple, prefer outsourcing (or offshoring) production to countries
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UNIT 6: THE FIRM: OWNERS, MANAGERS, AND EMPLOYEES
to the tasks required for these decisions to be implemented and attempts to ensure
that the assignments are carried out.
Like any organisation, firms have a
decision-making process and ways of
imposing their decisions on the people
in it. In a firm’s decision-making
structure there is often people with
power over others. The figure to the
right shows a simplified picture of the
firm’s
actors
and
decision-making
structure.
In the figure above, directions or commands are represented by grey arrows and the
flow of information is represented by green arrows. The upward green arrows are
dashed because groups within the organisational hierarchy often know information
that other groups do not, which represents a problem of asymmetric information.
Asymmetric information: information that is relevant to the parties in an economic
interaction but is known by some but not by others.
Contracts and relationships
The difference between market interactions and relationships within firms is clear
when we consider the differing kinds of contracts that form the basis of exchange.
Contract: a legal document or understanding that specifies a set of actions that parties
to the contract must undertake.
Below are examples of contracts:

Sales contracts. The ownership of goods is (permanently) transferred to a new
owner who can now use the good and exclude others from its use.

Rental contracts. The ownership of goods is not transferred, instead it gives
an individual a limited set of rights over the good, including the right to exclude
others from its use.

Wage labour contracts. An employee gives an employer the right to direct
him/her to be at work at specific times, and to accept the authority of the
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employer over the use of his/her time while at work. These contracts temporarily
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transfer authority over a person’s activities from the employee to the manager
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Wage labour: a system in which producers are paid for the time they work for their
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or owner.
n.
employers.
Firms differ from markets in that social interactions within firms can extend over
decades, while social interactions in markets are typically short-lived and not repeated.
One of the reasons for this difference is that working in a firm means acquiring a
network of associates who are essential for the job to be done well. Some colleagues
might become friends. Managers and employees also acquire both technical and
social skills that are specific to the firm they work for. Oliver Williamson (economist)
termed these skills, networks, and friendships firm-specific assets, because they are
valuable only while the worker remains employed in a firm.
Firm-specific asset: something that a person owns or can do that has more value in
the individual’s current firm than in their next best alternative. Also known as relationspecific assets.
When the relationship (employment) ends, their value is lost to both sides. This social
aspect becomes important economically when economic changes disrupt social
interactions. The people making up the firm are united in their common interest in the
firm’s success, because all of them would suffer if it were to fail. However, they have
conflicting interests about how to distribute the profits from the firm’s success amongst
themselves and may disagree about other policies such as conditions of work,
managerial perks, and who makes the key decisions.
6.2 Other people’s money: The separation of ownership and control
The firm’s profits legally belong to the people who own the firm’s assets, including its
capital goods. The owners direct the other members of the firm to take actions that
contribute to the firm’s profits. This in turn will increase the value of the firm’s assets
and improve the wealth of the owners. The owners take whatever remains after
revenues are used to pay the firm’s obligations, i.e. the profit is the residual. The
owners claim it, which is why they are called residual claimants. Managers and
employees are not residual claimants.
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Residual claimant: the person who receives the income left over from a firm or other
project after the payment of all contractual costs.
This division of revenue has an important implication. If the firm’s revenues increase
because managers or employees do their job well, the owners will benefit, but the
managers and employees will not, unless they receive promotions, bonuses, or salary
increases.
In small enterprises, owners are typically also the managers and oversee operational
and strategic decisions. In most cases the owner will try to maximise the profits of the
enterprise by providing what customers want. In large corporations, there are typically
many owners. Most of them play no part in the firm’s management. The owners of the
firm are the parties that own the shares issued by the firm.
Share: a part of the assets of a firm that may be traded. It gives the holder a right to
receive a proportion of a firm’s profit and to benefit when the firm’s assets become
more valuable. Also known as a common stock.
By issuing shares to the general public, a company can raise capital to finance its
growth, leaving strategic and operational decisions to a relatively small group of
specialised managers. These decisions include what, where, and how to manufacture
the firm’s products, or how much to pay employees and managers. The senior
management of a firm is also responsible for deciding how much of the firm’s profits
are distributed to shareholders in the form of dividends, and how much is retained to
finance growth. The owners benefit from firm growth because they own part of the
value of the firm, which increases as the firm grows.
When managers decide on the use of other people’s funds, this is referred to as
the separation of ownership and control.
Separation of ownership and control: the attribute of some firms by which
managers are a separate group from the owners.
The separation of ownership and control results in a potential conflict of interest. The
decisions of managers affect profits, and profits decide the income of the owners, but
it is not always in the interest of managers to maximise profits. Managers might choose
to take actions that benefit themselves, at the expense of the owners. Even single
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owners of firms are not required to maximise their profits, but when they lose profits
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as a result, the cost comes directly out of their pocket.
1. They can structure contracts so that managerial compensation depends on the
performance of the company’s share price.
2. The board of directors, who typically have a substantial share in the firm, can
monitor the managers’ performance. They have the authority to dismiss
managers, and shareholders in turn have the right to replace members of the
board.
The owners of large companies with many shareholders rarely exercise this authority,
partly because shareholders are a large and diverse group that cannot easily get
together to decide something. Occasionally, however, this free-rider problem is
overcome and a shareholder with a large stake in a company may lead a shareholder
revolt to change or influence senior management.
6.3 Other people’s labour
The decision-makers in a firm manage not only other people’s money, but other
people’s labour, as well. People participate in firms because they can do better if they
are part of the firm than individually, because there are mutual gains.
A firm’s profits, before the payment of taxes, depend on the costs of acquiring the
inputs necessary for the production process, the output quantities, and the sales
revenues received from selling goods or services.
Hiring employees, although different from buying other goods and services, is still an
input to the process. A firm cannot write an enforceable employment contract that
specifies the exact tasks employees have to perform in order to get paid, because:

When the firm write a wage labour contract, it cannot know exactly what it will
need the employee to do, which will be determined by unforeseen future events.

It would be impractical or too costly for the firm to observe exactly how much
effort each employee makes in doing the job.
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n.
can incentivise managers to serve their interests.
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interests, rather than those of shareholders. Smith suggested two ways that owners
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Adam Smith (economist) observed the tendency of senior managers to serve their own

The information can also not be the basis of an enforceable contract, if firms
can find this information.
Clearly there is contractual incompleteness.
Incomplete contract: a contract that does not specify, in an enforceable way, every
aspect of the exchange that affects the interests of parties to the exchange (or of
others).
Why is it not possible for firms just to pay employees according to how productive they
are? An example is paying employees for product they finish. This method of payment
is known as piece rate, which provides the employee with an incentive to exert more
effort.
Piece-rate work: a type of employment in which the worker is paid a fixed amount for
each unit of the product made.
Why do most firms not use this simple method?

It is very difficult to measure the amount of output an employee is producing in
modern knowledge- and service-based economies.

Employees rarely work alone, so measuring the contribution of individual
workers is difficult.
Just as the owners of the firm protect their interests by linking management pay to the
firm’s share price, the manager uses incentives so that employees will work effectively.
6.4 Employment rents
There are many reasons why people put in a good day’s work. Once of the main
reasons to do a good job is the fear of being fired, or of missing the opportunity to be
promoted into a better position. Laws and practices concerning the termination of
employment for cause differ among countries. The question is whether workers do
care whether they lose their jobs? If firms paid their employees the lowest wages the
employee would accept, the answer would be no. But in practice most workers care
very much, because there is a difference between the value of the job and the value
of the next best option, i.e. being unemployed and having to search for a new job. In
other words, there is an employment rent.
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exceeds the net value of her next best alternative (that is, being unemployed). Also
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Employment rent: the economic rent a worker receives when the net value of her job
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Employment rents can benefit owners and managers in two ways:
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known as cost of job loss.

The employee is more likely to stay with the firm, which saves the firm
recruitment and training costs.

The firm can threaten to fire the employee, implicitly or explicitly, which will
motivate the worker to perform better and keep their job.
We can use the same reasoning in the employment of managers by the owners of the
firm. The main reason owners wield power over managers is that they can fire them,
and so eliminate their managerial employment rents.
Counting the cost of job loss
To calculate employment rent the benefits and costs of working compared with being
unemployed and searching for another job needs to be considered.
There are some costs of working, such as:

The disutility of work, i.e. employees must spend time doing things they would
prefer not to do; and

The cost of travelling.
But there are many benefits, which would be lost if you lost your job:

Wage income;

Firm-specific assets;

Medical insurance; and

The social status of being employed.
The question now arises how we measure these considerations?
6.5 Determinants of the employment rent
To construct a model of how employment rents may be used to motivate employees
to work hard, we consider Maria, an employee earning $12 an hour for a 35-hour
working week. To determine her economic rent, we need determine how she evaluates
two aspects of her job:

