0% found this document useful (0 votes)

26 views103 pages

Chapter 1,2,3,4

Uploaded by

houldakazadi17

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

0% found this document useful (0 votes)

26 views103 pages

Chapter 1,2,3,4

Uploaded by

houldakazadi17

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

You are on page 1/ 103

2 PART 1 Introduction to economics

The Economic Problem

There are three questions that any economy must face:
●● What goods and services should be produced?
●● How should these goods and services be produced?
●● Who should get the goods and services that have been produced?
To satisfy these questions, economies have resources at their disposal which are classified as land, labour
and capital.
●● Land – all the natural resources of the earth. This includes mineral deposits such as iron ore, coal, gold
and copper; oil and gas; fish in the sea; and all the food and raw materials produced from the land.
●● Labour – the human effort, both mental and physical, that goes into production. A worker in a factory
producing precision tools, an investment banker, an unpaid carer, a road sweeper, a teacher – these are
all forms of labour.
●● Capital – the equipment and structures used to produce goods and services. Capital goods include
machinery in factories, buildings, tractors, computers, cooking ovens – anything where the good is not
used for its own sake but for the contribution it makes to production.

land all the natural resources of the earth

labour the human effort, both mental and physical, that goes into production
capital the equipment and structures used to produce goods and services

Scarcity and Choice

It is often assumed that these resources are ultimately scarce in relation to the demand for them. As
members of households, we invariably do not have the ability to meet all our wants and needs. Our needs
are the necessities of life which enable us to survive – food and water, clothing, shelter and proper health
care – and our wants are the things which we believe make for a more comfortable and enjoyable life –
holidays, different styles of clothes, smartphones, leisure activities, the furniture and items we have in our
houses, and so on. Our demand for these wants and needs is generally greater than our ability to satisfy
them. Scarcity means that society has limited resources and therefore cannot produce all the goods and
services households demand. Just as a household cannot give every member everything they want, a
society cannot give every individual the highest standard of living to which they might aspire. Because of
the tension between our wants and needs and scarcity, decisions must be made by households and firms
about how to allocate our incomes and resources to meet our wants and needs.

scarcity the limited nature of society’s resources

Economics investigates the issues arising due to the decisions that households and firms make as
a result of this tension. A typical textbook definition of economics is ‘the study of how society makes
choices in managing its scarce resources and the consequences of this decision-making’. This definition
can, however, mask the complexity and extent of the reach of economics. We might characterize house-
holds as having unlimited wants, but not everyone in society is materialistic, which the idea of unlimited
wants might imply. Some people are more content with the simple things in life and their choices are based
on what they see as being important. These choices are no less valid but reflect the complexity of the sub-
ject. Some people choose to maintain their standard of living through crime. A decision to resort to crime
has reasons and consequences, and these may be of as much interest to an economist as the reasons why
firms choose to advertise their products or why central banks make decisions on monetary policy.

economics the study of how society manages its scarce resources

Copyright 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CHAPTER 1 WHAT IS ECONOMICS? 3

Some might point out that the very idea of scarcity should be questioned in some instances. In Greece,
Spain and some other European countries, there are millions of people who want to work but who cannot
find a job. It could be argued that labour is not scarce in this situation, but job vacancies certainly are.
Economists will be interested in how such a situation arises and what might be done to alleviate the
issues that arise as a result of high levels of unemployment.
The study of economics, therefore, has many facets but there are some central ideas which help define
the field even though economics draws on related disciplines such as psychology, sociology, law, anthro-
pology, geography, statistics and maths, among others. These central ideas provide themes around which
this book is based, and which form the basis of many first-year undergraduate degree courses.

How People Make Decisions

The behaviour of an economy reflects the behaviour of the individuals who make up the economy. We will
now outline some of the core issues which economics explores in relation to individuals making decisions.

People Face Trade-offs

Households and firms must make choices. Making choices involves trade-offs. A trade-off is the loss of
the benefits from a decision to forego or sacrifice one option, balanced against the benefits incurred from
the choice made. When choosing between alternatives we must consider the benefits gained from choos-
ing one course of action but recognize that we must forego the benefits that could arise from the alter-
natives. To get one thing we like, we usually must give up another thing that we might also like. Making
decisions, therefore, requires trading off the benefits of one action against those of another.

trade-off the loss of the benefits from a decision to forego or sacrifice one option balanced against the benefits incurred
from the choice made

To illustrate this important concept, we provide some examples below.

Example 1 Consider an economics undergraduate student who must decide how to allocate their time.
They can spend all of their time studying, which will bring benefits such as a better class of degree; they
can spend all their time enjoying leisure activities, which yield different benefits; or they can divide their
time between the two. For every hour they study, they give up the benefits of an hour they could have
devoted to spending time in the gym, riding a bicycle, watching TV, sleeping or working at a part-time job
for some extra spending money. The student must trade-off the benefits from studying against the bene-
fits of using their time in other ways.

Example 2 A firm might be faced with the decision on whether to invest in a new product or a new
accounting system. Both bring benefits – the new product might result in improved revenues and profits in
the future, and the accounting system may make it more effective in controlling its costs, thus helping its
profits. If scarce investment funds are put into the accounting system, the firm must trade-off the benefits
that the new product investment would have brought.

Example 3 When people are grouped into societies, they face different kinds of trade-offs which can high-
light the interaction of individuals and firms within society in general. An example is the trade-off between
a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost
of producing goods and services. Because of the higher costs, firms can end up earning smaller profits,
paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution
regulations give us the benefit of a cleaner environment and the improved levels of health that come with
it, they can have the cost of reducing the incomes of the firms’ owners, workers and customers.

Efficiency and Equity An important trade-off that has interested economists for many years is the trade-
off between efficiency and equity. In economics, efficiency deals with ways in which society gets the
most it can (depending how this is defined) from its scarce resources. An outcome can be identified as
being efficient by some measure, but not necessarily desirable. Equity looks at the extent to which the
benefits of outcomes are distributed fairly among society’s members. Often, when government policies
are being designed, these two goals conflict. Because equity is about ‘fairness’ it inevitably involves value
judgements. Differences in opinion lead to disagreements among policymakers and economists.

equity the property of distributing economic prosperity fairly among the members of society

There are some economists who dismiss the idea of a trade-off between equity and efficiency as a
myth in some contexts, because the idea has been generalized to all situations. The historical context and
origins of many economic ideas are important to understand. The origins of the equity and efficiency trade-
off came from Arthur Okun in the 1970s. There are some economists who argue that improving equality
can lead to improvements in efficiency – in effect that it is possible to have a bigger cake and to eat it.
Policies aimed at achieving a more equal distribution of economic well-being, such as the social security
system, involve a trade-off between the effects of a benefits system versus the effects on the efficiency
of the tax system that pays for it. A government decision to raise the top rate of income tax on what it
considers ‘the very rich’ but to abolish income tax for those earning the minimum wage is effectively
a redistribution of income from the rich to the poor. It provides incentive effects for some in society to
seek work, but may reduce the reward for working hard, so some in society choose to work less or even
move to another country where the tax system is less onerous. Whether the trade-off is a ‘good’ thing is
dependent on the philosophy, belief sets and opinions of the decision-makers, and the power which they
have in society. Recognizing that people face trade-offs does not by itself tell us what decisions they will
or should make. Acknowledging and understanding the consequences of trade-offs is important, because
people are likely to make more informed decisions if they understand the options they have available.

Self Test You will often hear the adage ‘there is no such thing as a free lunch’. Does this simply refer to the
fact that someone must have paid for the lunch to be provided and served? Or does the recipient of the ‘free
lunch’ also incur a cost?

Opportunity Cost
Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative
courses of action. In many cases, however, the costs of an action are not as obvious as might first appear.
Consider, for example, the decision whether to go to university. The benefits are intellectual enrich-
ment and a lifetime of better job opportunities. In considering the costs, you might be tempted to add
up the money you spend on tuition fees, resources and living expenses over the period of the degree.
This approach is intuitive and might be a way in which non-economists would approach the decision. An
economist would point out that even if you decided to leave full-time education, you would still incur living
expenses and so these costs would be incurred in any event. Accommodation becomes a cost of higher
education only if it is more expensive at university than elsewhere.
This calculation of costs ignores the largest cost of a university education – your time. For most stu-
dents, the wages given up attending university are the largest single cost of their higher education. When
making decisions it is sometimes more helpful to measure the cost in terms of what other options have
had to be sacrificed rather than in money terms. Opportunity cost is the measure of the options sacri-
ficed in making a decision. The opportunity cost of going to university is the wages from full-time work
that you have had to sacrifice.

opportunity cost whatever must be given up to obtain some item; the value of the benefits foregone (sacrificed)

Calculating Opportunity Costs Opportunity cost is the cost expressed in terms of the next best alternative
sacrificed – what must be given up in order to acquire something. As a general principle, we can express
the opportunity cost as a ratio expressed as the sacrifice in one good in terms of the gain in the other:
Sacrifice of good x
Opportunity cost of good y 5
Gain in good y
Expressing the opportunity cost in terms of good x would give:
Sacrifice of good y
Opportunity cost of good x 5
Gain in good x
Opportunity cost can be expressed in terms of either good – they are the reciprocal of each other.

Thinking at the Margin

Decisions in life are rarely straightforward and usually involve weighing up costs and benefits. Having a
framework or principle on which to base decision-making can help if we want to maximize benefits or
minimize costs. Thinking at the margin is one such framework that economists adopt in thinking about
decision-making. Marginal changes describe small incremental adjustments to an existing plan of action.
Marginal analysis is based around an assumption that economic agents (an individual, firm or organiza-
tion that has an impact in some way on an economy) are seeking to maximize or minimize outcomes when
making decisions. Consumers may be assumed to seek to maximize the satisfaction they gain from their
incomes, and firms to maximize profits and minimize costs. Maximizing and minimizing behaviour is based
on a further assumption that economic agents behave rationally.

marginal changes small incremental adjustments to a plan of action

economic agents an individual, firm or organization that has an impact in some way on an economy

It is important to stop and consider what we mean by the term ‘rational’ in this context. When some
economists use the term ‘rational’ in the context of decision-making, it simply means the assumption
that decision-makers can make consistent choices between alternatives. We will look at this in more detail
later in the book, but at this stage we will express rationality based on decision-makers’ ability to rank their
preferences and do the best they can with their existing resources. Thinking at the margin means that
decision-makers choose a course of action such that the marginal cost is equal to the marginal benefit. If
a decision results in greater marginal benefits than marginal costs, it is worth making that decision and
continuing up to the point where the marginal cost of the decision is equal to the marginal benefit.

rational the assumption that decision-makers can make consistent choices between alternatives

The assumption of rational behaviour provides a framework around which decisions can be analyzed
and has been a basic tenet of economics since the 1870s, with thinkers such as William Stanley Jevons
and Carl Menger building on work by David Ricardo and Jeremy Bentham, which became part of the
so-called marginalist school. The assumptions of rational economic behaviour have implications which
have been subject to criticism. In studying economic models which rely on the assumption of rational
behaviour, it is important to remember that if these assumptions are relaxed, outcomes might be very
different. We will cover a number of economic models which are based on this assumption, because it
provides a view into the way in which economic analysis has developed historically and how it is subject to
evolution and change. It also provides a way of thinking about issues which can be contrasted with other
ways of thinking when different assumptions are held.

People Respond to Incentives

If we assume the principle of rational behaviour and that people make decisions by comparing costs and
benefits, it is logical to assume that their behaviour may change when the costs or benefits change. That

is, people respond to incentives. The threat of a fine and the removal of a driving licence is designed to
regulate the way in which people drive and park their cars; putting a price on the provision of plastic bags
in supermarkets aims to encourage people to re-use bags and reduce the total number used.
There has been an increase in the amount of research conducted on incentives because the intentions
of policymakers do not always lead to the outcomes expected or desired. A fine imposed on parents who
are late picking up their children from day care centres might be expected to reduce the number of late
pickups, but one study in Israel showed that far from reducing the number of late pickups, parents were
willing to pay the fine and the number arriving late actually increased. Such consequences are referred to
as ‘unintended consequences’.