The pay that she gets, which is something she values; and
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
How hard she works, because she would like to do no more work than is
necessary due to the disutility of work.
Maria’s utility is therefore increased by the goods and services that she can buy with
her wage income but is reduced by the disutility of work. Her disutility of work depends
on how much effort she puts into her job. Suppose she spends half of her working time
working, and the other half doing other things. Her effort level (which can range from
zero to one) is therefore 0,5 – the proportion of her working hours in which she exerts
effort to do her work. Working this hard is equivalent to a cost of $2 per hour to Maria.
To calculate her employment rent we first find her net utility of working and earning
$12, compared with being unemployed and earning nothing:
net utility per hour = wage − disutility of effort per hour = $12 − $2 = $10
The total employment rent depends on how long she expects to remain unemployed.
Let’s suppose that if she loses her job, she will remain unemployed for 44 weeks. The
analysis of Maria’s total
employment
rent
is
shown in the figure to
the right.
Maria will continue to
receive this $12 an hour
for
the
foreseeable
future if she keeps her
job, as indicated by the
horizontal line at the top
of the figure. Maria’s
current effort level is 0,5. Working this hard is equivalent to a cost of $2 per hour to
Maria, illustrated by the small, bottom rectangle on the figure above. The difference
between her wage and disutility of effort is the economic rent per hour ($10) that she
receives while employed, illustrated by the blue shaded rectangle at the top of the
figure above. If instead Maria were to lose her job at time 0, she would no longer
receive her wages. This unfortunate state would persist if she remains unemployed,
indicated by the horizontal line at the bottom of the figure. The expected duration of
unemployment is 44 weeks, where she would have worked 35 hours per week (a total
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of 1 540 hours), which represents how long she will remain without pay and without
= $10 per hour × 1 540 hours = $15 400
People who lose their jobs can typically expect help from family and friends while they
are out of work. Also, people who lose their jobs receive unemployment benefit or
financial assistance from the government.
Unemployment benefit: a government transfer received by an unemployed person.
Also known as unemployment insurance.
If Maria receives an unemployment benefit or income from any sources, it will partially
offset her lost wage income. Let us suppose that while Maria remains unemployed,
she will receive an unemployment benefit equivalent to being paid $6 an hour for a 35hour week. This is her reservation wage.
Reservation wage: what an employee would get in alternative employment, or from
an unemployment benefit or other support, when they are not employed in their current
job.
In the figure above, Maria’s reservation wage was zero, because she would not have
received an unemployment benefit. The employment rent per hour, and accordingly
the total employment ret, needs to, however, be recalculated by considering the
reservation wage:
employment rent per hour = wage − reservation wage − disutility of effort
= wage − unemployment benefit − disutility of effort
= $12 − $6 − $2 = $4
By taking into account the full duration of the unemployment period of 44 weeks, we
see that the new total employment rent will be:
total employment rent
= employment rent per hour × expected hours of lost work time
= $4 per hour × 1,540 hours = $6 160
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n.
total employment rent = employment rent per hour × expected lost hours of work
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times the number of hours of work she will lose if her job is terminated, as below:
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weeks. Maria’s total employment rent is calculated as the employment rent per hour
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the disutility of working. Maria expects to find another job at the same wage after 44
The figure below shows how Maria’s employment rent is affected by the
unemployment benefit, assuming her effort and disutility of work are unchanged.
Unemployment benefits usually run out eventually, which will change the opinion of
the employee. If Maria’s eligibility for unemployment benefits of $6 lasted only for 13
weeks, her reservation wage would in fact not be $6. Her employment rent would be
higher, and her reservation wage would be lower, because the average level of
benefits she could expect over the 44-week period of unemployment would be much
less than $6.
6.6 Work and wages: The labour discipline model
When the employment rent is large, workers will be willing to work harder in order to
reduce the likelihood of losing the job. A firm can increase the employment rent, and
therefore the effort exerted by its employees, by raising the employees’ wages. We
now represent this social interaction in the firm as a game played by the owners
(through their managers) and the employees.
The two players in this game is the owner (the employer) and a single worker, Maria.
The game is sequential, i.e. one players makes a decision and the other player follows.
This game will also be repeated in each period of employment. The following will be
the order of play in this game:
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1. The employer will choose a wage based on the knowledge of how employees
given that Maria responds the way she does, their strategies are a Nash equilibrium
Nash equilibrium: a set of strategies, one for each player in the game, such that each
player’s strategy is a best response to the strategies chosen by the other players.
In this situation, we will ignore additional supervision costs and assume that the
employer occasionally gets information on how hard employees are working. This is
not enough to implement a piece-rate wage, but sufficient to fire a worker. Maria knows
that the chance of the employer getting bad news decreases the harder she works.
To decide on the wage to set, the employer needs to know how the employee’s work
effort will respond to higher wages. We will consider Maria’s decision first. We will
assume Maria has a reservation wage of $6. This means that her best response to a
wage of $6 would be an effort level of zero. What if she were to be paid a higher wage?
For Maria, effort has a cost, which is the disutility of work, but also a benefit: it
increases the likelihood of her keeping the job, as well as her employment rent. She
therefore needs to find a balance between the benefits and the costs. A higher wage
will increase the employment rent, so it will lead Maria to choose a higher level of
effort, which means her best response (her effort level) will increase with the level of
the wage chosen by the employer. Maria’s best response curve is shown in the figure
on the following page.
Worker’s best response function (to wage): the optimal amount of work that a
worker chooses to perform for each wage that the employer may offer. This is also
known as the best response curve.
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n.
to the employer’s offer, and the employer chooses the wage that maximises his profit
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considering the disutility of work. If Maria’s chooses her work effort as a best response
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the employer will make. Maria’s payoff is her net value of the wage she receives,
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greater Maria’s effort, the more goods or services she will produce, and the more profit
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The payoff for the employer is the profit made after the deduction of wages. The
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considering the costs of losing her job if she does not provide enough effort.
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2. Maria chooses a level of work effort in response to the wage offered,
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employed in subsequent periods at the same wage, if they work hard enough.
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respond to higher or lower wages and informs the employee that they will be
This upward-sloping curve shows the relationship between Maria’s effort level for each
level of the wage rate that the employer offers her. When the wage is low, the best
response curve is steep, i.e. a small wage increase raises effort by a substantial
amount. Furthermore, this curve also indicates diminishing marginal returns.
This best response curve was constructed with the reservation being $6 (where the
function touches the horizontal axis) and under the assumption that the duration of
unemployment is 44 weeks. If the expected duration were to change, the best
response function would change too, because Maria’s employment rent would change.
The best response curve is the frontier of the employer’s feasible set of combinations
of wages and effort that it gets from its employees. The slope of the best response
curve is the employer’s MRT of higher wages into more worker effort. The best
response curve is concave, i.e. it becomes flatter as the wage and the effort level
increase. This is because, as the effort level approaches the maximum possible level,
the disutility of effort becomes greater, which means it takes a larger employment rent
(and therefore wage) to get effort from the employee.
From the standpoint of the owner, the best response curve shows how paying higher
wages can elicit higher effort, but with diminishing marginal returns. In other words,
the higher the initial wage, the smaller the increase in effort and output the employer
gets from an extra $1 per hour in wages.
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face a trade-off. They can get more effort only by paying higher wages.
To maximise profits, firms want to minimise the costs of production. They want to pay
the lowest possible price for inputs. Accordingly, the employer would like to purchase
employment at the lowest possible price. This does not, however, mean paying the
lowest possible wage, because the employer knows if they pay the reservation wage,
workers will have an effort level of zero.
The wage, w, is the cost to the employer of an hour of a worker’s time. The hour does
not matter, however, but rather the units of effort, which is the actual input in the
production process. If Maria chooses to provide 0,5 units of effort per hour, the cost of
a unit of effort to the employer will be 2 . In general, if Maria provides e units of effort
per hour, the cost of a unit of effort is:
e
To maximise profits, the employer should therefore find a feasible combination of effort
and wage that minimises . The employer should maximise the number of units of
effort, also called efficiency units, that they get per dollar of wage cost, .
The
upward-sloping
straight lines in the
figure to the right joins
together a set of points
that have the same
ratio
of
effort
to
wages, . We will call
these lines isocost line
for effort, where the
cost of effort will be the
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n.
curve. The fact that the best response curve slopes upwards means that employers
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that they cannot get Maria to provide more effort than is given by her best response
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the conditions under which she makes her choice. The owners and managers know
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Maria can choose how hard she works. The best the employer can do is to determine
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6.7 Wages, effort, and profits in the labour discipline model
same at any point on the line. These are essentially the indifference curves of the
employer.
The line slopes upward because a higher effort level must be accompanied by a higher
wage for the
ratio to remain unchanged. On an isocost line, the slope is , which is
also the MRS, but the cost of effort is . A steeper line has a lower cost of effort (hence
higher profits for the employer), and a flatter line has a higher cost of effort.
The employer is indifferent between points on an isocost line. To minimise costs, the
employer will seek to reach the steepest isocost line for effort, where the cost of a unit
of effort is lowest. But because he cannot dictate the level of effort, he must pick a
point on Maria’s best
response curve. As the
figure to the right shows,
the
employer’s
best
option would therefore
be to set the wage rate
at $12 on the isocost line
that is tangent to Maria’s
best
response
curve
(point A), where the
isocost line is tangential
to the worker’s best
response curve. At this point, the MRS (the slope of the isocost line for effort) is equal
to the MRT of higher wages into greater effort (the slope of the best response function).
Even though a point such as point B would have lower costs for the employer, they
are infeasible, as Maria would not work for that combination of hourly wage and effort
level. And the employer would also not choose point C, because they would be able
to pay more in order to decrease the effort to wage ratio. Therefore $12 is the hourly
wage that the employer should set to minimize costs and maximize profits.
When wages are set by the employer in this manner, they are sometimes
called efficiency wages because the employer is recognising that what matters for
profits is , the efficiency units per dollar of wage costs, rather than how much an hour
of work costs.
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reservation wage, to motivate the employee to provide more effort on the job than he
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Efficiency wages: the payment an employer makes that is higher than an employee’s
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What has the labour discipline model told us?
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or she would otherwise choose to make.
Labour discipline model: a model that explains how employers set wages so that
employees receive an economic rent (called employment rent), which provides
workers an incentive to work hard in order to avoid job termination.

Equilibrium. In the owner-employee game, the employer offers a wage and
the employer provides a level of effort in response, which are strategies that
represent a Nash equilibrium.

Rent. The employee provides an effort because they receive an employment
rent that they might lose if they were to slack off on the job, because they would
be fired.

Power. The employer can exercise power over the employee, as the employee
fear a loss of employment rent, which would incentivise a higher effort level,
which contributes to the profits of the employer.
Involuntary unemployment
When we think about the implications of the labour discipline model for the whole
economy, it tells us that there must always be involuntary unemployment.
Involuntary unemployment: the state of being out of work but preferring to have a
job at the wages and working conditions that otherwise identical employed workers
have.
Being unemployed involuntarily means not having a job, although you would be willing
to work at the wage that other workers similar to you are receiving.
In developing our previous model, we assumed that Maria could expect to be
unemployed for 44 weeks before receiving another wage offer at the same level. This
model was built on the assumption that there must be an extended period of
unemployment. To see why, try to imagine an equilibrium where the employer offers
Maria a wage of $12 per hour, and if she lost her job, she could immediately find
another at the same wage. In this case, Maria’s employment rent would be zero, i.e.
she would be indifferent between keeping her job and losing it, which means her best
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response would be an effort level of zero. But this could not be an equilibrium, because
the employer would not pay a wage for an employee to do nothing.
In the event that there were plenty of jobs available in the economy at $12 per hour,
and no one was unemployed, such a situation could not last. Employers would offer
higher wages to ensure that their workers had something to lose and would therefore
work hard. But with higher wages, they would not be able to offer as many jobs, which
means there will definitely be involuntary unemployment. It is therefore important to
realise that in equilibrium, both wages and involuntary unemployment must be high
enough to ensure that there is enough employment rent for workers to put in effort.
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Monopoly rents: a form of economic profits, which arise due to restricted competition
in selling a firm’s product.
The
figure
to
the
right
illustrates key decisions that
a firm makes. This unit will
specifically focus particularly
on how a firm chooses the
price of a product, and the
quantity to produce, which
will depend on the demand it
faces and its production
costs.
The demand for a product
will depend on its price, and
the costs of production may
depend on how many units
are produced. But a firm can actively influence both consumer demand and costs in
more ways than through price and quantity. Innovation may lead to new and attractive
products, or to lower production costs. If the firm can innovate successfully it can earn
economic rents—at least in the short term until others catch up. Further innovation
may be needed if it is to stay ahead. Advertising can increase demand. The firm sets
the wage, which is an important component of its cost.
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n.
higher profit margins, and monopoly rents.
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through product selection and advertising. Those with fewer competitors can achieve
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employees who can make all these things happen. Firms can also increase profits
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quality than their competitors. They also need to be able to recruit and retain
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choice, their ability to attract customers, and produce at a lower cost and a higher
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A firm’s success depends on more than getting the price right, but also on their product
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their profits, considering the product demand curve and the cost function.
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Firms producing differentiated products choose price and quantity to maximise
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UNIT 7: THE FIRM AND ITS CUSTOMERS
7.1 Breakfast cereal: Choosing a price
To decide what price to charge, a firm needs information about demand, i.e. how much
potential consumers are willing to pay for its product.
Demand curve: the curve that gives the quantity consumers will buy at each possible
price.
The figure to the right shows
the demand curve of a company
called
Apple-Cinnamon
Cheerios.
This
figure,
for
example, shows that if the price
were
$3,
customers
would
demand 25 000 pounds of
Apple-Cinnamon Cheerios. For
most products, the lower the price, the more customers wish to buy.
To choose a price and quantity to produce, the firm needs to consider how this decision
will affect their profits, which is the difference between sales revenue and production
costs. Suppose that the unit cost of Apple-Cinnamon Cheerios is $2. To maximise
their profit, they should produce exactly the quantity they expect to sell, and no more.
Total profit is therefore calculated as:
profit = total revenue − total costs = price × quantity − unit cost × quantity =
= P × Q − 2 × Q = (P − 2) × Q
Using this formula, you could calculate the profit for any choice of price and quantity
and draw relevant isoprofit curves. Isoprofit curves join points (combinations of price
and quantity) that give the same level of total profit. Isoprofit curves can therefore be
considered as the firm’s indifference curves, because the firm will be indifferent
between combinations of price and quantity that give them the same profit. Isoprofit
curves of a different total profit can be seen in the figure on the following page.
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The horizontal line in the figure above shows the choices of price and quantity where
the profit is zero, because the price of the cereal is exactly equal to the cost of
production.
To achieve a high profit, the firm would like both price and quantity to be as high as
possible, but the prices and quantity of the goods are constrained by the demand
curve. If you choose a high price, you will only be able to sell a small quantity; and if
you want to sell a large quantity, you must choose a low price. Accordingly, the
demand curve also determines a feasible set. To determine the feasible set, it is
important to consider the isoprofit curves and the demand curve together, as in the
figure below. The firm wants to choose a feasible price and quantity combination that
will maximize your profit.
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The firm will always want to choose a point on the highest possible isoprofit curve,
while still remaining in the feasible set. In the figure on the previous page, this happens
at point E, where the manager should choose P = $4,40, and Q = 14 000 pounds. The
optimal combination occurs where MRS = MRT.

The slope of the isoprofit curve represents the trade-off you are willing to make
between P and Q, the MRS.

The slope of the demand curve is the trade-off you are constrained to make
between P and Q, the MRT.
Even from an economist’s point of view, there are other ways to think about profit
maximisation. The lower panel in the figure to the right shows how much profit the firm
would make at each
point on the demand
curve.
When
the
quantity is low, so is
their profit. As the
quantity
demanded
increases, profit will
rise until it reaches a
maximum at point E.
Beyond point E, the
profit will start to fall.
Profits will fall until
they are zero where
the price is equal to
the unit cost of $2.
From the figure to the
right, it is clear that profits can often be negative, which typically occurs when selling
a very high quantity where the price is lower than the unit cost. The graph in the lower
panel of the figure above is the profit function, which shows the profit the firm would
generate at every quantity, Q. The profit function is based on the highest price that
would enable the firm to sell the relevant quantity, according to the demand function.
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Technological advantages. Large-scale production often uses fewer inputs
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produces its output at lower cost per unit. This may be possible for two reasons:
fo
An important reason why a large firm may be more profitable is that the large firm
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7.2 Economies of scale and the cost advantages of large-scale production
per unit of output.

Cost advantages. In larger firms, fixed costs often have a smaller effect on the
cost per unit.

Bargaining power. Large firms often have the ability to purchase their inputs
at a negotiated lower cost.
Economies and diseconomies of scale
If we increase all inputs by a given proportion, and it:

increases output more than proportionally, then the technology is said to
exhibit increasing returns to scale in production.

increases
output
less
than
proportionally,
then
the
technology
exhibits decreasing returns to scale in production.
Diseconomies of scale: these occur when doubling all the inputs to a production
process less than doubles the output. Also known as decreasing returns to scale.

increases output proportionally, then the technology exhibits constant returns
to scale in production.
Constant returns to scale: these occur when doubling all the inputs to a production
process doubles the output. The shape of a firm’s long-run average cost curve
depends both on returns to scale in production and the effect of scale on the prices it
pays for its inputs.
Economies of scale may result from specialisation within the firm, as it minimises
training time by limiting the skill set that each worker needs; or for purely engineering
reasons. There also exists built-in diseconomies of scale. Think of the firm’s owners,
managers, work supervisors and production workers.
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Cost advantages
Cost per unit may fall as the firm produces more output, even if there are constant or
even decreasing returns to scale. This happens if there is a fixed cost that is
independent on the number of units.
Fixed costs: costs of production that do not vary with the number of units produced.
Examples of fixed costs include research and development or marketing expenses.
Research and development (R&D): expenditures by a private or public entity to
create new methods of production, products, or other economically relevant new
knowledge.
Secondly, large firms can also get cost advantages because they can purchase their
inputs on more favourable terms, because they have more bargaining power to
negotiate with suppliers.
Demand advantages
Large firms may also benefit a firm in selling its product. This occurs because people
are more likely to buy a product or service if it already has a lot of users. Such demandside benefits of scale are called network economies of scale.
Network economies of scale: these exist when an increase in the number of users
of an output of a firm implies an increase in the value of the output to each of them,
because they are connected to each other.
7.3 Production: The cost function for Beautiful Cars
Consider a firm, Beautiful Cars, that manufactures cars, which produces specialty cars
and will turn out to be rather small. Think about the costs of producing and selling cars.
The firm needs premises equipped with machines to produce car body parts, as well
as raw materials and components to produce the relevant car parts, and lastly, also
pay employees to operate the equipment.
A firm’s owners would usually not be willing to invest in a firm if they could make better
use of their money by investing and earning profits elsewhere. What they could receive
if they invested elsewhere, per dollar of investment, is called the opportunity cost of
capital.
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Opportunity cost of capital: the amount of income an investor could have received
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by investing the unit of capital elsewhere.
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shareholders to cover the opportunity cost of capital to induce them to continue to
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Part of the cost of producing cars is the amount that the firm has to pay to the
invest in the assets that the firm needs to produce cars.
The more cars the firm
produces, the higher the
total costs will be. The
upper panel of the figure to
the right shows that total
costs
depend
quantity
of
on
the
cars, Q,
produced per day. This is
the firm’s cost function,
C(Q). The cost function
shows that when the firm
does not produce or sell
any cars, they still need to
cover their fixed costs, F,
which is illustrated in the
top panel of the figure to
the right.
From the cost function, the firm can calculate its average cost of a car (
), and
how it changes with Q; the average cost curve (AC) is plotted in the lower panel of the
figure to the right. Initially, as output rises, fixed costs are shared between more cars,
and the average cost falls. The average cost will then reach a minimum, as illustrated
by point B above. Thereafter, the average cost will start to rise again as the increase
in variable costs outweigh the benefit of the fixed cost being shared over many cars.
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Marginal cost
At each point on the cost function, the marginal cost (MC) can also be calculated,
which corresponds to the slope of the cost function.
Marginal cost: the effect on total cost of producing one additional unit of output. It
corresponds to the slope of the total cost function at each point.
If cost increases by ΔC when quantity is increased by ΔQ, the marginal cost can be
estimated by:
MC =
ΔC
ΔQ
If we calculate marginal cost at every point on the cost function, we can draw the
marginal cost curve. The figure below indicates the marginal cost at every quantity,
plotted along with the average cost at that quantity.
The marginal cost curve is an upward-sloping line as it represents the slope of the total
cost curve, which becomes increasingly steeper as the quantity increases. It is this
rising marginal cost that eventually causes the average costs to increase and causes
the “upswing” in the average cost curve, as shown above.
Now if we compare the AC and MC curves, we can draw the following conclusions

The AC curve is downward-sloping at values of Q where the AC is greater than
the MC; and
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The AC curve is at a minimum at the Q where AC = MC.
7.4 Demand and isoprofit curves: Beautiful Cars
Cars are differentiated products.
Differentiated product: a product produced by a single firm that has some unique
characteristics compared to similar products of other firms.
We expect that a firm selling a differentiated product to face a downward-sloping
demand curve. For any product that consumers might wish to buy, the product demand
curve is a relationship that tells you the number of items (the quantity) they will buy at
each possible price. Each consumer has a willingness to pay (WTP) for a Beautiful
Car, which depends on how much the customer personally values it.
Willingness to pay (WTP): an indicator of how much a person values a good,
measured by the maximum amount he or she would pay to acquire a unit of the good.
A consumer will buy a car if the price is less than or equal to their WTP. Suppose we
line up the consumers in order of WTP, with the highest first, and plot a graph to show
how the WTP varies along the line, as illustrated in the figure to the right. Then if we
choose
say P = $3
any
price,
200,
the
graph shows the number
of
consumers
whose
WTP is greater than or
equal to P. In this case,
60 consumers are willing
to pay $3 200 or more, so
the demand for cars at a
price of $3 200 is 60.
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n.
produced jointly by a single firm, rather being produced in separate firms.
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Economies of scope: cost savings that occur when two or more products are
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This happens regardless of the shape of the total cost function.
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
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The AC curve is upward-sloping at values of Q where AC is less than MC.
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
If the price is lower, there are a larger number of consumers willing to buy, so the
demand is higher. Demand curves are often drawn as straight lines, as in the figure
above, although there is no reason to expect them to be straight in reality. In reality,
demand curves are curved as we saw in the demand curve for Apple-Cinnamon
Cheerios. The downward slope of the demand curve can be explained by the
relationship between price and quantity, which is also known as the Law of Demand.
The demand curve determines the feasible set of combinations of P and Q.
To find the profit-maximising point, we need to combine the demand curve and the
isoprofit curves again and look for the point of tangency. The firm’s profit is the
difference between its revenue and its total costs:
profit = total revenue − total costs = P × Q − C(Q)
This calculation gives us what is known as the economic profit.
Economic profit: a firm’s revenue minus its total costs (including the opportunity cost
of capital).
Remember, the cost function includes the opportunity cost of capital, which is referred
to as normal profits.
Normal profits: corresponds to zero economic profit and means that the rate of profit
is equal to the opportunity cost of capital.
Economic profit is the additional profit above the minimum return required by
shareholders. Equivalently, profit is the number of units of output multiplied by the
profit per unit, which is the difference between the price and the average cost:
profit = Q × (P − C(Q)) = Q × (P − AC)
From this equation, it is clear that the shape of the isoprofit curves will depend on the
shape of the average cost curve.
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The figure to the right
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combines the different
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graphs that we have
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looked at so far. The
n.
the
io
lowest curve shows
zero-economic-
profit curve, i.e. the
combinations of price
and quantity for which
the firm will make a normal profit, because the P = AC at each quantity.
In the figure on the previous page, the MC of Beautiful Cars can be distinguished from
the MC curve at ay given quantity. The P is determined by tracing that quantity to the
isoprofit curve. Bearing this in mind, we can note that:

Isoprofit curves slope downwards at points where P > MC, i.e. the isoprofit
curve is above the MC curve.

Isoprofit curves slope upward at points where P < MC, i.e. the MC curve is
above the isoprofit curve.
Profit margin: the difference between the price and the marginal cost.
At any point on an isoprofit curve the slope is given by:
slope of isoprofit curve = −
(P − MC)
=−
profit margin
quantity
7.5 Setting price and quantity to maximise profit
To determine the best choice of price and quantity for the firm, the firm needs to
consider the demand curve, the isoprofit curves and its MC curve. The only feasible
choices are the points on or below the demand curve, shown by the pink shaded area
on the diagram. To maximize profit the firm should choose the tangency point E, which
is on the highest possible isoprofit curve, as shown in the figure below.
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The profit-maximizing price and quantity are P* = $5 440 and Q* = 32, and the
corresponding profit is $63 360. The optimal combination of price and quantity
balances the trade-off that the firm would be willing to make between price and quantity
for any given level of total profit, against the trade-off the firm is constrained to make
by the demand curve.
Constrained optimisation
The profit-maximisation problem is another constrained choice problem. Each of these
problems have the same structure:

The decision-maker wants to choose the values of one or more variables to
achieve a goal, or objective.

The objective is to optimize something.

The decision-maker faces a constraint, which limits what is feasible.
A decision-maker chooses the values of one or more variables to achieve an objective
subject to a constraint that determines the feasible set.
This far, the decision-maker’s choice is represented graphically by showing the
indifference curves, which relate to the objective (iso-utility, isocost, or isoprofit), as
well as the feasible set of outcomes, which is determined by the constraint. The
solution of the problem is always at the tangency point where the MRS (slope of the
indifference curve) is equal to the MRT (slope of the constraint).
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isoprofit curves. Instead, we use the marginal revenue curve. Remember that if Q cars
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Let’s consider a different method of finding the profit-maximising point, without using
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7.6 Look at profit maximization as marginal revenue and marginal cost
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are sold at a price P, revenue, R, is given by:
R = P × Q
Calculating the revenue, also allows the firm to determine the marginal revenue of the
firm.
Marginal revenue: the increase in revenue obtained by increasing the quantity by one
unit.
The firm can calculate its marginal revenue as:
R
Q
The table below indicates how to calculate the marginal revenue when Q = 20.
Quantity
Price
Revenue
Q = 20
P = $6 400
R = $128 000
Q = 21
P = $6 320
R = $132 720
ΔQ = 1
ΔP = $80
MR = $4 720
Gain in revenue (Price of selling the 21st car)
$6 320
Loss of revenue ($80 on each of the other 20 sold cars)
−$1 600
Marginal revenue
$4 720
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The table above shows
that
the
marginal
revenue can also be
calculated
as
the
difference between the
gain of $6,320 and the
loss of $1,600. This can
also
be
graphically
illustrated by the figure to
the
right.
The
figure
shows that the firm’s
revenue is the area of the rectangle drawn below the demand curve. When Q is
increased from 20 to 21, revenue changes for two reasons – the extra car sold at the
new price, and the loss of $80 on each of the other 20 cars. The marginal revenue is
the net effect of these two changes.
The series of figures on the following page illustrate how to find the marginal revenue
curve and how it can be it to find the point of maximum profit. The upper panel shows
the demand curve, which depicts a series of changes in revenue by means of shaded
rectangles as in the figure above. The middle panel shows the marginal cost curve
together with the marginal revenue curve, which is constructed from the additional
revenue as illustrated by the shaded rectangles in the top panel. The marginal revenue
curve is usually downward sloping, but it does not necessarily have to be.
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The firm’s profit
The lower two panels in the figure above demonstrate that the profit-maximising
quantity is found where the MR and MC curves intersect. To understand why, it is
important to note that the change in profit if Q was increased by one unit, the marginal
profit, would be the difference between the change in revenue, and the change in
costs:
marginal profit = MR − MC
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Marginal profit is the slope of the profit function. A summary of the figure on the
previous page can be given by the following:

If MR > MC (Marginal profit > 0), the firm could increase profit by raising Q;