Self Test What sort of incentives might governments put in place to encourage workers to find work and
get off welfare benefits? What might be the unintended consequences of the incentives you identify?

How People Interact

Decision-making not only affects ourselves but other economic agents as well. We will now explore some
issues which arise when economic agents interact with others.

Trade Can Make Everyone Better Off

The United States and China are competitors with Europe in the world economy because US and Chinese
firms produce many of the same goods as European firms. It might be thought that if China increases its
share of world trade at the expense of Europe this might be bad news for people in Europe. This might
not be the case.
Trade between Europe and the United States and China is not like a sports contest, where one side
wins and the other side loses (a zero-sum game). In some circumstances trade between economies can
make all better off. Households, firms and countries have different resource endowments; individuals
have talents and skills that allow them to produce some things more efficiently than others; some firms
have experience and expertise in the production of goods and services; and some countries, like Spain,
are blessed by plenty of sunshine which allows their farmers to grow high quality soft fruit. Trade allows
individuals, firms and countries to specialize in the activities they do best. With the income they receive
from specializing they can trade with others who are also specializing and can improve their standard of
living as a result.
However, while trade can provide benefits and winners, there are also likely to be costs and losers. The
economic development of some countries in the last 50 years has meant that many people have access to
cheap, good quality goods and services as a result of the export of these goods and services. For workers
and employers in these industries in developed economies, the competition from developing countries
might mean that they find themselves without work or must close their businesses. In some situations, it
is difficult for these people to find alternative work, and whole communities can be greatly affected by the
changes being experienced. They may not agree that ‘trade can benefit everyone’.

The Capitalist Economic System

The economic problem highlights three questions that any society must answer. What goods and services
should be produced, how they are to be produced and who will get what is produced are determined
by the economic system. An economic system is the way in which resources are organized and allo-
cated to provide for the needs of an economy’s citizens. In many countries of the world, a capitalist
economic system based on markets is the primary way in which the three questions are addressed.
A capitalist economic system incorporates the principles of the private ownership of factors of pro-
duction to produce goods and services which are exchanged through a price mechanism. Production is
operated primarily for profit.

economic system the way in which resources are organized and allocated to provide for the needs of an economy’s
citizens
capitalist economic system a system which relies on the private ownership of factors of production to produce goods
and services which are exchanged through a price mechanism and where production is operated primarily for profit

Capitalist economic systems have proved capable of raising the standard of living of millions of people
over the last 200 years. We can measure the standard of living in terms of the income that people earn
which allows them to purchase the goods and services they need to survive and enjoy life. While capitalist
systems have increased living standards for many, it is not the case that everyone in society benefits equally.
Capitalism has meant that some people and countries have become very rich whereas others remain poor.
The existence of the profit motive provides an incentive for entrepreneurs to take risks to organize factors
of production. This dynamism in capitalist systems not only leads to developments in technology and capital
efficiency which help generate profits for the individuals and firms concerned but also increases knowledge
and information in society as a whole, which further contributes to economic development.
Critics of capitalist systems argue that they are inherently unstable and lurch from boom to bust. In
addition, capitalist systems favour those who have acquired ownership of factor inputs. Ownership of
factor inputs can result in the exploitation of workers. Owners of factors of production can wield consid-
erable economic and political power which can distort resource allocation. Karl Marx spent a large part
of his life seeking to understand and analyze the capitalist system and develop theories to explain why it
exploited workers and was unstable.

Markets Can Be a Good Way to Organize Economic Activity

The role of markets in capitalist economic systems is central. In a market economy, the three key ques-
tions of the economic problem are addressed through the decentralized decisions of many firms and
households as they interact in markets for goods and services. Firms decide whom to hire and what to
make. Households decide which firms to work for and what to buy with their incomes. These firms and
households interact in the marketplace, where prices and, it is assumed, self-interest guide their decisions.

market economy an economy that addresses the three key questions of the economic problem by allocating resources
through the decentralized decisions of many firms and households as they interact in markets for goods and services

In a pure market economy (one without any government intervention) no one is considering the eco-
nomic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods
and services, and all of them are interested, primarily, in their own well-being. Yet, despite decentralized
decision-making and self-interested decision-makers, market economies have proven remarkably suc-
cessful in organizing economic activity in a way that can promote overall economic well-being for millions
of people, even though it is recognized there are inequalities that will arise.

Planned Economic Systems The inequitable distribution of wealth in capitalist societies which was wit-
nessed in the countries which benefitted from the Industrial Revolution in the 1700s and 1800s led to
the development of other economic systems, most notably planned economic systems, sometimes
referred to as communist systems or command economies. Communist countries worked on the premise
that central planners could guide economic activity and answer the three key questions of the economic
problem. The theory behind central planning was that the government could organize economic activity in
a way that promoted economic well-being for the country as a whole and led to a more equitable outcome.

planned economic systems economic activity organized by central planners who decided on the answers to the
fundamental economic questions

Today, most countries that once had centrally planned economies such as Russia, Poland, Angola,
Mozambique and the Democratic Republic of Congo have abandoned this system and are developing
more market-based economies.

FYI
Adam Smith and the Invisible Hand
Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776 and it is a landmark in
economics. Smith’s work reflected a point of view that was typical of so-called enlightenment writers at the end of
the eighteenth century – that individuals are usually best left to their own devices, without government guiding their
actions. This political philosophy provides the intellectual basis for the market economy.
Here is Adam Smith’s description of how people interact in a market economy:

Man (sic) has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their
benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that
it is for their own advantage to do for him what he requires of them … It is not from the benevolence of the butcher,
the brewer, or the baker that we expect our dinner, but from their regard to their own interest…
Every individual … neither intends to promote the public interest, nor knows how much he is promoting it … He
intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which
was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own
interest, he frequently promotes that of the society more effectually than when he really intends to promote it.

Smith suggested that participants in the economy are motivated by self-interest and that the ‘invisible hand’
of the marketplace guides this self-interest into promoting general economic well-being. Smith’s use of the term
‘self-interest’ should not be interpreted as ‘selfishness’. Smith was interested in how humans pursue their own
self-interest in their own way. As the 2002 Nobel Prize in Economics winner, Vernon L. Smith, put it in his Prize
Lecture, ‘doing good for others does not require deliberate action to further the perceived interest of others’.
The term ‘invisible hand’ is widely used in economics to describe the way market economies allocate scarce
resources but interestingly, Adam Smith only used the phrase once in The Wealth of Nations. The phrase was also
used in an earlier book, The Theory of Moral Sentiments. In both instances, Smith outlined the idea that self-interested
individuals’ actions could produce socially desirable results.
In the Theory of Moral Sentiments, the phrase is used to show how human desire for luxury can have the effect of
providing employment for others, and in The Wealth of Nations the phrase is used in relation to investment choices.
There are similarities in sentiment in both uses, but in the former case, Smith, it seems, was seeking to explore
the political philosophy of the economic system he was writing about; a system which was very different in many
respects to that which we witness today.

Governments Can Sometimes Improve Market Outcomes

An economy can allocate some goods and services through the price mechanism, but markets do not
always lead to efficient or equitable outcomes. In some cases, goods and services would not be provided
by a market system because it is not practicable to do so, and in other cases market-based allocations
might be deemed undesirable, with either too few or too many goods and services consumed. The capi-
talist system and markets rely on laws and regulations to ensure that property rights are enforced.
Governments provide goods and services which might not be provided in sufficient quantities in a
market system and set the legal and regulatory framework within which firms and households can operate.
Government intervention in markets may aim to promote efficiency and equity. That is, most policies
aim either to enlarge the economic cake, or change the way in which the cake is divided, or even try to
achieve both. Market systems do not always ensure that everyone has sufficient food, decent clothing

and adequate health care. Many public policies, such as income tax and the social security system, are
designed to achieve a more equitable distribution of economic well-being.
When markets do allocate resources, the resulting outcomes might still be deemed inefficient. Econ-
omists use the term ‘market failure’ to refer to a situation in which the market on its own fails to pro-
duce an efficient allocation of resources. One possible cause of market failure is an externality, which
is the uncompensated impact, both negative and positive, of one person’s actions on the well-being of a
bystander (a third party). For instance, the classic example of a negative externality is pollution. Another
possible cause of market failure is market power, which refers to the ability of a single person or business
(or group of businesses) to unduly influence market prices or output. In the presence of market failure,
well-designed public policy can enhance economic efficiency.

market failure a situation where scarce resources are not allocated to their most efficient use
externality the cost or benefit of one person’s decision on the well-being of a bystander (a third party) which the decision-
maker does not take into account in making the decision
market power the ability of a single economic agent (or small group of agents) to have a substantial influence on market
prices or output

To say that the government can improve on market outcomes at times does not mean that it always
will. Public policy is made by a political process that is also imperfect. Sometimes policies are designed
simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are
not fully informed. One goal of the study of economics is to help you judge when a government policy is
justifiable to promote efficiency or equity, and when it is not.

How the Economy as a Whole Works

We started by discussing how individuals make decisions and then looked at how people interact with one
another. We will now look at issues arising that concern the workings of the economy as a whole.

Microeconomics and Macroeconomics

Since roughly the 1930s, the field of economics has been divided into two broad subfields. Microeconomics
is the study of how households and firms make decisions and how they interact in specific markets.
Macroeconomics is the study of economy-wide phenomena. The Nobel Prize winning economist Ragnar
Frisch is credited with being the first to use the two terms (along with the term ‘econometrics’ incidentally),
and the Cambridge economist Joan Robinson, an associate of Keynes, was one of the first to define
macroeconomics, referring to it as ‘the theory of output as a whole’.

microeconomics the study of how households and firms make decisions and how they interact in markets
macroeconomics the study of economy-wide phenomena, including inflation, unemployment and economic growth

Microeconomics might involve the study of the effects of a congestion tax on the use of cars in a city
centre, the impact of foreign competition on the European car industry, or the effects of attending univer-
sity on a person’s lifetime earnings. A macroeconomist might study the effects of borrowing by national
governments, the changes over time in an economy’s rate of unemployment or alternative policies to raise
growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because changes in the overall econ-
omy arise from the decisions of millions of individuals, it is impossible to understand macroeconomic
developments without considering the associated microeconomic decisions. For example, a macroeco-
nomist might study the effect of a cut in income tax on the overall production of goods and services in

an economy. To analyze this issue, they must consider how the tax cut affects the decisions of households
concerning how much to spend on goods and services.
Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct.
Because microeconomics and macroeconomics address different questions, they sometimes take quite
different approaches and are often taught in separate courses.

An Economy’s Standard of Living Is Related to Its Ability to Produce

Goods and Services
A key concept in macroeconomics is economic growth – the increase in the number of goods and ser-
vices produced in an economy over a period of time, usually expressed over a quarter and annually. One
measure of the economic well-being of a nation is given by gross domestic product (GDP) per capita
(per head) of the population, which can be seen as being the average income per head of the population.
If you look at GDP per capita figures, it becomes clear that many advanced economies have a relatively
high income per capita, whereas in countries in sub-Saharan Africa, average incomes are much lower and,
in some cases, significantly lower. For example, in 2017, the GDP per capita of Benin in West Africa was
reported by the World Bank as being $860. In comparison, the GDP per capita of Germany was $44,470.
Put another way, average incomes in Benin are around 1.93 per cent of those in Germany.

economic growth the increase in the amount of goods and services in an economy over a period of time
gross domestic product per capita the market value of all goods and services produced within a country in a given
period of time divided by the population of a country to give a per capita figure

Not surprisingly, this large variation in average income is reflected in various other measures of the
quality of life and standard of living. Citizens of high-income countries typically have better nutrition,
better health care and longer life expectancy than citizens of low-income countries, as well as more TV
sets, more gadgets and more cars.

standard of living refers to the amount of goods and services that can be purchased by the population of a country.
Usually measured by the inflation-adjusted (real) income per head of the population

Changes in the standard of living over time are also large. Between 2010 and 2016, economic growth,
measured as the percentage growth rate of GDP, in Bangladesh averaged around 6.3 per cent per year
and in China about 8.0 per cent a year, but in Brazil the economy only grew by around 1.35 per cent over
the same time period, and in the period 2014–16, the economy of Brazil actually shrank in size by around
3 per cent (source: World Bank).
Variation in living standards is attributable to differences in countries’ productivity – that is, the amount
of goods and services produced by a worker (or other factor of production) per time period. In nations where
workers can produce a large quantity of goods and services per unit of time, many people enjoy a high
standard of living; in nations where workers are less productive, people endure a more meagre existence.
Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.

productivity the quantity of goods and services produced from each hour of a worker or factor of production’s time

The relationship between productivity and living standards also has profound implications for public
policy. When thinking about how any policy will affect living standards, the key question is how it will affect
our ability to produce goods and services. To boost living standards, policymakers need to raise productiv-
ity by ensuring that workers are well educated, have the tools and infrastructure needed to produce goods
and services, and have access to the best available technology.