If MR = MC (Marginal profit = 0), the firm is at its maximum profit; and/or

If MR < MC (Marginal profit < 0), the firm could increase profit by decreasing Q.
7.7 Gains from trade
When people engage voluntarily in economic interactions, they do so because they
can obtain a surplus called economic rent. The total surplus for the parties involved is
a measure of the gains from exchange. We can analyse the outcome of the economic
interactions between consumers and a firm just as we did for Angela and Bruno in Unit
5. We judge the total surplus, and the way it is shared, in terms of Pareto efficiency
and fairness.
We have assumed that the rules of the game for allocating Cheerios and cars to
consumers are:
1. A firm decides how many items to produce and sets a price; and
2. Then individual consumers decide whether to buy.
These rules reflect typical market institutions for the allocation of consumer goods. In
the interactions between Beautiful Cars and its consumers, there are potential gains
for both, if the firm can manufacture a car at a cost less than the value of the car to a
consumer.
Recall, the demand curve shows the WTP of each of the potential consumers. A
consumer whose WTP > P will buy the good and receive a surplus, since the value to
her of the car is more than she must pay for it. Similarly, the marginal cost curve shows
what it costs to make each additional car. And if the marginal cost is lower than the
price, the firm receives a surplus too. The figure on the following page will be used to
shows how the firm can determine the total surplus for the firm and its consumers,
when Beautiful Cars sets the price to maximize its profits.
Total surplus: the total gains from trade received by all parties involved in the
exchange. It is measured as the sum of the consumer and producer surpluses.
total surplus = sum of WTPs of consumers − sum of MCs of producers
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Gains from trade
line at the quantity 10. Similarly, the 15th consumer with a WTP of $6 800 will have a
surplus of $1 360.
To find the total surplus obtained by consumers, we add together the surplus of each
buyer, which is shown by the red shaded triangle between the demand curve and the
line where price is P*. This measure of the consumers’ gains from trade is
the consumer surplus.
Consumer surplus: the consumer’s WTP for a good minus the price at which the
consumer bought the good, summed across all units sold.
consumer surplus = sum of WTPs − sum of prices paid
Similarly, the firm makes a producer surplus on each car sold.
Producer surplus: the price at which a firm sells a good minus the minimum price at
which it would have been willing to sell the good, summed across all units sold.
producer surplus = sum of prices received − sum of MCs of each unit
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n.
example, whose WTP is $7 200 makes a surplus of $1 760, as shown by the vertical
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means that the particular buyer’s surplus is equal to zero. The 10th consumer, for
fo
32nd consumer whose WTP is $5 440 is indifferent between buying a car and not. This
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When the firm sets its profit-maximizing price at $5 440 and sells 32 cars per day, the
The marginal cost of the 20th car is $2 000. By selling it for $5 440, the firm gains $3
440, shown by the vertical line in the figure above between P* and the marginal cost
curve. To find the total producer surplus we add together the surplus on each car
produced, which is shown by the purple-shaded area. We see from the relative size of
the two areas in the figure on the previous page, that in this market, the firm obtains a
greater surplus share.
The producer surplus is closely related to the firm’s profit, but it is not quite the same
thing. Producer surplus is the difference between the firm’s revenue and the marginal
costs of every unit, but it doesn’t allow for the fixed costs, which are incurred even
when Q = 0. The profit is therefore the producer surplus minus fixed costs.
Similar to Angela and Bruno’s situation, both parties gain in the market for Beautiful
Cars, and the division of the gains is determined by the bargaining power of the
players. In this case the firm has more bargaining power than its consumers, which is
illustrated by the larger producer surplus.
Pareto efficiency
The question arises whether the allocation of cars in this market are Pareto efficient?
The answer is no, because there are consumers who do not purchase cars at the
firm’s chosen price, but who would nevertheless be willing to pay more than it would
cost the firm to produce them.
The figure to the right (an
extension of the one on the
previous page) indicates that
the firm makes a surplus on
the marginal
car (the
32nd
car), because the price is
greater than the marginal
cost.
The
firm
could,
however, produce another
car and sell it to the 33rd consumer at a price lower than $5 440, which is still higher
than the production cost. This would be a Pareto improvement, because the firm and
the 33rd consumer would be better off. This means that the potential gains from trade
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in the market for this type of car was not exhausted at point E, even though it was the
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profit maximising point.
consumers would be willing to pay. At point F, the consumer surplus would be higher
than at point E, but the producer surplus is less. Since the firm will choose E, as its
producer surplus is higher, there is a loss of potential (consumer) surplus, known as
the deadweight loss.
Deadweight loss: a loss of total surplus relative to a Pareto efficient allocation.
In the figure on the previous page, deadweight loss is equal to the triangular area
between Q = 32, the demand curve, and the marginal cost curve. Accordingly, the firm
will choose point E, because that is the best it can do given the rules of the game, i.e.
selling to all customers at one. This example therefore shows that the allocation that
results from price-setting by the producer of a differentiated product is Pareto
inefficient. because the firm uses its bargaining power to keep the price higher than
the marginal cost by producing a quantity that is too low, relative to the Pareto efficient
allocation.
Imagine the rules of the game were different, and the firm could charge separate prices
to each buyer, which is called perfect price discrimination, the firm would set the
price for each consumer just below their WTP. The firm would sell to all potential buyer
where their WTP > MC, and as a result all mutually beneficial trades would take place,
resulting in the Pareto efficient quantity of cars. To enable perfect price discrimination,
the firm would need to know the WTP of every buyer. Here, the deadweight loss would
disappear, and the firm would be able to capture the entire surplus, i.e. there would be
no consumer surplus. It might be unfair, but the allocation would be Pareto efficient.
7.8 The elasticity of demand
A firm’s profit maximisation decision will be affected by the slope of the demand curve,
i.e. the sensitivity of consumers’ demand for a good if prices were to change. The price
elasticity of demand is a measure of the responsiveness of consumers to a price
change.
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n.
because the production cost of another car would exceed how much any remaining
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cost curve crosses the demand curve. This would be a Pareto efficient allocation,
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Suppose the firm had chosen point F on the figure above instead, where the marginal
Price elasticity of demand: the percentage change in demand that would occur in
response to a 1% increase in price. We express this as a positive number. Demand is
elastic if this is greater than 1, and inelastic if less than 1.
To illustrate, suppose the price of a product increases by 10% and a firm observes a
5% fall in the quantity sold. The elasticity, ε, can then be calculated as follows:
=−
% ℎ
/% ℎ
=−
% ℎ
−5
= 0,5
10
Due to the nature of the demand curve, one variable will always decrease, i.e. if
quantity sold increases, the price will fall, or vice versa. The minus sign in the formula
therefore ensures that the price elasticity of demand is always a positive number that
measures responsiveness.
The price elasticity of demand is related to the slope of the demand curve. If the
demand curve is quite flat, the quantity changes a lot in response to a change in price,
so the elasticity is high. Conversely, a steeper demand curve corresponds to a lower
elasticity. But the slope of the demand curve and the price elasticity of demand are not
the same thing, and it is important to notice that the elasticity changes as we move
along the demand curve, even if the slope doesn’t.
If you were to calculate the price elasticity of demand and the marginal revenue at
every point on the demand curve, you would be able to make certain general
conclusions. These general conclusions are indicated on the figure below.

Any point on the demand curve to the right of the of the midpoint (Point C), will
have a
> 1 and the MR > 0.
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
Any point on the demand curve to the left of the of the midpoint (Point C), will
= 1 and MR = 0.
without losing much on the other cars and total revenue will rise, i.e. MR > 0.
Conversely, if demand is inelastic, the firm cannot increase Q without a big drop in P,
so MR < 0. This relationship is true for all demand curves.
How does the elasticity of demand affect a firm’s decisions? The firm would never
want to choose a point where the demand curve is inelastic, because the marginal
revenue is negative there. Accordingly, the firm would always choose a point where
the elasticity is greater than 1.
Furthermore, the firm’s profit margin is also closely related to the elasticity of demand.
When the demand curve is relatively flat, the price elasticity of demand is high. In these
cases, the profit margin will be relatively small.
When the demand curve is
relatively steep and the price
elasticity of demand therefore
low, the profit margin will be
high,
but
maximising
the
quantity
profitwill
typically be much lower than
the Pareto efficient allocation,
which results in a larger
deadweight
loss,
as
illustrated by the figure to the right.
The aforementioned illustrates that the lower the elasticity of demand, the more the
firm will raise the price above the marginal cost to achieve a high profit margin. When
demand elasticity is low, the firm has the power to raise the price without losing many
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n.
quantity. So, by producing one extra car, the firm will gain revenue on the extra car
io
When demand is highly elastic, price will only fall a little if the firm increases its
ut
when demand is elastic, and MR < 0 when demand is inelastic. Why does this happen?
rib
< 1. Therefore, MR > 0
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di
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> 1, we say that demand is elastic, and inelastic if
rs
At the midpoint, point C, the
fo
When
< 1 and the MR < 0.
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
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have a
customers, and the markup, which is the profit margin as a proportion of the price, will
be high.
Price markup: the price minus the marginal cost divided by the price. It is inversely
proportional to the elasticity of demand for this good.
The price markup is inversely proportional to the elasticity of demand. We can find a
formula that shows that the markup is high when the elasticity of demand is low. We
know that the firm chooses a point where the slope of the isoprofit curve is equal to
the slope of the demand curve, and that the slope of the demand curve is related to
the price elasticity of demand:
=−
×
1
slope
By rearranging the formula above, we can get that the:
slope of the demand curve = −
×
1
From before, we know that the:
slope of isoprofit curve = −
−
The firm will therefore choose a point where:
−
−
=−
×
1
By multiplying throughout by − , we get:
−
=
1
The left-hand side, which is the profit margin as a proportion of the price, is the price
markup. Therefore, the firm’s markup is inversely proportional to the elasticity of
demand.
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
If demand is highly elastic a tax will cause a large reduction in sales, which also
reduces potential tax revenue.
If a government therefore wishes to raise tax revenue, they should choose to impose
a tax on products with inelastic demand. This is the case, for example, with tobacco
products and alcoholic beverages, with the so-called sin tax. This is because it would
be difficult to deter consumers from buying the products, even with the price increase
associated with the imposition of taxes.
7.10 Price-setting, competition, and market power
The firm’s pricing decision that we have modelled up until now, applies to all firms that
produce and sell differentiated products and is affected by the price elasticity of
demand. But what determines the price elasticity of demand product, and why do
some firms face more elastic demand than others?
Markets with differentiated products reflect differences in the preferences of
consumers. People who want to buy a car are looking for different combinations of
characteristics. A consumer’s WTP for a model will depend not only on its
characteristics, but also on the characteristics and prices of similar products sold by
other firms. When consumers can choose between several quite similar producers,
the demand for each product is likely to be quite elastic. If the price of product A, for
example, were to rise, the demand would fall because consumers would choose to
buy one of the other similar product instead. Conversely, if the price of product A were
to fall, the demand would increase because consumers would be attracted away from
the other similar product. The more similar the products, the more responsive
consumers will be to price differences. Only consumers with high brand loyalty and
strong preference for a characteristic of a specific product would fail to respond. The
firm will then have a relatively low price and profit margin.
In contrast, the manufacturer of a very specialised product, very different from any
other brand in the market, faces little competition and hence less elastic demand. It
can set a price well above marginal cost without losing customers. Such a firm is
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paid by the consumers, so the effect of the tax will depend on the elasticity of demand:
rs
considering the imposition of taxes. This is because a tax on a good will raise the price
fo
Measuring elasticities of demand is useful to policymakers, especially when
ot
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op
Sh
s.
ie
7.9 Using demand elasticities in government policy
earning monopoly rents arising from its position as the only supplier of this type of car.
Augustin Cournot (economist) identified that differentiated products can lead to the
development of a monopoly and therefore a monopolised market.
Monopoly: a firm that is the only seller of a product without close substitutes. Also
refers to a market with only one seller. In monopolies, firms set prices greater than the
marginal production cost.
Based on the above definition, it is clear that a firm will be in a strong competitive
position if there are few firms producing close substitutes for its own brand, because
it faces little competition.
Substitutes: two goods for which an increase in the price of one leads to an increase
in the quantity demanded of the other.
Accordingly, its elasticity of demand will be relatively low. We say that such a firm
has market power.
Market power: an attribute of a firm that can sell its product at a range of feasible
prices, so that it can benefit by acting as a price-setter (rather than a price-taker).
The firm will have enough bargaining power in its relationship with customers to set a
high price without losing them to competitors.
Competition policy
Market power allows firms to set high prices, and make high profits, at the expense of
consumers. Potential consumer surplus would be lost because few consumers would
buy at these high prices, and those who do buy have to pay a high price. The owners
of the firm benefit, but overall, there is a deadweight loss.
A firm selling a niche product catering for the preferences of a small number of
consumers is unlikely to attract the attention of policymakers, despite the loss of
consumer surplus. But if one firm is becoming dominant in a large market,
governments may intervene to promote competition. A concern is that when there are
only a few dominant firms in a market they may form a cartel.
Cartel: a group of firms that collude in order to increase their joint profits by keeping
prices artificially high.
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By working together and behaving as a monopoly, rather than competing, the firms
prices.
7.11 Product selection, innovation, and advertising
The profits that a firm can achieve depend on the demand curve for its product, which
in turn depends on the preferences of consumers and competition from other firms.
The firm may be able to move the demand curve to increase profits by changing its
selection of products, or through increased marketing efforts. When deciding what
goods to produce, the firm would ideally like to find a product that is attractive to
consumers and is differentiated from products sold by other firms. In this case,
demand would be high and the elasticity low. This is not likely to be easy.
Technological innovation could provide opportunities for firms to get ahead of
competitors.
If a firm has invented or created a new product, it may be able to prevent competition
altogether by claiming exclusive rights to produce it, using patent or copyright laws.
This could result in the legal protection of monopolies that limits the gains from trade,
but conversely provides other firms with the incentive to conduct R&D to develop new
products.
Advertising is another strategy that firms can use to influence demand. When products
are differentiated, the firm can use advertising to inform consumers about the
existence and characteristics of its product, attract them away from its competitors,
and create brand loyalty. Advertising is often not used to inform consumers about the
product, but rather to increase brand loyalty, and encourage consumers of competing
products to switch.
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n.
Dominant firms can also exploit their market position by strategies other than high
io
cartels. Also known as antitrust policy (in the US).
ut
Competition policy: government policy and laws to limit monopoly power and prevent
rib
policy in the US.
st
di
limit market power and prevent cartels is known as competition policy, or antitrust
e/
al
firms often find ways to cooperate in the setting of prices to maximise profits. Policy to
rs
producing countries. While cartels between private firms are illegal in many countries,
fo
Organisation of the Petroleum Exporting Countries (OPEC), an association of oil-
ot
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within the cartel can increase their profits. A well-known example of a cartel is the
7.12 Prices, costs, and market failures
One example of a market failures is when firms set prices above the marginal cost of
producing their goods, especially when the elasticity of demand is low.
Market failure: when markets allocate resources in a Pareto-inefficient way, resulting
in a deadweight loss.
Firms set prices above marginal costs when the goods they produce are differentiated
from those produced by other firms, so that they serve consumers with different
preferences and face limited competition. Firms can benefit from strategies that reduce
competition, but without competition the deadweight loss may be high, so
policymakers try to reduce the deadweight loss through competition policy.
Product differentiation is not the only reason for a price above marginal cost. A second
important reason is decreasing average costs, for whatever reason. In such cases, the
average cost of production is greater than the marginal cost of each unit, and the
average cost curve slopes downward. The firm’s price must be at least equal to
average cost to prevent making a loss, which is therefore above the marginal cost.
Decreasing average costs mean that firms can produce at lower cost per unit when
operating at a large scale. This is common in the provision of utilities, such as
supplying watering. If a single firm operates at a large enough scale can supply the
whole market at lower average cost than other firms, the industry is said to be a natural
monopoly.
Natural monopoly: a production process in which the long-run average cost curve is
sufficiently downward-sloping to make it impossible to sustain competition among
firms in this market.
In the case of a natural monopoly, policymakers may not be able to induce firms to
lower their prices by promoting competition, since average costs would rise with more
firms in the market. Governments may then choose to regulate the firm’s activities,
limiting its discretion over prices in order to increase consumer surplus. An alternative
solution is public ownership, for example the supply of electricity in South Africa.
The price of a differentiated product is above the marginal cost as a direct result of the
firm’s response to the absence of competing firms and price-insensitivity of
consumers. The source of the problem in the cases of utilities is the cost structure,
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rather than the lack of competition per se. However, the two problems, i.e. limited
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138
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scale eliminates other firms and therefore competition.
rs
winner-takes-all. The first firm to exploit the cost advantages of operating at a large
fo
competition among firms with downward-sloping average cost curves tends to be
ot
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competition and decreasing average costs, are often closely related because
UNIT 8: SUPPLY AND DEMAND: PRICE-TALKING AND
COMPETITIVE MARKETS

The interaction of supply and demand determines a market equilibrium in which
both buyers and sellers are price-takers, called a competitive equilibrium.
The prices and quantities in competitive equilibrium change in response to supply and
demand shocks.

The model of perfect competition describes idealized conditions under which
all buyers and sellers are price-takers.
Price-taking behaviour ensures that all gains from trade in the market are exhausted
at a competitive equilibrium. It is important to acknowledge and evaluate the
similarities and differences between price-taking and price-setting firms.
The market price of a good is determined by the interaction of supply and demand, but
sometimes there is a large excess demand.
Excess demand: a situation in which the quantity of a good demanded is greater than
the quantity supplied at the current price.
The amazing thing about prices being determined by markets is that individuals do not
send the messages, but rather the anonymous interaction of sometimes millions of
people. And when conditions change nobody has to change the message they are
sending. A price change results from a change in firms’ costs.
8.1 Buying and selling: Demand and supply
For a simple model of a market with many buyers and sellers, think about the trade of
second-hand textbooks. Demand for the book comes from students who are about to
begin a specific course, and they will differ in their WTP. No one will pay more than
the price of a new copy. Below that price, students’ WTP will differ and depend on
various things. When you buy something, you don’t need to think about your exact
WTP, because you just decide whether to pay the asking price
Figure 8.1 shows the demand curve. As in Unit 7, we line up all the consumers in order
of WTP, highest first. The first student is willing to pay $20, the 20th $10, and so on.
For any price, P, the graph tells you how many students would be willing to buy: it is
the number whose WTP is at or above P.
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The demand curve as we know it, represents the WTP of buyers; similarly, supply
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depends on the sellers’ willingness to accept (WTA) money in return for books.
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willing to sell a unit only for a price at least this high.
rs
fo
Willingness to accept (WTA): the reservation price of a potential seller, who will be
The supply of second-hand books comes from students who have previously
completed a specific course and no longer need the textbook. Each of these suppliers
will differ in the amount they are willing to accept, i.e. their reservation price.
Reservation price: the lowest price at which someone is willing to sell a good
(keeping the good is the potential seller’s reservation option).
We can draw a supply curve by lining up the sellers in order of their reservation prices,
or their WTAs, as in the figure to the right.
Supply curve: the curve that shows the number of units of output that would be
produced at any given price. For a market, it shows the total quantity that all firms
together would produce at any given price.
We put the sellers who are
most willing to sell, i.e. those
who
have
the
lowest
reservation prices, first, so the
graph of reservation prices
slopes upward. The supply
curve slopes upward because
the higher the price, the more
students will be willing to sell.
8.2 The market and the equilibrium price
Traditional market institutions brought buyers and sellers together in one (physical)
place. With modern communications, sellers can advertise their goods and buyers can
more easily find out what is available, and where to buy it. In some cases, it is still
convenient for many buyers and sellers to meet each other.
Alfred Marshall (economist) introduced his model of supply and demand. He called the
price that equated supply and demand the equilibrium price. If the price was above the
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equilibrium, suppliers would want to sell large quantities of grain, but fewer consumers
would be willing to buy. This means there is excess supply.
Excess supply: a situation in which the quantity of a good supplied is greater than
the quantity demanded at the current price.
In this case, even consumers who were willing to pay that much would realise that the
suppliers would have to lower their prices. Accordingly, consumers would therefore
wait until suppliers lowered their prices. Similarly, if the price was below the
equilibrium, there would be an excess demand, so, sellers would rather wait for the
price to increase before they sell. If, at any going price, the amount supplied did not
equal the amount demanded, Marshall reasoned that some sellers or buyers could
benefit by charging another price, i.e. the going price is not a Nash equilibrium. The
price would therefore settle at an equilibrium level, where demand and supply were
equated.
Equilibrium (of a market): a state of a market in which there is no tendency for the
quantities bought and sold, or the market price, to change, unless there is some
change in the underlying costs, preferences, or other determinants of the behaviour of
market actors.
Marshall argued that the model of supply and demand can be applied to markets in
which all sellers are selling identical goods, which is a different model as opposed to
the model implemented for differentiated products in Unit 7.
Marshall and Léon Walras (economist) termed the neoclassical school of economics
and used calculus to formulate the workings of markets and firms, and express key
concepts such as marginal costs and marginal utility, along with others, such as
consumer and producer surplus.
Marginal utility: the additional utility resulting from a one-unit increase of a given
variable.
To apply the supply and demand model to the textbook market, we assume that all the
books are identical and that a potential seller can advertise a book for sale by
announcing its price on a local website. We would expect that most transactions would
occur at similar prices, because buyers and sellers can easily observe all the
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advertised prices. The
.N
op
ot
equilibrium price can be
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determined by drawing
ut
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the supply and demand
n.
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curves on one set of
axes, as in the figure to
the
right.
The
equilibrium price always
occurs
at
the
intersection of the supply and demand curve, as at point A in the figure above. The
equilibrium price can also be called the market clearing price.
Market-clearing price: at this price there is no excess supply or excess demand.
We say that a market is in equilibrium if the actions of buyers and sellers have no
tendency to change the price or the quantities bought and sold, unless there is a
change in market conditions such as the numbers of potential buyers and sellers, and
how much they value the good. At the equilibrium price for textbooks, all those who
wish to buy, or sell can do so, so there is no tendency for change.
Price-taking
Will the market always be in equilibrium? As we have seen, Marshall argued that prices
would not deviate far from the equilibrium level, because people would want to change
their prices if there were excess supply or demand.
In the textbook market that we have described, individual students must accept the
prevailing equilibrium price in the market, determined by the supply and demand
curves. No one would trade with a student asking a higher price or offering a lower
one, because anyone could find an alternative seller or buyer with a better price. The
participants in this market are price-takers, because there is enough competition from
other buyers and sellers so the best they can do is to trade at the same price.
Price-taker: characteristic of producers and consumers who cannot benefit by offering
or asking any price other than the market price in the equilibrium of a competitive
market. They have no power to influence the market price
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Any buyer or seller is of course free to choose a different price, but they would not
benefit by doing so. In this unit, we study market equilibria where both buyers and
sellers are price-takers. There are scenarios in which sellers are not price-takers, for
example when suppliers sell differentiated products. When buyers and sellers are
price-takers, we expect to see price-taking on both sides of the market where there
are many sellers selling identical goods, and many buyers wishing to purchase them.
On both sides of the market, competition eliminates bargaining power. We will
describe the equilibrium in such a market as a competitive equilibrium.
Competitive equilibrium: a market outcome in which all buyers and sellers are pricetakers, and at the prevailing market price, the quantity supplied is equal to the quantity
demanded. It is a Nash equilibrium, because given the actions of all other players, no
player could do any better than to continue with what they are already doing.
8.3 Price-taking firms
We will now look at markets where the sellers are firms, instead of individuals as
before. If there are many firms producing identical products, and consumers can easily
switch from one firm to another, then firms will be price-takers in equilibrium. They will
be unable to benefit from attempting to trade at a price different from the prevailing
price.
To see how price-taking firms
behave, consider the figure to
the right where there are
many small bakeries that
produce bread and sell to
consumers.
The
market
demand curve, which shows
the total daily demand for
bread of all consumers in the city, is downward sloping as before.
Suppose you are the owner of one of the bakeries and need to decide what price to
charge and how many loaves to produce each morning. The neighbouring bakeries
are selling identical loaves at €2.35, the prevailing market price. Because there are so
many bakeries, you are a price-taking firm.
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As your bread output increases, your marginal cost will increase. When the quantity is
fo
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of loaves per day increases,
ut
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the average cost will fall, but
At
n.
gradually.
io
the marginal cost will begin to
rise
higher
quantities the marginal cost is
above the average cost, then
average costs will start to rise
again.
The
marginal
and
average cost curves can be
seen in the figure to the right.
If the price of a loaf of bread were equal to the average cost, the economic profit would
be zero, as illustrated by the lowest curve in the figure above. The owner typically
generates a normal return on your capital, which means that the average cost curve
is the zero-economic-profit curve. The zero-economic-profit curve is just another
isoprofit curve. The isoprofit curves in the figure above show the price and quantity
combinations at which you would receive higher levels of profit. As explained before,
isoprofit curves slope downwards where price is above marginal cost, and upwards
where price is below marginal cost, so the marginal cost curve passes through the
lowest point on each isoprofit curve.
Because the bakery is a
price-taker, the price at
which a loaf of bread
needs to be sold is €2,35,
the market prevailing price.
Accordingly, the demand
curve
of
price-taking
an
individual
firm
is
a
horizontal line at P*, the
market
prevailing
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small, the marginal cost is low, but the average cost of a loaf is high. As the number
price.
The feasible set for the individual baker is therefore any price below the marketprevailing price and any corresponding quantity.
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The quantity that yields the highest profit for the individual firm is indicated as point A
in the figure on the previous page. At this point, the individual firm produces 120 loaves
per day, sells them at €2,35 each and generates a profit of €80 per day, in addition to
the owner’s normal profits. Point A can be determined in two different methods:
1. This is the point where the highest isocost line is tangential to the demand
curve; and/or
2. This is the point where MC and the demand curve intersect, i.e. where the
marginal cost is equal to the market price.
A price-taking firm maximises profit by accepting the market price and choosing its
quantity where the marginal cost is equal to the market price and selling it at that price.
Consider the situation where the market price changes. If the market price were to rise
to €3,20, the individual firm would be able to reach a higher isoprofit curve and
accordingly the profit maximising quantity will increase to 163 loaves per day. If the
price, however, falls to €1,52 the individual firm can only reach a lower indifference
curve and accordingly the profit maximising quality will decrease to 66 loaves, and
your economic profit would be zero. In each of these cases, you will choose the point
on your marginal cost curve where the marginal cost is equal to the market price. From
this, we can also construct the firm’s individual supply curve, as illustrated in the figure
below.
From the example on the previous page, the marginal cost curve is the supply curve
for a price-taking firm. The individual supply curve shows that for each price it shows
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the profit-maximizing quantity, i.e. the quantity that the firm will choose to supply. If the
If you expect the price to rise soon, you might be willing to incur some shortterm losses, and it might be worth continuing to produce bread if the revenue
helped you to cover the costs of maintaining your premises and retaining staff.
8.4 Market supply and equilibrium
The market for bread in a particular city has many consumers and 50 bakeries. Each
bakery has a supply curve corresponding to its own marginal cost curve, so we know
how much it will supply at any given market price. To find the market supply curve, we
have to add up the total amount that all the bakeries will supply at each given price
level. In the event that each bakery has the same cost functions, it is easy to calculate
the total market supply – determine how each individual bakery would supply at a
given price and multiply it by 50 to find the total market supply at that price. The market
supply curve has the same shape as the individual firm’s supply curve, as illustrated
in the figure below.
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n.

io
leave the market.
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If you expect market conditions to remain bad, it might be best to sell up and
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worth continuing to produce bread. Your decision depends on what you expect to
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be minimising your loss. If this happened, you would have to decide whether it was
fo
below the zero-economic-profit curve. On the supply curve, the individual firm would
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price were to fall below €1,52 the individual firm would be making a loss as you are
What if different firms had different costs?
If the bakeries had different cost functions, at each given price level, each bakery
would produce a different amount of loaves of bread, but we could still add them
together to find market supply.
The total amount of loaves of
bread will then be plotted against
the given price level to determine
the market supply curve. The
demand and supply curve for the
bread market can be illustrated
as in the figure to the right.
In the market equilibrium, each bakery is producing on its marginal cost curve, at the
point where its marginal cost is equal to the market price of €2,00, which is where the
market supply and market demand curve intersects.
8.5 Competitive equilibriums: Gains from trade, allocation, and distribution
Buyers and sellers of bread voluntarily engage in trade because there are mutual
benefits in participating in the transaction. Their mutual benefits from the equilibrium
allocation can be measured by the consumer and producer surpluses. Any buyer
whose WTP is higher than the market price, receives a consumer surplus. Similarly, if
the marginal cost of producing
a good is below the market
price, the producer receives a
producer surplus. The figure to
the right illustrates that the total
surplus
in
a
competitive
equilibrium is computed the
same as before. The entire
shaded
area
between
the
demand and supply curve, shows the sum of all gains from trade in this market, known
as the total surplus. The allocation between consumer and producer surplus is easy
to determine. The red shaded area above the equilibrium price under the demand
curve illustrates the consumer surplus. The blue shaded area below the equilibrium
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price above the supply curve illustrates the producer surplus. In a competitive
fo
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than the equilibrium quantity
of
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and
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trade
gains
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unexploited
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di
were produced, there would
be
accordingly a
deadweight
loss,
as
illustrated in the figure to the
right. If any quantity more
than the equilibrium quantity
were produced, the surplus
on the extra loaves of bread produced would be negative, because these loaves of
bread would cost more to make than consumers were willing to pay.
At the equilibrium, all the potential gains from trade are exploited, which means there
is no deadweight loss. This property holds in general – if buyers and sellers are pricetakers, the equilibrium allocation will always maximise the sum of the gains achieved
by trading in the market, relative to the original allocation. The competitive equilibrium
allocation will always be Pareto efficient. Pareto efficiency follows from three
assumptions we have made about the bread market.