The standard of living is not the only measure of well-being. In the UK, for example, the Office for
National Statistics (ONS) publishes data on well-being through 41 different measures which attempt to
incorporate how people feel about their lives; whether they see what they do as worthwhile; their satis-
faction with family life; how satisfied they are with their jobs and their health; where people live and how
safe they feel; their involvement in sport, culture and volunteer work; and the extent to which they access
the natural environment.

Prices Rise When the Government Prints Too Much Money

In Zimbabwe in March 2007 inflation was reported to be running at 2,200 per cent. That meant that a good
priced at the equivalent of Z$2.99 in March 2006 would be priced at Z$68.77 just a year later. In February
2008, inflation was estimated at 165,000 per cent. Five months later it was reported as 2,200,000 per
cent. In July 2008, the government issued a Z$100 billion note. At that time, it was just about enough to
buy a loaf of bread. Estimates for inflation in Zimbabwe in July 2008 put the rate of growth of prices at
231,000,000 per cent. In January 2009, the government issued Z$10, 20, 50 and 100 trillion dollar notes – a
trillion is 1 followed by 12 zeros. This episode is one of history’s most spectacular examples of inflation,
an increase in the overall level of prices in the economy. It is not the only example of inflation that is out of
control, however. Weimar Germany in the early 1920s, the Balkans in the mid-1990s and, more recently,
Venezuela in 2018, all experienced hyperinflation. In Venezuela, inflation was reported by Steve Hanke of
Johns Hopkins University in the United States as being over 4,000 per cent.

inflation an increase in the overall level of prices in the economy

High inflation is a problem because it imposes various costs on society; keeping inflation at a low level
is a goal of economic policymakers around the world. In almost all cases of high or persistent inflation, a
causal factor is the growth in the quantity of money. When a government creates large quantities of the
nation’s money, without any corresponding increase in output or productivity, the value of the money falls.
In the period outlined above, the Zimbabwean government was issuing money in ever higher denomina-
tions. It is generally accepted that there is a relationship between the growth in the quantity of money and
the rate of growth of prices.

Self Test What is the difference between microeconomics and macroeconomics? Write down three
questions that the study of microeconomics might be concerned with and three questions that might be
involved in the study of macroeconomics.

Summary
●● Key issues arising in individual decision-making are that people face trade-offs among alternative goals, that the
cost of any action is measured in terms of foregone opportunities, that rational people make decisions by comparing
marginal costs and marginal benefits, and that people change their behaviour in response to the incentives they face.
●● When economic agents interact with each other, the resulting trade can be mutually beneficial.
●● In capitalist economic systems, the market mechanism is the primary way in which the questions of what to pro-
duce, how much to produce and who should get the resulting output are answered.
●● Markets do not always give outcomes that are efficient or equitable. In such circumstances, governments can
potentially improve market outcomes.
●● The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists
study decision-making by households and firms, and the interaction among households and firms in the market-
place. Macroeconomists study the forces and trends that affect the economy as a whole.
●● The fundamental lessons about the economy as a whole are that productivity is a key source of living standards
and that money growth can be a primary source of inflation.

In the News

Incentives
Intuition might tell us that people respond to incentives. Economics deals with human beings, and what might seem to be
a common sense statement reveals more complex relationships which make outcomes different from those expected.
Research by Gneezy, Meier and Ray-Biel (2011) highlight some of these complexities. Their research suggested
that incentives may work better in certain circumstances than in others. Policymakers need to consider a wide vari-
ety of issues when deciding on putting incentives in place.
First, they must consider the type of behaviour to be changed. For example, society might want to encourage what
Gneezy et al. call ‘prosocial’ behaviour. This might include donating blood, sperm or organs; increasing the amount of
waste put out for recycling; attending school, college or university; working harder in education to improve grades; install-
ing insulation or solar panels in homes to reduce energy waste; or finding ways of encouraging people to stop smoking.
Policymakers then must consider the parties involved. This can be expressed as a principal–agent issue. The
principal is a person or group for whom another person or group, the agent, is performing some act. In encouraging
people to stop smoking, the smoker is the agent and society is the principal. Next, the type of incentive offered to
bring about desired behaviours must be considered – often this will be monetary. Gneezy et al. note that monetary
incentives have a direct price effect and a psychological effect. Finally, policymakers must think about how the
incentive is framed.
Providing a monetary incentive to bring about a desired change in behaviour might seem an obvious policy choice
such as offering a monetary incentive to donate blood or install solar panels. Gneezy et al. point to reasons why the
outcome might not be as obvious as first hoped. They suggest that in some cases, offering monetary incentives can
‘crowd out’ the desired behaviour. Offering a monetary incentive can change the perceptions of agents. People have
intrinsic motivations – personal reasons for particular behaviours. Others have perceptions about the behaviour of
others, for example, someone who donates blood might be seen by others as being ‘nice’. Social norms may also be
affected, for example attitudes to smoking or the recycling of waste.
Gneezy et al. suggest that monetizing behaviour changes the psychology, and the psychology effect can be greater
than the direct price effect. The price effect would suggest that if you pay someone to donate more blood, you should
get more people donating blood. People who donate blood, however, might do so out of a personal conviction – they
have intrinsic motivations. By offering monetary incentives, the perception of the donor and others might change so
that they are not seen as being ‘nice’ any more but as being ‘mercenary’, and not motivated intrinsically but by extrin-
sic reward – greed, in other words. If the psychological effect outweighs the direct money effect, the result could be
a reduction in the number of donors.
In the case of cutting smoking, the size of the money effect might be a factor. This chapter has raised the idea of
rational people thinking at the margin. With smoking, the marginal decision to have one more cigarette imposes costs
and benefits on the smoker – the benefit is the pleasure people get from smoking an additional cigarette, and the cost
the (estimated) 11 minutes of their life that is cut as a result. The problem is that the marginal cost is not tangible and
is likely to be outweighed by the marginal benefit (not to mention the addictive qualities of tobacco products). Over
time, however, the total benefit of stopping smoking becomes much greater than the total cost. The incentive offered,
therefore, must be such that it takes into account these marginal decisions, and it might be difficult to estimate the
size of the incentive needed.
Other issues relating to incentives involve the trust between the principal and agent. If an incentive is provided,
for example, this sends a message that the desired behaviour is not taking place. There may be a reason for this.
This might be that the desired behaviour is not attractive and/or is difficult to carry out. Incentives also send out a
message that the principal does not trust the agent’s intrinsic motivation; for example, that people will not voluntarily
give blood or recycle waste effectively. Some incentives may work to achieve the desired behaviour in the short term,
but will this lead to the desired behaviour continuing in the long term when the incentive is removed?
Incentives might be affected by the way they are framed – how the wording or the benefits of the incentive are
presented to the agent by the principal. Gneezy et al. use a very interesting example of this. Imagine a situation, they

say, where you meet a person and develop a

relationship. You want to provide that person
with the incentive to have sex. The effect of the
way the incentive is framed might have a con-
siderable effect on the outcome. If, for exam-
ple, you framed your ‘offer’ by saying ‘I would
like to make love to you and to incentivize you
to do so I will offer you €50,’ you might get a
very different response to that if you framed it
by saying: ‘I would like to make love to you –
I have bought you a bunch of red roses’ (the
roses just happened to cost €50).
Finally, the cost effectiveness of incentives
must be considered. Health authorities spend
millions of euros across Europe on drugs to Should incentives be provided to encourage people to exercise
reduce blood pressure and cholesterol. Getting more by, for example, paying for gym membership, to help reduce
people to take more exercise can also help strokes and heart disease?
achieve the same result. What would be more cost effective and a more efficient allocation of resources? Providing
incentives (assuming they work) to encourage people to exercise more by, for example, paying for gym membership,
or spending that same money on drugs but not dealing with some of the underlying causes?
Reference: Gneezy, U., Meier, S. and Rey-Biel, P. (2011) ‘When and Why Incentives (Don’t) Work to Modify Behaviour’.
Journal of Economic Perspectives, 25(4): 191–210.

Critical Thinking Questions

1 Why should people need incentives to do ‘good’ things like donating blood or putting out more rubbish for recycling?
2 What is meant by the ‘principal–agent’ issue?
3 What might be the price and psychological effect if students were given a monetary incentive to attain top
grades in their university exams?
4 Why might the size of a monetary incentive be an important factor in encouraging desired behaviour, and what
side effects might arise if the size of an incentive were increased?
5 What is ‘framing’ and why might it be important in the way in which an incentive works? Refer to the need to
increase the number of organ donors in your answer to this question.

Questions for Review

1 What are the three economic questions which any society must answer?
2 Describe the main features of a capitalist economic system and explain why private property and a strong legal
system are vital to the success of this system.
3 Give three examples of important trade-offs that you face in your life.
4 What is the opportunity cost of going to a restaurant for a meal?
5 Water is necessary for life. Is the marginal benefit of a glass of water large or small?
6 Why should policymakers think about incentives?
7 Why can specialization and trade help improve standards of living?
8 Explain the two main causes of market failure and give an example of each.
9 Why is productivity important?
10 What do you think are the main costs of inflation that is out of control on the population?

Problems and Applications

1 Describe some of the trade-offs faced by each of the following:
a. A family deciding whether to buy a new car.
b. A government deciding whether to build a high-speed rail link between two major cities in the north of the country.
c. A company chief executive officer deciding whether to recommend the acquisition of a smaller firm.
d. A university lecturer deciding how much time to devote to preparing for their weekly lecture.
2 In 2019, the youth unemployment rate in Spain was 32.6 per cent. Does this mean that labour is not a scarce resource
in Spain?
3 You are trying to decide whether to take a holiday. Most of the costs of the holiday (airfare, hotel, foregone wages) are
measured in euros, but the benefits of the holiday are psychological. How can you compare the benefits to the costs?
4 Many of the countries which had planned economic systems have transitioned to a more market-based economic
system in the face of numerous problems. What do you think are the disadvantages of planned economic systems? How
do market economies solve these problems? Can market systems solve all problems?
5 You win €10,000 on the EuroMillions lottery draw. You have a choice between spending the money now or putting it away
for a year in a bank account that pays 5 per cent interest. What is the opportunity cost of spending the €10,000 now?
6 Three managers of the van Heerven Coach Company are discussing a possible increase in production. Each suggests
a way to make this decision.
FIRST MANAGER: We need to decide how many additional coaches to produce. Personally, I think we should examine
whether our company’s productivity – number of coaches produced per worker per hour – would rise or fall if we
increased output.
SECOND MANAGER: We should examine whether our average cost per worker would rise or fall.
THIRD MANAGER: We should examine whether the extra revenue from selling the additional coaches would be greater
or smaller than the extra costs.
Who do you think is right? Why?
7 Assume a social security system in a country provides income for people over the age of 65. If a recipient decides to
work and earn some income, the amount they receive in social security benefits is typically reduced.
a. How does the provision of this grant affect people’s incentive to save while working?
b. How does the reduction in benefits associated with higher earnings affect people’s incentive to work past the age
of 65?
8 Your flatmate is a better cook than you are, but you can clean more quickly than your flatmate can. If your flatmate did
all the cooking and you did all the cleaning, would your household chores take you more or less time than if you divided
each task evenly? Give a similar example of how specialization and trade can make two countries both better off.
9 Explain whether each of the following government activities is motivated by a concern about equity or a concern about
efficiency. In the case of efficiency, discuss the type of market failure involved:
a. Regulating water prices.
b. Regulating electricity prices.
c. Providing some poor people with vouchers that can be used to buy food.
d. Prohibiting smoking in public places.
e. Imposing higher personal income tax rates on people with higher incomes.
f. Instituting laws against driving while using a mobile phone.
10 In what ways is your standard of living different from that of your parents or grandparents when they were your age?
Why do you think these changes occurred?