Buyers and sellers are price-takers.

The exchange of products in a competitive market is governed by a complete
contract between buyer and seller.

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equilibrium, the allocation will always maximise the total surplus. If any quantity lower
What happens in the competitive market affects no one except the buyers and
sellers.
Fairness
Even if we think that the market allocation is Pareto efficient, we should not conclude
that it is necessarily a desirable one. What can we say about fairness in the case of
the bread market? If we examine the distribution of the gains from trade between
producers and consumers, it is clear that both consumers and producers obtain a
surplus. In the example that we have been studying, the consumer surplus was slightly
higher than the producer surplus, because the demand curve was relatively steep
compared with the supply curve, which corresponds to a low elasticity of demand.
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Similarly, the slope of the supply curve also corresponds to the elasticity of supply. In
the example, the demand was less elastic than supply. In general, the distribution of
the total surplus between consumers and producers depends on the relative
elasticities of demand and supply.
Furthermore, to evaluate the fairness of the allocation, we could also consider the
market participants’ standard of living. For example, if the consumers in the bread
market were exceptionally poor, it might be fairer to pass a law setting a maximum
bread price lower than €2 to achieve a fairer, yet Pareto-inefficient, outcome.
The Pareto efficiency of a competitive equilibrium allocation is often interpreted as a
powerful argument in favour of markets as a means of allocating resources. But we
need to be careful not to exaggerate the value of this result:

The allocation may not be Pareto efficient, because we might not have taken
everything into account;

There are other important considerations, for example fairness; and

Price-takers are hard to find in real life.
8.6 Changes in supply and demand
An increase in demand
In the market for second-hand textbooks, demand comes from new students enrolling
in a specific course, and supply comes from students who complete a specific course
in previous years. At the original levels of demand and supply, the equilibrium occurs
at point A where
the price is $8,
and 24 books are
sold,
as
illustrated in the
figure below.
If
there
more
were
students
enrolling in one
year, there would be an increased demand at every given price level. An increase in
demand corresponds to a rightward shift of the demand curve. If the price remained
at $8, there would be excess demand for books, equal to the distance between the
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original and the new demand curve. The new equilibrium will therefore be at point B
itself has not shifted.
An increase in supply due to improved productivity
In contrast, as an example of an increase in supply, think again about the market for
bread in a given city. Suppose that bakeries discover a new technique to bake bread
faster, which will lead to a fall in the marginal cost of baking a loaf of bread.
Accordingly, the marginal cost curve of each bakery shifts down, which corresponds
to a downward shift of each bakery’s supply curve.
At the original levels of
demand and supply,
the equilibrium occurs
at point A where the
price is $8, and 24
books are sold, as
illustrated in the figure
to
the
right.
increase
leads
in
to
The
supply
a
new
equilibrium at point B where the price is $1,60 and 6 000 loaves of bread are sold. The
increase in supply has therefore led to a rise in the equilibrium quantity and a fall in
the equilibrium price. If the price remained at $2, there would be an excess supply of
loaves of breads, equal to the distance between the original and the new supply curve.
Such shifts in supply and demand as explained above are often referred to as shocks
in economic analysis.
Shock: an exogenous change in some of the fundamental data used in a model.
In economic analysis, we start by specifying an economic model and find the
equilibrium. Thereafter, we look at how the equilibrium position will change when the
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n.
curve, which corresponds to a movement along the supply curve. The supply curve
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It is important to note that an “increase in demand” leads to a shift of the demand
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led to a rise in the equilibrium quantity and price.
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where the price is $10 and 32 books are sold. The increase in demand has therefore
model receives a shock. These shocks are said to be exogenous, because the model
does not explain why the shock happened, i.e. the model shows the consequences of
the shock, not the cause.
Exogenous: coming from outside the model rather than being produced by the
workings of the model itself.
An increase in supply: More bakeries enter the market
Another reason for a change in the market supply is the entry of more firms, or the exit
of existing firms. Typically, if firms that are already in the profit make economic profits,
other firms would be incentivised to enter the market for bread. Since there is an
opportunity for making economic profits, new bakers may decide to enter the market.
If new bakers enter the market, the market supply curve will increase, which means
that the price will fall and the quantity of loaves of bread will rise, as we saw before.
For bakers to enter the market for bread, there will, however, be some costs of entry.
Provided that these are not too high, it would still be worthwhile for new bakers to enter
the market for bread.
Costs of entry: start-up costs that would be incurred when a seller enters a market or
an industry. These would usually include the cost of acquiring and equipping new
premises, research and development, the necessary patents, and the cost of finding
and hiring staff.
The entry of new firms is unlikely to be welcomed by the existing bakeries. Their
production costs will not have changed, but the market price will have fallen, which
means they will be making less profit than before.
8.7 The effects of taxes
As noted before, governments can use taxation to raise revenue or to affect the
allocation of goods and services, perhaps because the government considers a good
to be harmful. The supply and demand model is a useful tool for analysing the effects
of taxation.
Using taxes to raise revenue
A typical example of how taxation was used to raise revenue was the taxation that was
imposed on salt in the past. The figure on the following page illustrates how a salt tax
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would affect the market for
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salt. Initially, the market
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equilibrium is at point A
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where the price is P* and
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the quantity of salt traded
is Q*.
Suppose now a sales tax of
30% is imposed on the
price of salt, to be paid to
the government by the
suppliers. If suppliers have
to pay the 30% tax, their marginal cost of supplying a unit of salt increases by 30%,
which means the supply curve will shift upwards. The new equilibrium will then be at
point B where the higher price of P1 is charged for the lower quantity of Q1.
Suppliers will not be happy with this because the price that they receive is P0. The
distance from point B to the point on the market supply at that quantity, shows the tax
paid to the government on each unit of salt sold. Although the consumer price has
risen, it did not raise by 30%. Suppliers receive a lower price than before, they produce
less, and their profits will be lower. This illustrates an important feature of taxes – it is
not necessarily the taxpayer who feels the main effect of the tax. In this case, although
the suppliers pay the tax to the government, the tax incidence falls partly on
consumers and partly on producers.
Tax incidence: the effect of a tax on the welfare of buyers, sellers, or both.
From the figure above, it is clear that the tax led to consumers having to pay higher
prices; producers producing less, and producers receiving less, after they have paid
the taxes to the government.
The figure on the following page, shows how the imposition of taxes affect the
consumer and producer surplus.

The consumer surplus falls.

The producer surplus falls.

The total surplus is lower, which causes a deadweight loss.
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The figure to the right
shows
that
consumer
the
surplus
after the imposition of
the tax is equal to the
area
of
the
red
triangle, the producer
surplus is equal to the
area
of
the
blue
triangle, the area of
the green rectangle is
equal
to
the
tax
revenue of (P −P ) ×Q , and the area of the white triangle is equal to the deadweight loss
caused by the imposition of the tax, because the quantity of salt traded is no longer at the level
that maximises gains from trade.
After the tax is imposed on the price of salt, the total surplus from trade in the salt
market is given by:
total surplus = consumer surplus + producer surplus + government revenue
We can think of the total surplus as a measure of the welfare of society, provided that
the tax revenue is used for the benefit of society. So, there is a second reason for a
government that cares about welfare to prefer taxing goods with low elasticity of
demand – the loss of total surplus will be lower. The overall effect of the tax depends
on what the government does with the revenues that it collects:

If the government spends the revenue on goods and services that enhance the
wellbeing of the population, then the tax may enhance public welfare, even
though it reduces the surplus in the taxed market.

If the government spends the revenues on an activity that does not contribute
to wellbeing, then the lost consumer surplus is a reduction in the living
standards of the population.
Clearly, taxes can either improve or reduce the overall welfare of society. The only
thing that can be said without a doubt is that taxing a good whose demand is inelastic
is an efficient way to transfer the surplus from consumers to the government.
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The government’s power to impose taxes is similar to the price-setting power of a firm
tackling the obesity epidemic. In 2011, the Danish government introduced such a tax
on products with high saturated fat content. A tax of 10 Danish kroner (kr) per kg of
butter was imposed. This is an example of a specific tax where a tax is levied as a
fixed amount per unit of butter.
Conversely, the salt tax from before, levied as a percentage of the price, is known as
an ad valorem tax.
We can illustrate the effects of the butter tax in the same way as we did for the salt
tax, using the supply and demand model, assuming that butter retailers are pricetakers. The figure to the right shows the market for butter. In this instance, the supply
curve was drawn
flatter,
which
illustrates
inelastic
an
supply
curve. The initial
equilibrium
is
at
point A where the
price of butter is 45
kr per kg and each
person consumes 2
kg of butter per year.
A tax of 10 kr per kg levied on suppliers, raises their marginal costs by 10 kr at every
quantity, which means the supply curve will shift upwards by 10 kr for every kp of butter
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n.
consumption of unhealthy foods with the objective of improving public health and
io
Policymakers in many countries are interested in the idea of using taxes to deter
ut
Using taxes to change behaviour
rib
revenue is accepted as a necessary part of social and economic policy.
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di
Provided that citizens believe taxes have been implemented fairly, using them to raise
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the institutions for tax collection are well-established, usually with democratic consent.
rs
on the institutions it can use to enforce and collect them. In many modern economies
fo
and collect revenue, while reducing the quantity sold. Its ability to levy taxes depends
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that sells a differentiated product. The government uses its power to raise the price
per person per year. The new equilibrium will then be at point B where the price is 54
kr per kg and each person consumes 1,6 kg of butter per year. This means that the
consumer price rises by 9 kr, which is nearly the full amount of the tax and the
suppliers’ net revenue per kg of butter falls to 44 kr.
In this case, although suppliers pay the tax, the tax incidence is felt mainly by
consumers, because of the 10 kr tax per kg of butter, the consumer effectively pays 9
kr per kg of butter, while the producer only pays 1 kr per kg of butter. The price received
by the producer, net of
tax, is therefore only 1
kr per kg of butter
lower. The figure to the
right shows that the
imposition
of
taxes
reduces the consumer
and producer surplus,
as well as the total
surplus, of course.
The consumer surplus is equal to the area of the red triangle, the producer surplus is
equal to the area of the blue triangle, the area of the green rectangle is equal to the
tax revenue of 10 kr per kg ×1,6 kg = 16 kr per person per year, and the area of the
white triangle is equal to the deadweight loss caused by the imposition of the tax.
The question remains: how effective was the fat tax? For a full evaluation of the effect
on health we should look at all the foods taxed and consider the cross-price effects –
the changes in consumption of other foods caused by the tax. The figure above
illustrates the following implications of the tax:

The consumption of butter products will fall.

There was a large fall in surplus, especially in the consumer surplus.
The loss of surplus caused by the imposition of the tax represents a deadweight loss,
which sounds negative, but policymakers could be seen as a gain if, health-wise,
butter is considered “bad” for consumers.
One aspect of taxation not illustrated in our supply and demand analysis is the cost of
collecting it. Any taxation system requires effective mechanisms for tax collection and
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designing taxes that are simple to administer, and difficult to avoid, is an important
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ways of minimising administrative costs, since these costs cannot be eliminated.
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goal of tax policy. Policymakers who want to introduce food taxes will need to find
In what kinds of markets would we expect to see price-taking on both sides? To
generate competition between sellers that are forced to act as price-takers, we need:

Many sellers selling homogenous products to avoid firms having market power.
Homogenous products: each firm produces identical product, i.e. products that are
exactly the same from one seller to another.

Sellers must act independently to prevent the formation of cartels.

There must be many buyers who want to buy the product.

Buyers know the sellers’ prices, otherwise they cannot choose the lowest price.

There must be many buyers, competing with one another, forcing other buyers
to be price-takers.
A market with all these properties is described as perfectly competitive.
Perfectly competitive equilibrium: such an equilibrium occurs in a model in which
all buyers and sellers are price-takers. In this equilibrium, all transactions take place
at a single price. This is known as the law of one price. At that price, the amount
supplied equals the amount demanded: the market clears. No buyer or seller can
benefit by altering the price they are demanding or offering. They are both price-takers.
All potential gains from trade are realized.
Predictably, the equilibrium in a perfectly competitive equilibrium will have the following
characteristics:

All transactions take place at a single price, which is known as the law of one
price.
Law of one price: holds when a good is traded at the same price across all buyers
and sellers. If a good were sold at different prices in different places, a trader could
buy it cheaply in one place and sell it at a higher price in another.

At the “single price”, the amount supplied equals the amount demanded.

All buyers and sellers are price-takers.
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n.
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8.8 The model of perfect competition

All potential gains from trade are fully realised.
The model of perfect competition describes an idealised market structure.
The figure below shows the market for an imaginary product called Choccos, for which
there are close substitutes, as many similar products compete in the wider market for
chocolate bars. Due to competition from other chocolate bars, the demand curve is
nearly flat, as shown in the left-hand panel of the figure below. The narrow range of
feasible prices for this firm is determined by the behaviour of its competitors, and the
firm chooses a price and quantity where the marginal cost is close to the price. This
firm is in a similar situation to a firm in a perfectly competitive market. It is the
equilibrium price in the larger market for chocolate bars that determines the feasible
prices for Choccos, because Choccos have to be sold at a similar price to other
chocolate bars.
We can construct the market supply curve for chocolate bars in the right-hand panel
by adding the quantities from the individual marginal cost curves of all the chocolate
bar producers. If most consumers do not have strong preferences for one firm’s
product, we can draw a market demand curve for chocolate bars.
8.9 Looking for competitive equilibria
If we look at a market in which conditions seem to favour perfect competition, how can
we tell whether it satisfies the conditions for a competitive equilibrium? Economists
have used two tests:
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2. Are firms selling goods at a price equal to marginal cost?
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1. Do all trades take place at the same price?
useful approximation for economic analysis. Even if the conditions for perfect
competition are not all satisfied, the model of supply and demand is a valuable tool for
economic analysis, applicable when there is enough competition that individuals have
little influence on prices.
8.10 Price-setting and price-taking firms
In practice, economies are a mixture of more and less competitive markets, however,
firms act the same regardless of the number of firms in the market. Regardless of the
aforementioned, there are important differences. Advertising in a competitive market
is a public good, because the benefits go to all firms in the industry.
Public good: a good for which use by one person does not reduce its availability to
others. Also known as a non-rival good.
The same is true of expenditures to influence public policy. If a large firm with market
power is successful in, for example, relaxing environmental regulations, then it will
directly benefit all firms in the industry. Activities like lobbying or contributing money to
electoral campaigns, however, will be unattractive to the competitive firm because the
result is a public good, and they would not like to benefit all firms in the industry.
The differences between price-setting and price-taking firms are given in the table
below.
Price-setting firm or monopoly
Firm in a perfectly competitive market
Sets price and quantity to maximize
profits (‘price-maker’)
Takes market determined price as given
and chooses quantity to maximize profits
(‘price-taker’)
Chooses an output level at which
marginal cost is less than price
Chooses an output level at which
marginal cost equals price
Deadweight losses (Pareto inefficient)
No deadweight losses for consumers
and firms (can be Pareto efficient if no
one else in the economy is affected)
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n.
quantifying marginal cost. Nevertheless, the model of perfect competition can be a
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find evidence of perfect competition. One of many reasons for this is the difficulty in
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Regardless of the existence of these tests, the crux of the matter is that it is hard to
Price-setting firm or monopoly
Firm in a perfectly competitive market
Owners receive economic rents (profits
greater than normal profits)
If the owners receive economic rents, the
rents are likely to disappear as more
firms enter the market
Firms advertise their unique product
Little advertising: it costs the firm, but
benefits all firms (it’s a public good)
Firms may spend money to influence
elections, legislation and regulation
Little expenditure by individual firms on
this (same as advertising)
Firms invest in research and innovation;
seek to prevent copying
Little incentive for innovation; others will
copy (unless the firm can succeed in
differentiating its product and escaping
from the competitive market)
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Property rights and contracts that would reward actors for the positive external effects
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some of the effects of the decision-maker’s actions.
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External effects arise when property rights and legal contracts do not cover
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UNIT 12: MARKETS, EFFICIENCY, AND PUBLIC POLICY
imposed on others, and make them liable to pay damages for the negative effects, are
infeasible when the necessary information is not available to one or more of the parties
or cannot be used in a court of law.
Private property is a key requirement for a market system. If something is to be bought
and sold, then it must be possible to claim the right to own it, otherwise the buyer
would be hesitant to pay. Governments provide a system of laws and law enforcement
that guarantee these property rights and enforce contracts.

Policies can address market failures by inducing firms to internalise these
external effects.
Some of these policies include subsidising a firm’s R&D to the benefit of the industry,
or by imposing taxes that raise the price of goods that is environmentally destructive.
Other policies can directly regulate the actions of firms and households, for example
by banning the use of chemicals such as pesticides that impose costs on others.
Private bargaining among parties can sometimes constrain actors to take account of
the effect of their actions on others, for example a merger between a firm emitting
pollutants and a firm suffering damage as a result. Laws and legal traditions can also
help markets function when they provide compensation for individuals who are harmed
by the actions of others.
For a market to work effectively and to exist, various social institutions and social
norms are required.
Social norm: an understanding that is common to most members of a society about
what people should do in each situation when their actions affect others.
Social norms dictate that you respect the property rights of others, even when
enforcement is unlikely or impossible. Various economists have argued that these
institutions, including social norms, are fundamental for long-run growth in an
economic, as well as the proper functioning of economies.
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Whenever you agree with a seller to pay a certain amount of money in exchange for
a good you implicitly enter into a contract with the seller. If you have the protection of
a legal system, you can expect the contract to be honoured. It is the government that
determines the rules of the game in which market trade takes place. Of course,
enforcement by a court is rarely necessary because of social norms that motivate both
buyers and sellers to play by the rules of the game, even in cases where there is not
an actual contract or a transfer of a title of ownership. More complex transactions
require explicit written contracts that can be used in court as evidence that the parties
agreed to a transfer of ownership. Contracts govern relationships that are to be
maintained over a period of time, particularly employment. In the labour market, a court
upholds the right of the worker to work no more than the contracted hours and to
receive the agreed-upon pay.
12.1 Market failure: External effects of pollution
The market allocation of a good is unlikely to be Pareto efficient if the decisions of
producers and consumers affect others in ways that they did not adequately consider.
This is another cause of market failure. When we analyse gains from trade in such
cases, we must consider the consumer and producer surplus, as before, but also the
costs or benefits that other parties who are neither buyers nor sellers may experience.
In this unit, we will analyse the gains from trade in a case where the production of
bananas creates an external cost pollution by use of a pesticide called Weevokil.
External effect: a positive or negative effect of a production, consumption, or other
economic decision on another person or people that is not specified as a benefit or
liability in a contract. It is called an external effect because the effect in question is
outside the contract. Also known as an externality.
To model the implications of this kind of external effect, we need to consider the costs
of producing the bananas. The marginal cost of producing bananas for the growers is
the marginal private cost (MPC).
Marginal private cost (MPC): the cost for the producer of producing an additional unit
of a good, not considering any costs its production imposes on others.
The cost of an additional tonne of bananas increases as the land is used more
intensively, because more Weevokil is required. The bananas also have a marginal
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external cost (MEC) which includes the costs borne by fishermen whose waters are
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contaminated by the Weevokil.
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is incurred by anyone other than the producer of the good.
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Marginal external cost (MEC): the cost of producing an additional unit of a good that
Adding together the MPC and the MEC, we get the full marginal cost of banana
production – the marginal social cost (MSC).
Marginal social cost (MSC): the cost of producing an additional unit of a good,
considering both the cost for the producer and the costs incurred by others affected
by the good’s production. MSC is the sum of the MPC and the MEC.
These costs are all illustrated in the figure below. The MPC curve slopes upward
because the cost of producing an additional tonne increases as the land is more
intensively used, requiring more Weevokil. The MEC is the cost of the reduction in
quantity and quality of fish caused by each additional tonne of bananas.
The figure above shows that the MSC exceeds the MPC, due to the existence of the
MEC. The shaded area is equal to the area between the MSC and MPC curves.
We will consider a case in which the market for bananas is competitive, and the market
price is $400 per tonne. If the banana plantation owners wish to maximise their profit,
they will choose their output such that the price is equal to their marginal cost, i.e. the
MPC. The figure on the following page shows that the total output of the market will
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be 80 000 tonnes of bananas, indicated by point A, where the MEC is $270 per tonne
per year. Although this quantity maximises the profits for banana producers, it does
not include the cost imposed on the fishing industry, which means this allocation is not
a Pareto efficient outcome.
B
If the banana plantations were to produce less, the fishermen would benefit but the
owners of the plantations would lose. So, on the face of it, it appears that the allocation
is Pareto efficient. If the plantations produced one tonne less, the fishermen would
gain $270 by no longer suffering the loss of revenue that is caused by the production
of the 80 000th tonne of bananas. The plantations would lose hardly anything. Their
revenues would fall by $400, but their costs would also fall by almost exactly this same
amount because the MPC of producing the 80 000th tonne of bananas is equal to $400.
This means that if the fishermen paid the banana plantations any amount between
zero and less than $270, both groups would be better off with 79 999 tonnes of
bananas, which proves that producing 80 000 tonnes of bananas is not Pareto efficient
This process can be repeated until the MSC is equal to the market price, which in the
example above occurs at point B at a quantity of 38 000 tonnes of bananas. At this
point, the fishermen would no longer benefit by making further payments to the
plantation owners in return for reduced output. If production were lowered further, the
loss to the plantations would be greater than the gain to the fishermen, i.e. the
maximum payment the fishermen would be willing to make would not be enough to
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induce the plantation owners to cut production further. 38 000 tonnes of bananas is
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therefore the Pareto efficient level of banana output.
that rely on environmental resources.
12.2 External effects and bargaining
Does the previously mentioned process of bargaining suggest a remedy for this market
failure that might be implemented in the real world? It does. The fishermen and the
plantation owners could negotiate a private bargain. Solutions of this type are often
called Coasean bargaining, after Ronald Coase (economist). He argued that the two
parties to the exchange often have more of the information necessary to implement
an efficient outcome than the government does. Coase emphasised that his model
could not be directly applied to most situations because of the costs of bargaining and
other factors that prevent parties from exploiting all possible mutual gains. Establishing
each party’s actual costs and benefits is part of the cost of the transaction, and this
cost might be too high to make a bargain possible. Costs of bargaining, sometimes
called transaction costs, may prevent Pareto efficiency.
Transaction costs: costs that impede the bargaining process or the agreement of a
contract. They include costs of acquiring information about the good to be traded, and
costs of enforcing a contract.
Coase suggested that a lack of established property rights, and other factors leading
to high transaction costs, may stand in the way of using bargaining to resolve
externalities.
Coase suggested that the concept of property rights can be extended to other rights,
as well, for example the right to make a noise or to have a quiet work environment.
Coase believed that these can also be goods that can be bargained over and traded
in return for money. Let us consider the private bargaining as a solution to the pesticide
problem.
The allocation of property rights is such that the plantations have the right to use
Weevokil and choose to produce 80 000 tonnes of bananas. This allocation and the
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them, but by damaging the environment they impose external costs on other parties
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called environmental spillovers. They bring private benefits to those who decide to use
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In general, pollutants like Weevokil have negative external effects, sometimes
associated incomes and environmental effects represent the reservation option of the
plantation owners and fishermen, i.e. what they will get if they do not come to some
agreement. For the fishermen and the plantation owners to negotiate effectively, they
would each have to be organised so that a single person could make agreements on
behalf of the entire group. We imagine that a representative of an association of
fishermen sits down to bargain with a representative of an association of banana
growers. To keep things simple we will assume that, at present, there are no feasible
alternatives to Weevokil, so they bargain only over the output of bananas.
Both sides should recognise that they could gain from an agreement to reduce output
to the Pareto efficient level of 38 000 tonnes of bananas. In the figure below, the
situation begins at point A, before bargaining. After bargaining, they end up at the
Pareto efficient quantity. Reducing banana production will lead to a loss of profits for
the plantation, but it is smaller than the gain (the sum of the loss of profit and the net
social gain) that the fisherman receives (from cleaner water). The figure below shows
that the fall in profit is smaller than the gain for the fishermen, as there is a net social
gain that they could agree to share.
Since the gain to the fishermen would be greater than the loss to the plantations, the
fishermen would be willing to pay the banana growers to reduce output to 38 000
tonnes if they had the funds to do so. The minimum acceptable offer from the
fishermen depends on what the plantations get in the existing situation, which is their
reservation profit.
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that will not be rejected by the Responder. Generally applied in bargaining situations
loss of profit, the fishing industry would achieve a net gain from the agreement equal
to the net social gain, while plantations would be no better, or no worse, off.
The maximum the fishing industry would pay is determined by their reservation option,
as in the case of the plantations. It is the sum of the blue and green areas. In this case,
the plantations would get all the net social gain while the fishermen would be no better
off. The compensation they agree on, between these maximum and minimum levels,
will be determined by the bargaining power of the two groups.
You may think it unfair that the fishermen need to pay for a reduction in pollution. At
the Pareto efficient level of banana production, the fishing industry is still suffering from
pollution, and it must pay to stop the pollution getting worse. This happens because
we have assumed that the plantations have a legal right to use Weevokil.
An alternative legal framework could give the fishermen a right to clean water. If that
were the case, the plantation owners wishing to use Weevokil could propose a bargain
in which they paid the fishermen to give up some of their right to clean water to allow
the Pareto efficient level of banana production, which will be a much more favourable
outcome for the fishermen.
In principle, the bargaining process would result in a Pareto efficient allocation
regardless of which party has the initial rights, even though the distribution of the
benefits of solving the market failure differs drastically.
As Coase acknowledged, practical obstacles to bargaining may prevent the
achievement of Pareto efficiency. These practical obstacles include, amongst other
things, the following list of obstacles:

Impediments to collective action.
Private bargaining may be impossible if there are many parties on both sides of the
external effect. Each side needs to find a representative to bargain on their behalf. The
individuals representing the two groups would be performing a public service that
might be difficult to secure.
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If plantation owners agreed to this minimum payment to compensate them for their
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to mean the least favourable offer that would be accepted.
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Minimum acceptable offer: in the ultimatum game, the smallest offer by the Proposer

Missing information.
Devising the payment scheme makes it necessary to measure the costs of Weevokil
to each fisherman. We also need to establish the exact origin of the pollutant,
plantation by plantation. Only when we have this information can we calculate the size
of the payment that each fisherman must pay, and how much each plantation should
receive.