Introduction
A perpetual debate in many economies revolves around the provision of health services. In the UK and
many European countries, health provision is universal, meaning it is available to all regardless of their
income or status and is free at the point of use. Of course, health provision is not ‘free’ – it is extremely
expensive. If a government wants to increase spending on health, it must find a way of funding it. Assume
that a government announces an increase in spending on its health service of €2.8 billion, to be funded
by new measures to prevent large corporations avoiding their tax liabilities by tightening the rules on
corporate taxes.
How would an economist think about this policy? An economist would want to know what the addi-
tional investment would be spent on, whether this additional spending would result in a more efficient
health service and, crucially, would want to know how ‘efficient’ was being defined in this context.
Regardless of whether the economist has a personal view about whether the means of raising the
funds are ‘right’, they would think about whether the amount of money raised through these measures
would be sufficient, and whether tightening rules on tax avoidance would have consequences on the
behaviour of economic actors who would be affected. Political parties might not foresee these changes in
behaviour, and this could compromise the intended outcome.
Ultimately, the economist would want to investigate the costs and benefits of such a policy, try to
quantify those costs and benefits, and offer an informed view of the consequences. It would not simply
be a case of looking at the obvious costs and benefits but also the hidden costs and benefits which might
lead to an outcome or outcomes that are very different from those the policy was designed to achieve.
Economics, like most other fields of study, has its own language, its own processes, its methods of
discovery and its own way of thinking. As you embark on your study of economics you will have to learn
lots of terms and concepts. Many of the concepts you will come across in this book are abstract. Abstract
concepts are ones which are not concrete or real – they have no tangible qualities. We will talk about mar-
kets, efficiency, comparative advantage and equilibrium, for example, but it is not possible to physically
see these concepts.
As you work through your modules you will find that it is not always easy to think like an economist,
and there will be times when you are confused and find some of the ideas and concepts being presented
to you running contrary to common sense (i.e. they are counter-intuitive). What you will be experiencing is
perfectly normal and a part of the learning journey.

Economic Methodology
How do economists know what they know? What methods do they adopt to find out information and
arrive at theories? In this chapter we will discuss the methodology of economics. There is considerable
debate about this methodology and, crucially, about the assumptions which underpin the discipline. There
has been, and probably will continue to be, a number of books and articles published which are critical
of economics and economists. This has been exacerbated by the Financial Crisis of 2007–9. If you read
15

some of these books and articles, you might be forgiven for wondering what on earth you have done in
choosing to study such a bankrupt subject which is populated by automatons who ignore everything ‘real’
and blindly pursue their own narrow focus because it suits them to do so.
The reality is somewhat different. There have been debates and disagreements in economics for hun-
dreds of years; some of these disagreements are about the assumptions that are made in exploring eco-
nomic phenomena. In other cases, there may be broad agreement on the direction of (for example) cause
and effect, but the disagreement may be on the extent of the effects.

Economics as a Science
One of the debates about economics is the extent to which it is a ‘science’. Science is a process; it is
related to the discovery and creation of new knowledge and understanding but also relies on existing
knowledge and understanding. Science is ongoing. The knowledge and understanding associated with
the process are constantly evolving as new discoveries help improve our knowledge and understanding
of the world around us.
Of course, we tend to think of science from the perspective of physics, chemistry and biology, which
many people have studied at school. These subjects are referred to as ‘natural sciences’, because they are
associated with the study of physical things and the natural world. When studying natural phenomena,
it is often possible to conduct controlled experiments. This means that researchers can vary an object of
interest and observe what happens to other variables and objects. The experiment can be repeated, and
data gathered, which can help in the explanation of events and to establish cause and effect.
Other discipline areas cannot carry out experiments in the same way. Economics is one of those dis-
ciplines. Economics studies decision-making and the effect of decision-making on a wide range of topic
areas, but central to the study is human beings. Controlled experiments which can be carried out in the
natural sciences cannot be carried out in the same way in economics. Economics is referred to as a ‘social
science’ because it deals with human beings as individuals and in groups. The process of knowledge cre-
ation and development in social sciences can take on different nuances compared to the natural sciences,
but there are processes and methods which are common to both.

Self Test Can any discipline which deals with human behaviour truly call itself a ‘science’?

Models
Economics uses a lot of models. A model is a representation of reality which facilitates understanding
of how something works. Models can be used as a means of helping understand the real world and for
making informed decisions and judgements.
Models are, of necessity, simplifications of reality and not meant to represent every feature, nuance or
aspect of the real world it is attempting to explain. It is often worth thinking of models which architects use
to show how a building will look. The model will provide the observer with an image of what the eventual
building will look like. It shows its key features and helps in understanding the scale of the building, how it
integrates with its surroundings and its main structures. What the model does not do is incorporate every
feature and aspect of the building – that is not necessary to develop a broad understanding of the building
and its environment.
Similarly, economists use models to represent the world around them. We use models to represent
how markets work, how the economy as a whole works, how consumers behave and how firms behave.
These models are based on assumptions, some of which might not be fully accurate as a representation
of how the real world works or how the economic agents which form part of the model behave. This does
not necessarily detract from the value of the model in describing how the phenomenon under investiga-
tion works.
Economic models have two principal uses: one is for predicting or forecasting what might happen in
the future as a consequence of a decision or policy, and the other is to simulate an event and provide

a comparison with what would have happened if the decision, policy or change had not happened (the
counterfactual). Economists’ models are most often composed of diagrams and equations. By feeding in
data, economists can use models to generate outcomes which provide some insight and form the basis
of decision-making.

counterfactual analysis is based on a premise of what would have occurred if something had not happened

Models are valuable in that they allow economists to manipulate variables which form part of the model
and explore what might happen. Economics models will always contain a number of variables. Some of
these variables are determined by the model and some are generated within the model. For example, take
the market model where the quantity demanded (Qd ) is dependent on the price (P ). Qd is said to be the
dependent variable. Its value will be dependent on the functional relationships in the model (the factors
that affect demand) such as incomes, tastes and the prices of other goods. Qd can be described as an
endogenous variable. Price, on the other hand, is the independent variable – it affects the model (the
quantity demanded) but is not affected by it. The price is not determined by, or dependent on, the quantity
demanded. Price would be referred to as an exogenous variable.

endogenous variable a variable whose value is determined within the model

exogenous variable a variable whose value is determined outside the model

Models are inherently unstable the longer the time period being considered and forecast. Shocks occur
which are impossible to factor into the building of models. These not only have short-term impacts but
may also change longer-term dynamics. For example, the attacks on the World Trade Centre on 11 Sep-
tember 2001 have had a fundamental impact on the ways in which governments think and behave that
could not have been envisaged before the event. One of the reasons why models of climate change are
subject to debate and disagreement is that over time the internal dynamics of models change in ways
which render future predictions inherently unstable.
The so-called ‘butterfly wing’ effect, as described in chaos theory, highlights the complexity surround-
ing modelling in meteorology. The butterfly effect notes that a butterfly flapping its wings at a particular
point in time and space creates small changes in conditions which can lead to significant changes in
faraway places, such that a flap of a butterfly’s wings in New Mexico could be traced as the initial causal
factor of a hurricane in China sometime in the future. Chaos theory further tells us that minor errors in
measurements or assumptions can be amplified to such an extent that any predictions made by the model
are rendered useless, and that the further into the future we are attempting to make forecasts and predic-
tions, the more unstable our models are.

Cause and Effect One problem facing economists is separating out cause and effect. Observation and
experience can lead to the identification of phenomena occurring which intuition would seem to suggest
are related in some way. Does a change in price, for example, cause a change in the amount bought by
consumers, or does quantity bought affect price?
To get a clearer picture, economists will utilize an important aspect which is common to other sciences,
that of holding other variables in the model constant. The Latin term ‘ceteris paribus’ meaning ‘other
things equal’, is used to note when other factors that might affect outcomes are assumed to be constant.
Research can lead to a conclusion which provides an answer. The question which must be asked is ‘How
do we know this “answer” is correct?’

ceteris paribus (other things equal) a term used to describe analysis where one variable in the model is allowed to
vary while others are held constant

Take the case of the relationship between crime rates and unemployment. Is a rise in the crime rate, for
example, always caused by a rise in unemployment, or are there other factors that can also influence the
crime rate? How significant is the incidence of unemployment in determining crime rates? How do those
who research such a relationship establish the facts of the case?

Human Values in Models Models can be developed, predictions made and conclusions drawn, but there
are then human values to take into consideration. Many economists, for example, will agree that there
is sufficient evidence to suggest that government stimulus in a period of economic downturn can help
reduce the number of people unemployed. What might be the subject of more disagreement is the signif-
icance of the effect, or the value of the associated costs and benefits of such a policy.
Models of climate change may suggest that the increase in human-generated carbon emissions will
contribute to a change in the global climate. There may be some who would disagree with this basic con-
clusion, partly because they dispute the ‘facts’ which form the basis for the model.
Models also allow inferences to be made. This means that conclusions, consequences or explanations
can be drawn based on the evidence provided by the model. This is not to say that these conclusions are
full and final; they are simply what may be reasonably and logically derived based on the manipulations of
the model.

inference a conclusion or explanation derived from evidence and reasoning

The climate change model, for example, might infer a policy suggestion that significant measures might
have to be put in place to cut carbon emissions in the next 10 years to prevent the costs which our children
and grandchildren will have to bear. There may be people who disagree on whether the cost of the current
sacrifices required are outweighed by the value of the benefits that will occur between 50 and 100 years
into the future.

Manipulating Models Economists will often use models based on mathematical formulae. This can allow
the modeller the ability to manipulate the numbers in the formula and identify the extent to which out-
comes differ. When a model is manipulated, outcomes can be identified. The model may help to explain
the mechanism or reasons why the outcomes identified occur. The outcomes from models can then be
compared to actual data to see the extent to which the model is useful in explaining observed data and
behaviour.
This is a perfectly normal part of the scientific process. Those critical of a model and its outcomes can
provide refinements to the model which might better represent the phenomena it is meant to be describ-
ing or explaining. This is how knowledge is built, developed and improved upon. The explanatory power of
models is dependent on how well they are built. If they are too simplified or the assumptions cannot be
reasonably observed in the real world, then their explanatory power breaks down.

Self Test Make a list of five benefits of modelling in economics and five limitations.

Types of Reasoning
One of the ways in which science discovers new knowledge is through asking questions. The conse-
quences which arise from asking these questions can be significant. For example, if Isaac Newton really
did get hit on the head with an apple and, amidst his pain, asked the question ‘I wonder why apples fall
to the ground,’ the answers he generated have fundamentally changed the way we look at the world.
Newton’s work on gravity spawned many other questions and led Einstein to arrive at the theory of relativ-
ity, and the theory of relativity was used to help in the development of global positioning satellites (GPS)
which so many people in the world now use and rely upon in their cars, smartphones, watches and other
gadgets.

When questions are asked, there are different routes which scientists take to explore those questions
or, in some cases, arrive at the questions themselves. We can identify different types of reasoning which
help clarify the process involved. There is no ‘right’ way of reasoning, but there is debate about which
produces more reliable theories, which in turn have predictive power.

Deductive Reasoning Deductive reasoning begins with known ‘facts’ or ‘truths’ – things that we know
to be true (or think to be true). It then works through a process of using these facts or truths to arrive at
answers to the question we are interested in and, as a consequence, arriving at new facts or truths.
The ‘question’ might take the form of a general statement or hypothesis. The word is derived from
the Greek (hypotithenai ) meaning ‘a placing under’ or ‘to suppose’. A hypothesis is an assumption, a ten-
tative prediction, explanation, or supposition for something. To discover whether the hypothesis is true or
correct, it must be tested. If the facts or known truths are applied to the hypothesis, then the conclusions
drawn allow us to discover whether the hypothesis is ‘true’ or ‘correct’.

hypothesis an assumption, tentative prediction, explanation, or supposition for something

A very simple example can serve to highlight deductive reasoning. You observe an animal you haven’t
seen before and ask the question ‘I wonder if that animal is a bird?’ The hypothesis or supposition would
be that this animal is a bird. You observe that the animal has feathers. Based on the known truth that all
birds have feathers, if this animal has feathers then you can conclude that it is a bird.
The conclusion rests on the assumption that the facts or known truths used to arrive at the conclu-
sion are indeed true, in this case, that all birds have feathers. If the facts or the premise used in our
example was ‘All birds have feathers and fly,’ we might arrive at a conclusion which is unsound. This is
because while all birds have feathers, not all birds fly. This simple example serves to highlight one of the
reasons why there can be disagreement in economics. The ‘truths’ or facts that are used in deductive rea-
soning might be disputed. We will see this highlighted in our discussion on consumer behaviour later in
the book. The assumptions or ‘truths’ that are used to explain human behaviour and arrive at conclusions
in this context have been disputed and given rise to alternative conclusions.
Let us look at a simple example in economics. Many countries have put in place legislation to estab-
lish a minimum wage as a means of protecting the lowest paid workers in society. What will be the
consequences of this legislation? An economist might develop a hypothesis that a minimum wage
will result in increased unemployment. In analyzing whether this hypothesis is ‘true’ or not, the econ-
omist might use ‘known facts’ that when the price of something is set above equilibrium, the quantity
demanded will fall and the quantity supplied will rise, resulting in a surplus. In this example, the surplus
will be a surplus of labour, i.e. more people willing to supply labour services compared to the demand
by employers of those labour services. Therefore, the conclusion is that a minimum wage will indeed
result in unemployment.
Economists may use models of the labour market which are based on mathematical equations to help
quantify the extent of the unemployment which will occur. These models are in turn based on the ‘known
truths’ about the labour market and how it works. There is extensive debate around minimum wage laws,
which is a particular source of disagreement among economists. Part of the reason for this is disputes
over the ‘known truths’ and the parameters of the model, the way the variables are defined and quantified.
This is one of the reasons that economics differs from the natural sciences, in that the models used are
based on human behaviour and not on natural forces. Human behaviour tends to be unpredictable and
not always fully understood, whereas factors in natural science may be more stable and ‘easier’ to define
and quantify.

Inductive Reasoning Inductive reasoning begins with data and observation. The data or observations are
analyzed. From this analysis, patterns are identified, which may be patterns of behaviour. These patterns
generate a question, or hypothesis, which explains the observed behaviour or pattern. This explanation or
conclusion is then applied to all other instances of the phenomena. This is referred to as ‘generalization’.
In generalizing, the researcher is offering a theory or explanation of events and phenomena. This theory

can then be tested and verified, or could be shown to be inaccurate and amended, or a new theory pro-
posed to replace the incorrect one.

generalization the act of formulating general concepts or explanations by inferring from specific instances of an event
or behaviour

One example of inductive reasoning in economics might be the observation that countries experi-
encing rapid and accelerating inflation (hyperinflation) also seem to have central banks which print large
sums of money. The ‘pattern’ seems to be that rapid increases in the money supply are associated with
instances of hyperinflation. If there was only one instance of this ‘pattern’, it may be that the researcher
could not generalize to all instances, but if this pattern was observed and verified by the data in a number
of instances, it may be possible to arrive at a general theory which posits that hyperinflation is caused by
rapid increases in the money supply. Other instances of hyperinflation can then be monitored, the data
analyzed, and the theory could be confirmed or rejected, depending on the nature of the evidence which
arises from additional instances of this phenomena.
Inductive reasoning is thus empirical in nature – it refers to evidence to confirm or reject theories.
For this reason, inductive reasoning is seen as being a benchmark for developing knowledge and under-
standing. One of the challenges facing social sciences like economics in using inductive reasoning is that
conclusions and generalizations can be made based on partial or incomplete data.
Given the nature of human beings, this is a particular problem for economics. If we observe patterns
of behaviour for tens of thousands of households in Ireland, for example, and draw a general conclusion
and theory of this behaviour, can we safely assume that this also explains similar behaviour across Europe
or indeed the world? Identifying patterns in data means that the data must be collected, be available for
study and be reliably complete. This is not always possible. Looking at data for gross domestic product for
different countries online, for example, often highlights differences in results from one source to another.
This may be explained by the way in which the data is collected, how it is processed, who is gathering and
analyzing the data, and the statistical processes used.

Experiments in Economics
Although economists use inductive reasoning like other scientists, they do face an obstacle that
makes their task especially challenging. Physicists, for example, can set up controlled experiments
such as the Large Hadron Collider, which is seeking to recreate conditions that existed milliseconds
after the Big Bang. The experiments being conducted are designed to help confirm existing theories
and/or develop new ones to explain forces and matter and how the universe began. By contrast, econ-
omists studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate
useful data.
Economists pay close attention to the natural experiments offered by history. When political instability
interrupts the flow of crude oil, for instance, oil prices rise around the world. For consumers of oil and oil
products, such an event depresses living standards. For economic policymakers, it poses a difficult choice
about how best to respond. For economists, it provides an opportunity to study the effects of a key nat-
ural resource on the world’s economies, and this opportunity persists long after the increase in oil prices
is over.
Throughout this book, therefore, we consider many historical episodes. These episodes are valuable to
study because they give us insight into the economy of the past and, more importantly, they allow us to
illustrate and evaluate economic theories of the present.
Despite the challenges faced by economists in conducting experiments, there are two major fields that
are worthy of note. Experiments in economics can be conducted in a ‘laboratory’, where data can be col-
lected via observations on individual or group behaviour through questionnaires and surveys, interviews
and so on, or through the collection and analysis of data that exists such as wages, prices, stock prices,
volumes of trades, unemployment levels, inflation and so on. The data can be analyzed in relation to a
research question and conclusions drawn which help develop new understanding or refine and improve

existing understanding. The conclusions drawn from such experiments may be generalizable; in other
words, the findings of the experiment can be extended outside the ‘laboratory’ to explain behaviour or
economic phenomena and provide the basis for prediction.
One example of how such laboratory experiments can help change understanding is the work of people
such as Daniel Kahneman, Amos Tversky, Richard Thaler and Cass Sunstein, whose research has helped
to provide insights into judgement and decision-making and has offered a different perspective on the
assumptions of rational decision-making. Thaler, the 2017 Nobel Prize winner, for example, conducted a
number of experiments to explore how individuals respond when faced with different questions on losses
and gains in relation to a reference point. He found that prior ownership of a good, for example a ticket to
see a football game, altered people’s willingness to sell, even at prices significantly higher than they had
paid.
Thaler’s observations on the consistency of this behaviour across a number of experiments led him to
coin the term ‘endowment effect’ to explain the behaviour. It is now widely accepted that the endowment
effect does exist and that it runs counter to the assumptions of rational behaviour in economics. Thaler
worked with Kahneman and Tversky and extended the theory to distinguish between goods which are
held for trade and those which are held for use. The endowment effect, they suggested, was not universal;
it was more powerful when goods were held for use.
A second type of experiment in economics is natural experiments. A natural experiment is one where
the study of phenomena is determined by natural conditions which are not in the control of the experi-
menter. Natural experiments can be exploited when some change occurs which allows observation to be
carried out on the effects of this change in one population, and comparisons made with another population
that is not affected. Examples of natural experiments include observing the effects of bans on smoking in
public places on the number of people smoking or the possible health benefits; how far a change in the
way in which education is financed affects standards; the effect on income of the years spent in education;
the effects of a rise in a tax on property on the market for housing; and the effects on the female labour
market of changes in fertility treatment and availability.
Typically, natural experiments make use of the statistical tools of correlation and regression to deter-
mine whether there is any relationship between two or more variables; if any such relationship exists;
and, if it does, what the nature and strength of the relationship is. From such analysis, a model can be
developed which can be used to predict.
At the heart of such analysis is the extent to which a relationship between two or more variables can be
linked to cause and effect. Just because two variables appear to have some relationship does not neces-
sarily imply cause and effect. For example, a researcher might find that an observation of graduates in the
workforce shows that their incomes are generally higher than those of non-graduates. Can the researcher
conclude that having a degree will lead to higher income? Possibly, but not necessarily. There might be
other factors that have an effect on income apart from having a degree. Trying to build a model which takes
into account these different factors is an important part of the value of natural experiments.

Case Study The Basic Income Experiment

It is sometimes said that economists cannot conduct major experiments by intervening in economies, but
in Finland they have done just that. A two-year pilot was introduced in January 2017 to investigate the
effect of the introduction of a basic income scheme. Some 2,000 participants were chosen at random to
take part in the experiment.
The hypothesis being investigated was whether giving the unemployed a guaranteed basic income
had an impact on their employment prospects. The income amount was the same for every individual
regardless of their background or position and was paid periodically, for example, every month. Unlike
many unemployment insurance schemes, receiving basic income was not dependent on the individuals
having to demonstrate that they were seeking employment. If an individual received a guaranteed basic
income, would this help alleviate poverty and inequality, and encourage individuals to find work?

(Continued )

A number of similar experiments are in operation related to basic income. In Canada, for example, a
basic income experiment was introduced in June 2017 in two cities and a town in Ontario. Two groups
of people were selected. One group received a basic annual income of up to CDN$17,000 (around
€11,100) and the other group received nothing. In the Canada experiment, the participants must be on
a low income and, for those getting the basic income, if they find work their basic income is reduced
by half.
Barcelona launched a basic income experiment in October 2017 which, like the Finland experiment,
involved 2,000 participants, half of whom received between €400 and €525 per month over a two-year
period. Unlike the Finland experiment, in Barcelona the money was given to households, not individuals,
and those receiving the money were required to give something back in the form of attending support
programmes to help them find work, as well as other community-based programmes.
In Finland, the 2,000 unemployed participants received €560 per month as a basic income. By having
this guaranteed sum, the hypothesis was that individuals would be likely to be more flexible in seek-
ing work, moving between jobs and taking part in the gig economy with all its potential uncertainties.
The experiment was due to last
two years and an evaluation of the
results of the experiment was con-
sidered along with other welfare
measures in the country.
The experiment was run from
the Social Insurance Institution, a
government agency. The Institution
applied for an extension of the
experiment to include individuals
who were employed, but the
request was turned down by the
Finnish government in April 2018.
The experiment on the initial 2,000
participants continued as planned If an individual receives a guaranteed basic income, would this
and the results were analyzed and help alleviate poverty and inequality, and encourage individuals to
published in the latter part of 2019. find work?

Theories
Theories can be used to explain something and to make predictions. The theory of indifference curves
and budget lines can be used to explain consumer behaviour. The value of this theory is how reliable it is
in predicting consumer behaviour. If we observe the way consumers behave and the outcomes predicted
do not conform to the theory, it may be that new research must be conducted to offer refinements to the
theory, or even consigning the theory to history.
One of the criticisms of economics is that some theories commonly taught on undergraduate courses
have been derived through deductive reasoning, but that the premises used as the basis for the con-
clusions drawn are inaccurate, or just wrong, and not supported by data and evidence. For example,
the neo-classical theory of consumer behaviour makes assumptions that consumers act rationally, prefer
more to less and make purchasing decisions based on pure self-interest. The premises for the theory were
developed in the nineteenth century when the economy and society were very different. The historical
context of many theories in economics should not be ignored.
Critics argue that these assumptions are not supported by evidence and data, and thus any predictions
arising from such theories are unreliable or wrong. Supporters of such theories argue that they do contain
useful insights into behaviour that allow valid predictions to be made. While they may not explain human

behaviour in every instance, they still have some value. Models, they argue, are after all simplifications of
reality and cannot hope to replicate every aspect of human behaviour.