Tradability and enforcement.
The bargain involves the trading of property rights, and the contract governing the
trade must be enforceable. Both parties must therefore be able to rely on the legal
system to facilitate the process towards the Pareto efficient quantity.

Limited funds.
The pesticide example illustrates that although correcting market failures through
bargaining may not require direct government intervention, it does require a legal
framework for enforcing contracts so that property rights are tradable and so that all
parties stick to the bargains they make. Even with this framework, it might be unlikely
that Coasean bargaining alone can address market failures.
12.3 External effects: Policies and income distribution
Suppose in the case of our Weevokil example that Coasean bargaining proves to be
impractical, and that the fisherman and plantation owners cannot resolve the Weevokil
problem privately. We will continue to assume that it is not possible to grow bananas
without using Weevokil. What can the government do to achieve a reduction in the
output of bananas to the level that considers the costs for the fishermen? There are
three ways this might be done:

regulation of the quantity of bananas produced;

taxation of the production or sale of bananas; and

enforcing compensation of the fishermen for the costs imposed on them.
Each of these policies has different distributional implications for the fisherman and
plantation owners.
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Regulation
would lose their surplus on each tonne of bananas between 38 000 and 80 000 tonnes
of bananas.
Taxation
The figure below shows the MPC and MSC curves again. At the Pareto efficient
quantity, the MSC is $400 and the MPC is $295. the government puts a tax on each
tonne of bananas produced, equal to the MEC: $400 – $295 = $105, then the aftertax price received by plantations will be $295. Now, if plantations maximise their profit,
they will choose the point where the after-tax price equals the MPC and produce 38
000 tonnes, the Pareto efficient quantity.
The tax corrects the price message, so that the plantations face the full MSC of their
decisions. When the plantations are producing 38 000 bananas, the tax is exactly
equal to the cost imposed on the fishermen. This approach is known as a Pigouvian
tax after Arthur Pigou (economist).
Pigouvian tax: a tax levied on activities that generate negative external effects to
correct an inefficient market outcome.
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pollution for the fishermen, but it would lower the plantations’ profits, because they
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and enforce the right quota for each one. This policy would reduce the costs of
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efficient amount. If plantations differ in size and output, it may be difficult to determine
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The government could limit the total banana output at 38 000 tonnes, the Pareto
There are limits to how well governments can implement Pigouvian taxes, regulation
and compensation – often for the same reasons as for Coasean bargaining:

The government may not know the degree of harm suffered by each party.

MSC is difficult to measure.

The government may favour the more powerful group, i.e. the group with the
most bargaining power.
This concept could also be applied to positive external effects. If the marginal social
benefit of a decision is greater than the marginal private benefit, this becomes a
Pigouvian subsidy, which can ensure that the decision-maker takes this external
benefit into account.
External benefit: A positive external effect: that is, a positive effect of a production,
consumption, or other economic decision on another person or people that is not
specified as a benefit in a contract. Also known as external economy and/or positive
externalities.
The distributional effects of taxation are different from those of regulation. The costs
of pollution for fishermen are reduced by the same amount, but the reduction in banana
profits is greater, since the plantations pay taxes as well as reducing output, and the
government receives tax revenue.
Enforcing compensation
The government could require the plantation owners to pay compensation for costs
imposed on the fishermen. The compensation required for each tonne of bananas will
be equal to the MEC. Once compensation is included, the marginal cost of each tonne
of bananas will be the MSC. Now, plantations will maximise profits by choosing
point P₂ in the figure on the following page and produce 38 000 tonnes, the Pareto
efficient quantity. The shaded area shows the total compensation paid. The fishermen
are fully compensated for pollution, and the plantations’ profits are equal to the true
social surplus of banana production.
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The effect of this policy on the plantations’ profits is similar to the effect of the tax, but
the fishermen do better because they, rather than the government, receive payment
from the plantations.
Diagnosis and treatment in the case of chlordecone
If alternatives to Weevokil were available, it would be inefficient to restrict output to
38 000 tonnes, because if the plantations could choose a different production method
and the corresponding profit-maximising output, they could be better off, and the
fishermen no worse off.
In this situation, a policy of requiring the plantations to compensate the fishermen
would have given them the incentive to find production methods that caused less
pollution and could, in principle, have achieved an efficient outcome. The other two
policies would not do so. Rather than taxing or regulating banana production, it would
be better to regulate or tax the sale or the use of chlordecone, to motivate plantations
to find the best alternative to intensive chlordecone use.
In theory, if the tax on a unit of chlordecone was equal to its MEC, the price of
chlordecone for the plantations would be equal to its MSC, so it would be sending the
right message. The firms could then choose the best production method considering
the high cost of chlordecone, which would involve reducing its use or switching to a
different pesticide and determine the respective profit-maximising output. The profits
of the plantations and the pollution costs for the fishermen would fall, but the outcome
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would be better for the plantations, and possibly the fishermen also, if chlordecone
rather than bananas were taxed.
12.4 Property rights, contracts, and market failures
In taking action to maximise profits, the plantation owners did not take account of the
external costs they imposed on the fishermen. And they had no reason to take account
of them, because they had the right to pollute the fisheries. The same is true for the
overuse of antibiotics. A self-interested person has no reason to use antibiotics
sparingly, because the superbug that may be created will probably infect someone
else. If the prices of chlordecone and the antibiotic were high enough, there would be
no overuse. But the prices of these goods were based on the costs of production and
excluded costs that their use would inflict on others. As you have seen, the private
cost to the user fell short of the social cost for this reason.
Costs inflicted on others are termed external diseconomies or negative externalities,
while uncompensated benefits conferred on others are external economies or positive
externalities.
External diseconomy: a negative effect of a production, consumption, or other
economic decision, that is not specified as a liability in a contract. Also known as
external cost and negative externality.
Legal systems often fail to provide compensation for the benefits that one’s actions
confer on others and fails to incorporate the costs that one’s actions confers to others.
Market failures occur in these instances because the external benefits and costs of a
person’s actions are not owned by anyone. This is purely indicative of incomplete
contracts.
The external effects of a person’s actions are effects that are not governed by
contracts. Another way to express the problem is to say that there is no market in
which these external effects can be compensated. So economists also use the
term missing markets to describe problems like this.
Missing market: a market in which there is some kind of exchange that, if
implemented, would be mutually beneficial. This does not occur due to asymmetric or
non-verifiable information
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Why don’t countries just rewrite their laws to reward people for the benefits they confer

There can be no contract or property rights ensuring that external effects will
be compensated.

Some of the social costs or benefits of the decision-maker’s actions will not be
included, or will not be sufficiently important, in the decision-making process.
12.5 Public goods
The defining characteristic of a public good is that if it is available to one person it can
be available to everyone at no additional cost. Public goods are typically provided by
governments rather than the market. Once the good is available at all, the marginal
cost of making it available to additional people is zero. Goods with this characteristic
are also called non-rival goods.
A good is termed public if once available to one person, it can be available to everyone
at no additional cost and its use by one person does not reduce its availability to others.
This character of a public good is called being non-rival because potential users are
not in competition with each other for the good. Some economists add that others
cannot be excluded from the goods’ use. These goods are called non-excludable
public goods.
Non-excludable public good: a public good for which it is impossible to exclude
anyone from having access.
We consider the non-rival character of a public good to be its defining characteristic,
whether others can be excluded or not. For some public goods, it is possible to exclude
additional users, even though the cost of their use is zero, for a copyrighted book.
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is non-verifiable or asymmetric information.
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Some information that is of concern to someone other than the decision-maker
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The reason why uncompensated external costs and benefits occur is:
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Verifiable information: information that can be used to enforce a contract.
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contract, or there may be no legal system to enforce the contract.
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effects are too complex or difficult to measure to be written into an enforceable
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because the necessary information is either not available or not verifiable, the external
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on others, and make decision-makers pay for the costs they inflict on others? This is
Copyright: ownership rights over the use and distribution of an original work.
Public goods for which it is feasible to exclude others are sometimes called artificially
scarce.
Artificially scarce good: a public good that it is possible to exclude some people from
enjoying. Also known as club goods.
The opposite of a non-excludable public good is a private good.
Private good: a good that is both rival, and from which others can be excluded.
Markets typically allocate private goods. But for the other three kinds of good, markets
are either not possible or likely to fail. There are two reasons:

When goods are non-rival, the marginal cost is zero.
Setting a price equal to marginal cost will not be possible unless the provider is
subsidised.

When goods are not excludable there is no way to charge a price for them,
because the provider cannot exclude people who have not paid.
We have seen many examples of private goods, for example loaves of bread, dinners
in restaurants, and boxes of breakfast cereal. All these goods are both rival and
excludable.
There is a fourth kind of good that is rival, but not excludable, called a common-pool
resource.
Common-pool resource: a rival good that one cannot prevent others from enjoying.
Also known as common property resource.
The user of a common-pool resource imposes an external cost on other users. By
driving your car on a busy road, for example, you contribute to the congestion
experienced by other drivers.
The table on the following page summarises the four kinds of goods explained in this
Section.
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bads that affect many people simultaneously, for example polluted air.
Public bad: the negative equivalent of a public good. It is non-rival in the sense that
a given individual’s consumption of the public bad does not diminish others’
consumption of it.
Whether a good is private or public depends not only on the nature of the good itself,
but on legal and other institutions.
When goods are not private, public policy may be required to allocate them. National
defence is a responsibility of the government in all countries, or environmental policy.
Governments also adopt a range of policies to address the problem of knowledge as
a public good, such as issuing patents to give firms an incentive to undertake R&D.
Patent: a right of exclusive ownership of an idea or invention, which lasts for a
specified length of time. During this time, it effectively allows the owner to be a
monopolist or exclusive user.
Market failure in the case of public goods is closely related to the problems of external
effects, absent property rights and incomplete contracts.
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household waste. These are private bads. Analogously, we can define public bads as
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things that people do not want, and might be willing to pay to not have, such as
ut
“Goods” in economics are things that people want to use or consume, but “bads” are
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additional users is not completely zero, but instead very small.
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excludability in goods is a matter of degree. For some kinds of goods, the cost of
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The table above shows the four distinct categories of goods. The extent of rivalry or
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Non-excludable public goods and
Common-pool resources (fish bads (view of a lunar eclipse, public
Nonstocks in a lake, common grazing broadcasts, rules of arithmetic or
excludable
land)
calculus, national defence, noise
and air pollution)
fo
(food,
Public goods that are artificially
scarce
(subscription
TV,
clothes,
uncongested toll roads, knowledge
subject to intellectual property
rights)
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Private goods
houses)
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Excludable
Non-rival
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Rival
The table on the following page summarises cases of market failure – some that were
discussed in this unit, some not. The table also includes remedies for these market
failures.
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external cost
Other firms can exploit Private
the innovation
cost,
external benefit
overproduction of the crop for
which it is used
Taxes,
quotas,
bargaining,
bans,
common
ownership of all affected
assets
Overuse of air travel
Taxes, quotas
Tolls, quotas, subsidized
Overuse of cars
public transport
Publicly funded research,
Too little R&D
subsidies for R&D, patents
More effective monitoring,
An employee on a fixed
wage decides how hard to
work
Hard
work
raises Private
employer’s profits
cost,
external benefit
Too little effort; wage above performance-related
reservation
pay,
wage; reduced conflict of interest
unemployment
between
employer
and
employee
Someone who knows he
has
a
serious
health
problem buys insurance
Mandatory
Loss
for
company
purchase
of
insurance Private benefit, Too little insurance offered; health insurance, public
external cost
insurance premiums too high
provision,
mandatory
health information sharing
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cost,
and
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road users
other Private
pesticide
ut
for
external cost
of
rib
A firm invests in R&D
Congestion
external cost
global Private benefit,
carbon emissions
You travel to work by car
Private benefit,
Overuse
Possible remedies
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flight
in
of resources)
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You take an international Increase
benefit
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runs off into waterways
Downstream damage
Market failure (misallocation
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A firm uses a pesticide that
Cost or
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Decision
Decision
Someone
How it affects others
who
has
purchased car insurance
decides how carefully to
drive
Borrower
devotes
insufficient prudence or
effort to the project in
which the loan is invested
Prudent
driving
contributes to insurance
company’s profits
Project more likely to fail,
resulting
in
non-
repayment of loan
Cost or
Market failure (misallocation
benefit
of resources)
Private
cost, Too little insurance offered; Installing driver monitoring
external benefit insurance premiums too high
A
monopoly,
bank fails
a
or
a
firm
wealth;
Private benefit, Excessive risk; too few loans common responsibility for
external cost
issued to poor borrowers
repayment
of
loans
(Grameen Bank)
external cost
Excessively risky lending
Regulation
of
banking
practices
firm
producing a differentiated
good,
devices
Redistribute
Bank that is ‘too big to fail’ Taxpayers bear costs if Private benefit,
makes risky loans
Possible remedies
with
declining AC sets P > MC
Price is too high for Private benefit,
some potential buyers
external cost
Competition policy, public
Too low a quantity sold
(Unit 7)
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ownership
monopolies
of
natural