Falsifiability
As hinted at earlier, one of the criticisms of economics in recent years has been that while it claims to be
a science, it does not follow scientific principles, or at least only does so when it deems it convenient. In
particular, critics have argued that many of the theories we will present in this book are no longer accu-
rate and should be dismissed. Despite this, and critics would argue that this book is one of many that
perpetuate the problem, these theories continue to form the basis for many undergraduate economics
courses. Why do we continue to teach theories which are inaccurate or just wrong? Critics would argue
that including these theories in an economics course is like physics courses continuing to teach a theory
of the earth being flat.
In considering these debates, we can refer to the philosophy of science and one of its foremost expo-
nents, Sir Karl Popper. Popper was born in Vienna in 1902 and in 1946 moved to the UK to teach at the
London School of Economics. He was knighted in 1965, and his contribution to the philosophy of science
was extensive and highly regarded.
One of Popper’s important contributions was the principle of falsifiability. Popper based the idea on
the basic assumption that it is not possible to know the truth of everything. Ideas and theories might be
widely accepted and adopted, but ultimately, we cannot be 100 per cent sure that these ideas and theories
are correct. Knowledge is always subject to evolution and development, and in the light of new evidence,
our theories and ideas may change.

falsifiability the possibility of a theory being rejected as a result of the new observations or new data

Popper argued that it is not possible to prove beyond all doubt that a theory is ‘true’, but what is
possible is that a theory can be proved as false. New evidence can arise, be discovered or produced
that can prove a theory is false. Popper further argued that inductive reasoning is flawed because we
cannot claim to know ‘truth’ from what invariably is limited observation. Just because we observe many
instances of a phenomenon or behaviour does not mean that we can generalize to all instances of that
phenomenon or behaviour. The famous example cited by Popper to exemplify this is that of the ‘black
swan’. An observer could record many thousands of instances of white swans and generalize that ‘all
swans are white’. However, it is not possible to make this conclusion, since not all swans have been
observed. If one person subsequently observed a black swan, then the theory that all swans are white
can be declared false.
Popper’s view was that ‘good’ science should be based around the idea of falsifying theories rather
than attempting to prove theories. The researcher should make it clear in their findings the conditions
under which the theory being proposed can be falsified. This approach means that researchers who seek
to defend a theory and find ways of proving it is true, even in the face of evidence to the contrary, are not
adhering to the fundamentals of scientific method. A general principle behind scientific method, therefore,
is that it should be possible to falsify a theory, and ‘good science’ should be centred on this and not on
seeking to prove existing theories.
This debate is particularly relevant to economics because of the criticism that the subject has faced,
particularly since the Financial Crisis of 2007–9. You may well find that some of your lecturers are fierce
defendants of particular theories, or at the very least will seek to find ways in which a theory, or elements
of a theory, can be adjusted or explained in the light of evidence which may suggest the theory is false. As
you continue your studies, it is important to keep in mind the discussion in this section about the way we
discover and verify new theories, knowledge and understanding about the subject.
Economics is a dynamic subject and the detailed research that many economists continue to undertake
might hide the depth to which many take the criticisms of the subject. Popular criticism of the subject

can be just that – an attempt to appeal to the masses, many of whom will have little or no understanding
of exactly what economists do, how they research into the subject or the controls they put in place to
improve the quality of the research and outcomes. It is worth bearing in mind that the modelling method
allows economists to approach issues, research them, think about them and attempt to uncover new
knowledge and understanding. This is not the same thing as saying the models themselves, whatever
they be, are final truths and are more important than the method.
While this book will include many theories which have been the focus of some criticism, they are impor-
tant in understanding the historical development of economics and how we have come to know what we
know. However, it is also important to recognize that there is still much we do not know and much to be
discovered. Every economist knows this.

Keeping an Open Mind Understanding the processes and debates around scientific method, under-
standing the theories and their limitations helps generate more questions and the search for better ways
in which we can understand the economy and human behaviour. All we ask is that you keep an open
mind and recognize that there can be some truths hidden in theories, even if they are not the full truths,
and these theories and the discipline as a whole are subject to ongoing evolution. Economics is a way of
approaching problems and issues rather than a set of definitive truths. The debate about how economists
come to know things and present theories and models which claim to be predictive is one which contin-
ues to pervade the discipline.
The Cambridge economist, Joan Robinson, perhaps captured the debate very well when she wrote
economics ‘limps along with one foot in untested hypotheses and the other in untestable slogans … our
task is to sort out as best we may, this mixture of ideology and science’ (Robinson, J. (1968) Economic
Philosophy. Pelican).
As noted earlier, separating out cause and effect can be problematic. Observation and experience
can lead to the identification of phenomena occurring which intuition would seem to suggest are related
in some way. Empirical research can help provide a conclusion which provides an answer, for example,
whether a rise in the money supply does cause a rise in the price level. The question which must be
asked is, ‘How do we know this “answer” is correct?’ What are the factors that influence the price level?
How significant is the role of the money supply in determining the price level? How was the research
conducted, and what ‘facts’ and assumptions were used in building the model? Can these facts and
assumptions be accepted as an accurate representation of the ‘truth’, or are there interpretations of both
which might impact on the conclusions drawn?
If facts and assumptions are accepted, then we must presume that those who collected them did
so in an unbiased and unprejudiced way and that they were professionally competent and had sufficient
expertise to be able to do so in a way we can trust. Separating out cause and effect can be informed by
statistical tests but is also subject to interpretation. It is not always easy to establish cause and effect,
particularly when controlled experiments are not possible, and this characterizes much of economics.

The Role of Assumptions

If you ask a physicist how long it would take for a cannonball to fall from the top of the Leaning Tower
of Pisa, they will probably answer the question by assuming that the cannonball falls in a vacuum. This
assumption is false; the building is surrounded by air, which exerts friction on the falling cannonball and
slows it down. Yet the physicist will point out that friction on the cannonball is so small in relation to its
weight that its effect is negligible. Assuming the cannonball falls in a vacuum greatly simplifies the prob-
lem without substantially affecting the answer.
Economists make assumptions for the same reason: assumptions can simplify the complex world and
make it easier to understand. To study the effects of international trade, for example, we may assume that
the world consists of only two countries and that each country produces only two goods. The real world
consists of dozens of countries, each of which produces thousands of different types of goods, but by
assuming two countries and two goods, we can focus our thinking. Once we understand international
trade in an imaginary world with two countries and two goods, we are in a better position to understand
international trade in the more complex world in which we live.

The art in scientific thinking is deciding which assumptions to make. Suppose, for instance, that we
were dropping a beach ball rather than a cannonball from the top of the building. Our physicist would
realize that the assumption of no friction is far less accurate in this case: friction exerts a greater force
on a beach ball than on a cannonball because a beach ball is much larger and, moreover, the effects of
air friction may not be negligible relative to the weight of the ball, because it is so light. The assumption
that gravity works in a vacuum may, therefore, be reasonable for studying a falling cannonball but not for
studying a falling beach ball.
Similarly, economists use different assumptions to answer different questions. Most economic issues
will be affected by a number of different factors. If we try to model the issue taking into account all these
factors, the complexity might lead to outcomes which do not help in developing an understanding of
economic phenomena. In researching a phenomenon, economists will look at what happens when one
factor changes, but all other factors assumed to have an effect are held constant. This is a core feature of
neo-classical economic methodology. It might be assumed that the amount consumers wish to purchase
is affected by the price of the good concerned, income, tastes and the prices of other related goods.
Our understanding of consumer behaviour is simplified if we look at the effect on demand of a change in
income and hold all other factors constant. This can be repeated with the other factors to generate some
general principles about the demand for goods and services.
Assumptions must be tested to see the extent to which they are accurate and reasonable in the same
way that it is deemed reasonable by the physicist to drop the assumption of friction when considering the
effect of dropping a cannonball from the Leaning Tower of Pisa.

Schools of Thought
Given our preceding discussion on economic methodology, it might come as no surprise that there are
different approaches to economics, and different perspectives.
These may be informed by assumptions and belief systems which influence the way issues are looked
at, and the outcomes and policy implications which arise as a result. Perhaps the dominant methodology
is the neo-classical approach, which is sometimes referred to as ‘mainstream economics’.

Neo-classical Economics
The neo-classical approach takes the view that the market is a central feature in generating well-being and
in answering the three questions all societies have to face, which we looked at in Chapter 1. In analyzing
markets and outcomes, the neo-classical approach assumes that decisions are based on rationality, that
economic agents act out of self-interest, and are autonomous. The neo-classical approach models behav-
iour through constrained optimization problems. This means that it is assumed economic agents seek to
maximize or minimize outcomes but are subject to constraints. Individuals seek to maximize utility subject
to the constraint of their income; firms seek to minimize costs subject to the constraint of resources avail-
able and the price of those resources.
Critics of this approach argue that the assumptions are flawed, and that what is observed about human
behaviour does not conform to the neo-classical view. They argue that such is the power of the neo-classical
hold on economics that other views, so-called heterodox economics (where the term ‘heterodox’ means
views at odds with the mainstream), find it hard to gain any ground. These differing views include feminist
economics, Marxist economics and the Austrian school.

Feminist Economics
Feminist economics questions many of the assumptions of the neo-classical school. Economic well-being,
they argue, is not simply provided through market exchange but also includes unpaid work carried out in
the home. This housework, by both males and females, needs to have the recognition its significance to
well-being deserves. Economic activity, therefore, needs to include a valuation of this unpaid work.

Feminist economists also research into other areas where there are gender and social inequalities, and
they would argue that it is not possible to have value-free analysis and research into economic issues. For
example, the idea that humans face a trade-off between work and leisure is misleading in that ‘leisure’ is
associated with pleasurable activities which people choose to take part in. For many women, ‘non-work’
activity, i.e. that which is not paid, is not leisure at all and involves considerable work in caring for the home
and family. To only assume that ‘work’ is valuable betrays a value judgement which relegates analysis of
unpaid work below that of paid work.

Marxist Economics
In later chapters, we will look at the working of markets and firms in more detail. Much of the analysis will
be derived from the neo-classical approach, but there are other explanations for how markets and firms
work. Marxist economics presents different explanations for essentially the same phenomena and has
developed from the work of Karl Marx in the nineteenth century. Marx sought to analyze and understand
the capitalist system and explain how and why production takes place and the circumstances under which
different groups in society have economic power.
Marxist economics views firms and markets not as entities but as collections of humans, and it is
these humans who make decisions. Some humans have control over the means of production and can
exploit that power in ways which lead to different outcomes and which drive dynamism in economies. This
dynamism can be self-destructive, however, and the competition between capitalists to attempt to retain
control over the means of production is partly what generates booms and busts in capitalist economies.
Neo-classical economists propose different explanations for the swings in the business cycle.

The Austrian School

The Austrian school originated in work carried out at the University of Vienna in the latter part of the
nineteenth century. Academics at Vienna were of the belief that economic well-being is maximized when
markets are allowed to do their work and that the government should have a minimal role in the economy
(referred to as ‘laissez-faire’ roughly translated as ‘to leave’, or ‘let it be’). Individual liberty is a fundamental
principle in Austrian school economics.
The Austrian school is now not based in Vienna but has adherents in different parts of the world. Key
figures in the Austrian school include Carl Menger, Eugen Böhm-Bawerk, Friedrich Weiser, Ludwig von
Mises and Friedrich August von Hayek. Other influential economists such as the 1991 Nobel Prize winner
in Economics, Ronald Coase, were said to have been influenced by the Austrian school (Coase was at the
London School of Economics when Hayek was on the faculty and acknowledged the impact he made).
Austrian school economists look at the explanation for business cycles in the supply side of the econ-
omy rather than focusing on demand. Excess supply is what drives the economy into recession and this, in
turn, can be caused by interest rates being too low, leading to too much investment and the availability of
cheap money. It is this that triggers inflation. For Austrian economists, therefore, inflation is not the main
problem or focus of policy; inflation is a symptom of imbalances in the financial sector of the economy.
Economists from the Austrian school had been warning of too low interest rates and too high debt levels
for many years in the early part of the twenty-first century and there are those who argue that it was these
economists who correctly predicted the Financial Crisis of 2007–9 and not mainstream economists. Crit-
ics of the Austrian school argue that it relies on narrative analysis rather than mathematical, statistical and
empirical analysis and so their claims cannot be tested and verified.

The Economist As Policy Advisor

Often economists are asked to explain the causes of economic events and recommend policies to improve
economic outcomes. Why, for example, is unemployment higher for teenagers than older workers, and
given this situation what should the government do to improve the economic well-being of teenagers?
These two roles lead to important distinctions in the way in which we need to view statements and

analysis. To answer the first question, the economist might use scientific method to offer an explanation,
but the second involves a value judgement. This highlights the distinction between what is termed positive
and normative economics.

Positive versus Normative Analysis

Suppose that two people are discussing minimum wage laws.
Pascale: Minimum wage laws cause unemployment.
Sophie: The government should raise the minimum wage.
Pascale’s statement is making a claim about how the world works. Sophie is making a value judgement
about a change she would like to see implemented.
Pascale’s statement is referred to as a positive statement. Positive statements have the property that
the claims in them can be tested and confirmed, refuted or shown to not be provable either way. It would
be possible to conduct research to show whether there is any correlation between the imposition of mini-
mum wage laws and a rise in unemployment. A positive statement does not have to be true – it is possible
that the research might conclude that there is no link between minimum wages and unemployment.

positive statements claims that attempt to describe the world as it is

Sophie’s is said to be normative. Normative statements have the property that they include opinion and
make a claim about how the world ought to be; it is not possible to test opinions and confirm or reject them.

normative statements claims that attempt to prescribe how the world should be

Positive analysis incorporates the use of scientific methodology to arrive at conclusions which can be
tested. Normative analysis is the process of making recommendations about particular policies or courses
of action. It is perfectly possible to conduct both positive and normative analysis. For example, the state-
ment: the government should reduce the deficit as this will benefit the economy, contains a normative
statement – an opinion that the government ought to reduce the deficit. It also includes a positive state-
ment: A reduction in the government deficit will benefit the economy, which is capable of being tested.
A key difference between positive and normative statements, therefore, is how we judge their validity.
Deciding what is good or bad policy is not merely a matter of science; it also involves our views on ethics,
religion and political philosophy.
Of course, positive and normative statements may be related. Our positive views about how the world
works affect our normative views about what policies are desirable. Pascale’s claim that the minimum
wage causes unemployment, if true, might lead us to reject Sophie’s conclusion that the government
should raise the minimum wage.

Why Economists Disagree

If economics is classed as a science and adheres to scientific methods, why does there appear to be
considerable disagreement among economists surrounding many different policy initiatives? There are
two basic reasons:
●● Economists may disagree about the validity of alternative positive theories about how the world works.
●● Economists may have different values and, therefore, different normative views about what policy
should try to accomplish.
Let’s discuss each of these reasons.

Differences in Scientific Judgements

History shows us that there have always been disagreements between scientists about ‘truth’ and reality.
In 1964, for example, Peter Higgs at the University of Edinburgh had his original paper on the theoretical
model predicting what came to be known as the Higgs Boson, rejected by the journal Physics Lectures,
which saw the theory as having ‘little relevance to physics’. In 2012, the experiments at Cern in Switzerland
confirmed the existence of the Higgs Boson, and in 2013, Professor Higgs was jointly awarded the Nobel
Prize for Physics. Science is a search for understanding about the world around us. It is not surprising that
as the search continues, scientists can disagree about the direction in which truth lies.
Economists often disagree for the same reason. Economics is a young science, and there is still much
to be learned. Indeed, there are some who argue that economics can never be a true ‘science’ because
processes that are considered appropriate and necessary in natural sciences cannot be applied to eco-
nomics, because it deals with human behaviour. Humans cannot be subjected to the same controls and
comparisons that can be used in physics, for example.
Economists sometimes disagree because they have different beliefs about the validity of alternative
theories or about the size of important parameters. For example, economists disagree about whether the
government should levy taxes based on a household’s income or based on its consumption (spending).
Advocates of a switch from an income tax to a consumption tax believe that the change would encourage
households to save more, because income that is saved would not be taxed. Higher saving, in turn, would
lead to more rapid growth in productivity and living standards. Advocates of an income tax system believe
that household saving would not respond much to a change in the tax laws. These two groups of econ-
omists hold different normative views about the tax system because they have different positive views
about the responsiveness of saving to tax incentives.

Self Test ‘Sometimes, theories are worth defending. The experience of Peter Higgs is testament to this
view.’ Comment on this statement in relation to theories in economics and the principle of falsifiability.

Differences in Values
Anneka and Henrik both take water from the town well. To pay for maintaining the well, the town
imposes a property tax on its residents. Anneka lives in a large house worth €2 million and pays a prop-
erty tax of €10,000 a year. Henrik owns a small cottage worth €20,000 and pays a property tax of €1,000
a year.
Is this policy fair? If not, who pays too much and who pays too little? Would it be better to replace the
tax based on the value of the property with a tax that was just a single payment from everyone living in
the town (a poll tax) in return for using the well – say, €1,000 a year? After all, Anneka lives on her own and
uses much less water than Henrik and the other four members of his family who live with him and use
more water as a result. Would that be a fairer policy?
This raises two interesting questions in economics – how do we define words like ‘fair’ and ‘unfair’, and
who holds the power to influence and make decisions? If the power is in the hands of certain groups in
government or powerful businesses, policies may be adopted even if they are widely perceived as being
‘unfair’.
What about replacing the property tax, not with a poll tax but with an income tax? Anneka has an
income of €100,000 a year so that a 5 per cent income tax would present her with a tax bill of €5,000.
Henrik, on the other hand, has an income of only €10,000 a year and so would pay only €500 a year in tax,
and the members of his family who do not work don’t pay any income tax. Does it matter whether Henrik’s
low income is due to his decision not to go to university, and take a low paid job? Would it matter if it were
due to a physical disability? Does it matter whether Anneka’s high income is due to a large inheritance
from her family? What if it were due to her willingness to work long hours at a dreary job?
These are difficult questions on which people are likely to disagree. If the town hired two experts to
study how the town should tax its residents to pay for the well, we should not be surprised if they offered
conflicting advice.

This simple example shows why economists sometimes disagree about public policy. As we learned
earlier in our discussion of normative and positive analysis, policies cannot be judged on scientific grounds
alone. Economists give conflicting advice sometimes because they have different values.

Self Test Why might economic advisors to the government disagree about a question of policy such as
reducing a budget deficit?

Decision-Making in Economics
It could be said that economics is the science of decision-making. The way that economists go about
making or recommending decisions involves, first, identifying the problem or issue. For example, green-
house gas emissions are a contributory factor in climate change. Note that this is a premise which is
assumed to be ‘true’. One answer to this problem is a decision to cut the emissions of greenhouse gases.
The next stage is to look at the costs and benefits involved in the decision. These costs and benefits are
not just the private costs and benefits to individuals, firms and organizations; they will also include the
costs and benefits to third parties who are not directly involved in the actual decision. For example, cutting
greenhouse gas emissions means that resources will have to be diverted to new ways of production or dif-
ferent ways of producing energy. The private costs will be those borne by the businesses that will have to
implement measures to adhere to the limits placed upon them. The social costs might include the impact
on local people of the construction of wind farms or new nuclear power stations.
Having identified the costs and benefits, the economist then seeks to place a value on them to get
some idea of the relationship between the costs and benefits of making the decision. In some cases,
valuing costs and benefits can be easy, but many are much more challenging. The loss of visual amenity
for a resident living near a wind turbine or the value of the possible loss of life from a nuclear catastrophe
at a power plant, for example, may be very difficult to value. Economists have attempted to devise ways
in which these values can be estimated, but they are not perfect.
Once the sum of the costs and benefits is calculated, the decision then becomes clearer. If the cost
outweighs the benefit then making the decision may be unwise, but if the costs are less than the benefits,
then it may mean the decision can be supported. Policymakers may want to look at the extent to which the
costs outweigh the benefit, or the benefit outweighs the costs. Every day millions of decisions are made
by individuals, businesses and governments. While not every one of these decisions will be made using
the exact processes outlined above, and many of us certainly do not stop to think about how we rational-
ize our decisions, nevertheless our brains do engage in computational processes as we make decisions,
but they are mostly subconscious. Economists and psychologists are increasingly finding out more about
how humans make decisions, which is helping improve our understanding of the models which we use to
analyze consumer behaviour.

Summary
●● Economics is characterized by different methodologies and approaches, including neo-classical, feminist, Marxist
and Austrian.
●● There is a debate about whether economics is a ‘science’. It does follow certain scientific methodologies, but it
must be accepted that economists are working with human behaviour.
●● Economists make assumptions and build simplified models to understand the world around them. Economists use
empirical methods to develop and test hypotheses.
●● Economists must try to distinguish between cause and effect, and this is not always easy to do.
●● Research can be conducted by using inductive and deductive reasoning – no one way is the ‘right way’.
●● Economists develop theories which can be used to explain phenomena and make predictions.
●● The principle of falsifiability is based on the assumption that we cannot know everything for sure and, as a result,
researchers should clarify the conditions under which a theory can be proved false.

●● Using theory and observation is part of scientific method, but economists must always remember that they are
studying human beings and humans do not always behave in consistent or rational ways.
●● Economists can conduct experiments in laboratory settings and use ‘natural experiments’ observing outcomes
from changes in policy or when events occur.
●● A positive statement is an assertion about how the world is. A normative statement is an assertion about how the
world ought to be.
●● Economists who advise policymakers offer conflicting advice either because of differences in scientific judge-
ments or because of differences in values. At other times, economists are united in the advice they offer, but
policymakers may choose to ignore it.
●● Decision-making in economics can be made more informed by assessing the costs and benefits of a decision and
attempting to quantify the costs and benefits to provide the basis for an informed decision.

In the News

The State of Economics

You do not have to look too far to find plenty of debate about the state of economics. There are books written which
are heavily critical of mainstream economics, including ‘a chilling tale’ by John Quiggin called Zombie Economics:
How Dead Ideas Still Walk Among Us, Ken Blawatt’s Marconomics, and Rod Hill and Tony Myatt’s The Economics
Anti-Textbook to name but three.
Online there are also plenty of articles and blogs which extend the debate. One such example is Cahal Moran’s
‘Why the Problem Is Economics Not Economists’, which appeared on the Open Democracy New Thinking for the
British Economy website. Moran does note that many economists are very frustrated with what seems to be a con-
ventional wisdom that all of economics is rooted in neo-classical methodology, and that they are wedded to free
markets oblivious to any limitations or weaknesses in the models they use. Economists who do economics know
better, and Moran cites two of his colleagues at the University of Manchester, Rachel Griffiths and Diane Coyle (who
is now at the University of Oxford), as two examples of such researchers.
For other economists, the issue about whether economics is a science is ‘sterile and crushingly boring’, as noted
by Kartik B. Athreya in his book Big Ideas in Macroeconomics: A Nontechnical View. Those like Athreya who spend
their days doing economics, know of the lim-
itations of the subject and are well versed in
scientific method and process.
This does not, however, seem to stem the
flow of criticism of the subject. Hill and Myatt,
for example, note ‘The typical introductory
economics textbook teaches that economics
is a value-free science that economists have
an agreed upon methodology; and they know
which models are best to apply to any given
problem …This Anti-Textbook points out that
all this is a myth’ (p1). Blawatt’s opening s ection
is titled ‘The Flagging World of Mainstream
Classical Economics’, and Chapter 1 is titled
‘Economics of Power: Failure of Classical
Economics’. The sleeve jacket of Quiggin’s If you choose to read anything in economics, including criticisms
book notes: ‘Zombie economics takes the of the subject, it is important to do so with a critical eye.

reader through the origins, consequences and implosion of a system of ideas whose time has come and gone.’ If you
choose to read anything in economics, including criticisms of the subject, it is important to do so with a critical eye.
In the examples given above, for example, how many of the statements made are positive and how many normative?

References:
Athreya, K.B. (2015) Big Ideas in Macroeconomics: A Nontechnical View. London, The MIT Press.
Blawatt, K.R. (2016) Marconomics: Defining Economics through Social Science and Consumer Behavior. Bingley,
Emerald Publishing Limited.
Hill, R. and Myatt, T. (2010) The Economics Anti-Textbook: A Critical Thinkers Guide to Microeconomics. London, Zed
Books.
Moran, C. (n.d.) www.opendemocracy.net/neweconomics/problem-economics-not-economists/.
Quiggin, J. (2010) Zombie Economics: How Dead Ideas Still Walk among Us. Princeton, NJ, Princeton University
Press.

Critical Thinking Questions

1 Why do you think that economics has commanded such a barrage of criticism, particularly since 2008?
2 Write a defence of economic models as a methodology for finding out new information about economics.
3 Now write a criticism of economic models as a methodology for finding out new information about economics.
Which of your arguments do you find most convincing and why?
4 Choose one of the references cited. If you could ask the author or authors of the book or article two questions
about their book or article and the argument they are promoting, what would they be and why?
5 Look at the quotes provided in the last paragraph of the article. Try to identify which of the statements made are
positive statements and which are normative and give a reason for your judgement in each case.

Questions for Review

1 How is economics like a science?
2 Why do economists make assumptions?
3 Should an economic model describe reality exactly?
4 What is meant by empirical study in economics?
5 Using an example, explain the difference between inductive and deductive reasoning.
6 Should economic theories be developed as a result of observation or before observation? Explain.
7 What is the difference between a positive and a normative statement? Give an example of each.
8 Why do differences in values lead to disagreements among economists?
9 Using an example, explain the difference between an endogenous and an exogenous variable.
10 Why do economists sometimes offer conflicting advice to policymakers?

Problems and Applications

1 Terms like ‘investment’, ‘capital’, ‘interest’, ‘price’ and ‘cost’ have different meanings in economics than they do in
normal everyday usage. Find out what the differences are and explain why economists might have developed these
different meanings.

2 One common assumption in economics is that the products of different firms in the same industry are indistinguishable.
For each of the following industries, discuss whether this is a reasonable assumption:
a. steel
b. novels
c. wheat
d. fast food
e. mobile phones (think carefully about this one)
f. hairdressers.
3 A researcher in a university notices that the price of flights to holiday destinations tends to be much higher outside
semester dates. They formulate a theory to explain this phenomenon. Has the researcher arrived at the theory by
induction or deduction? What steps might the researcher take to apply scientific method to test the theory?
4 A politician makes a speech which is critical of the government’s immigration policy, saying that it is too loose and
encourages too many people to enter the country and take jobs away from local people. How might an economist go
about assessing the validity of the politician’s comments?
5 If models are not capable of representing the real world in any detail and rely too much on assumptions, then what value
can they be?
6 Does the fact that there are different schools of thought in economics reduce its validity as an academic discipline?
7 Rival political groups argue about the value and effectiveness of speed cameras as a means of influencing driver
behaviour and improving safety on the roads. An economist is asked to conduct research into the costs and benefits of
speed cameras to help decision-making. What sort of factors will the economist have to take into consideration in such
research, and what might be the challenges in identifying and quantifying the full range of costs and benefits?
8 If you were prime minister, would you be more interested in your economic advisors’ positive views or their normative
views? Why?
9 Would you expect economists to disagree less about public policy as time goes on? Why or why not? Can their differences
be completely eliminated? Why or why not?
10 Consider a theory which states that an increase in interest rates will lead to an increase in savings. How would the
principle of ceteris paribus be important in investigating the predictive power of this theory?

3 The Market Forces of

Supply and Demand

T his chapter introduces the theory of supply and demand. It considers how buyers and sellers behave
and how they interact with one another. It shows how prices act as a signal to both buyers and sell-
ers to help them make decisions, which in turn contributes to the allocation of the economy’s scarce
resources. The model of the market based on supply and demand, like any other model, is based on a
series of assumptions. These assumptions have been criticized on the basis that they are not reflective of
reality, and as a result the predictive power of the model is limited.
Others have argued that the model is sufficiently representative to have value and provides a useful
benchmark for comparison with how many markets behave. At the very least, the model provides a
framework to help shape thinking about how economic agents interact. Many undergraduate principles of
economics modules will include the model of supply and demand as a central part of the microeconom-
ics course and this chapter will cover this area. As we progress through the chapter and the analysis it is
important to bear in mind the assumptions of the model.

The Assumptions of the Competitive Market Model

The terms supply and demand refer to the behaviour of people as they interact with one another in mar-
kets. A market is a group of buyers and sellers of a particular good or service. The buyers as a group
determine the demand for the product, and the sellers as a group determine the supply of the product.

market a group of buyers and sellers of a particular good or service

The market model represents a neo-classical explanation of how resources are allocated. This analysis
was developed in the nineteenth century and follows on from the work of Adam Smith. One of the funda-
mental outcomes of the market model is that if the assumptions hold, the resulting allocation of resources
will be ‘efficient’. What this means is that the price buyers pay for goods in the market is a reflection of

the value (or utility) they get from acquiring the goods, and that the price producers receive is a reflection
of the cost of production including an element of profit which is sufficient to keep them in that line of
production. If consumers and producers are both maximizing benefits and minimizing costs, it is assumed
that society must be maximizing welfare, because the goods and services produced are those which are
most desirable and in demand.
The competitive model of supply and demand which leads to this ‘efficient’ outcome is based on the
following assumptions:
1. There are many buyers and sellers in the market.
2. No individual buyer and seller is big enough or has the power to be able to influence price.
3. There is freedom of entry and exit to and from the market.
4. Goods produced are homogenous (identical).
5. Buyers and sellers act independently and only consider their own position in making decisions.
6. There are clearly defined property rights which mean that producers and consumers consider all costs
and benefits when making decisions.
You will find there are economists who believe that markets are the most effective way we have yet
discovered to allocate scarce resources. This further implies that government intervention in markets
should be kept to a minimum. There are others who say that the model is so flawed that there is a much
bigger role for government to play in the economy. The diversity of opinion among economists is part of
what makes the subject so fascinating. Awareness of the difference between positive and normative
economics is important in distinguishing the belief systems on which particular views are based and
whether the outcomes claimed are testable.
Part of thinking as an economist is in teasing out the subtle (and sometimes not so subtle) belief
systems and value judgements underlying statements and being prepared to subject such statements
to critique and analysis. The market model has been criticized for just this point because it is based on a
number of value judgements. Consumers attempting to maximize utility include an assumption that more
is preferred to less and that this is desirable. Producers seeking to maximize profit will attempt to produce
an output that minimizes cost and reduces waste to a minimum, and that this is also desirable. Whether
these are desirable is subject to considerable debate and are essentially normative value judgements.

Competitive Markets
Competition exists when two or more firms are rivals for customers. In economics, however, in a
competitive market (the terms ‘perfectly competitive market’ or ‘perfect competition’ are synonymous
with ‘competitive market’) the assumptions outlined above lead to some important conclusions. Because
there are many buyers and sellers in a perfectly competitive market, neither has any power to influence
price – they must accept the price the market determines, and they are said to be price-takers. Each seller
has no control over the price, because other sellers are offering identical products and each seller only
supplies a very small amount in relation to the total supply of the market.

competitive market a market in which there are many buyers and sellers so that each has a negligible impact on the
market price

Because products are homogenous, a seller has little reason to charge less than the going price, and
if they charge more, buyers will make their purchases elsewhere. Similarly, no single buyer can influence
the price because each buyer purchases only a small amount relative to the size of the market. Buyers
make their decisions based on the utility (or satisfaction) they gain from consumption, and in doing so are
independent of the decisions of suppliers. Buyers and sellers make decisions independently and goods
are homogenous. This implies that there is no need for advertising or branding and that both producers
and consumers consider all costs and benefits, including the costs and benefits which may affect a third
party, when making decisions. For example, producers will consider the costs to society of the pollution
they create in production.

There are some markets in which the assumption of perfect competition applies to a degree. For example,
consider the market for rape seed oil, which is part of the market for agricultural products. Production of
rape seed oil across the European Union (EU) was around 22 million tonnes in 2018. Rape seed is part of a
global oil seed market which includes the production of soya beans, which account for around 70 per cent
of total oil seed production. In the EU agriculture market, there are about 14 million farmers who sell
cereals, fruit, milk, beef, lamb and so on; because no single seller can influence the price of agricultural
products, each takes the market price as given and can sell all their output at the market price (remember
that the total output of individual sellers represents only a small fraction of total output).
The products produced in agricultural markets are broadly similar – milk produced by one farmer is
not that much different from that produced by another, although it is important to remember that even in
markets where products might be perceived as being homogenous, there are differences in quality and
use. For example, wheat can be produced at different qualities with some going for animal feed and some
for bread making.
The characteristics of agricultural markets make them useful for using as examples in describing com-
petitive markets. As we proceed to look in more depth at the market model, let’s keep in mind a particular
good, milk, to help focus our thinking. The market for milk fulfils many of the characteristics of a perfectly
competitive market: milk is fairly homogenous, there are about half a million dairy farms and there are
millions of buyers of milk across the EU.

Self Test What constitutes a market? List the main characteristics of a competitive market.

Demand
We begin our study of markets by examining the demand for goods and services.

The Demand Curve: The Relationship Between Price and Quantity Demanded
The quantity demanded of any good is the amount of the good that buyers are willing and able to
purchase at different prices. Many things determine the quantity demanded of any good, but one deter-
minant plays a central role – the price of the good. If the price of milk rose from €0.25 per litre to €0.35
per litre, less milk would be bought. If the price of milk fell to €0.20 per litre, more milk would be bought.
Because the quantity demanded falls as the price rises and rises as the price falls, we say that the quan-
tity demanded is negatively or inversely related to the price. This relationship between price and quantity
demanded is referred to as the law of demand. It is called a ‘law’ because the relationship is observed so
often in the economy. The label ‘law’ dates from the observations made in the eighteenth and nineteenth
centuries with Alfred Marshall, in his 1890 work Principles of Economics, noting:
There is then one general law of demand: The greater the amount to be sold, the smaller must be
the price at which it is offered in order that it may find purchasers; or, in other words, the amount
demanded increases with a fall in price, and diminishes with a rise in price.

quantity demanded the amount of a good that buyers are willing and able to purchase at different prices
law of demand the claim that, other things being equal (ceteris paribus), the quantity demanded of a good falls when
the price of the good rises

We can represent the relationship between the price and quantity demanded in a table such as the
one shown in Figure 3.1. The table shows Rachel’s willingness to buy litres of milk each month at differ-
ent prices, holding other factors, such as her income, tastes and the prices of other goods, constant.
The willingness to pay determines the position of the demand curve and is related to the utility or level

of satisfaction Rachel gets from consuming milk. If milk has a zero price, Rachel would be willing to buy
20 litres per time period. At €0.10 per litre, Rachel would be willing to buy 18 litres. As the price rises fur-
ther, she is willing to buy fewer and fewer litres. When the price reaches €1, Rachel would not be prepared
to buy any milk at all. This table is a demand schedule, a table that shows the relationship between the
price of a good and the quantity demanded, holding constant everything else that influences how much
consumers of the good want to buy.

demand schedule a table that shows the relationship between the price of a good and the quantity demanded

The graph in Figure 3.1 uses the numbers from the table to illustrate the law of demand. By convention,
price is on the vertical axis, and the quantity demanded is on the horizontal axis. The downwards sloping
line relating price and quantity demanded is called the demand curve.

demand curve a graph of the relationship between the price of a good and the quantity demanded

Figure 3.1
Rachel’s Demand Schedule Price of milk 1.00
and Demand Curve per litre (€)
0.90
The demand schedule shows the
quantity demanded at each price. 0.80
The demand curve, which graphs 0.70
the demand schedule, shows how
the quantity demanded of the 1. A decrease 0.60
in price ...
good changes as its price varies. 0.50
Because a lower price increases
the quantity demanded, the 0.40
demand curve slopes downwards 0.30
from left to right.
0.20

0.10

0 2 4 6 8 10 12 14 16 18 20
Quantity of milk
demanded (litres)
2. ... increases quantity
of milk demanded

Price of milk per litre (€) Quantity of milk demanded (litres per month)
0.00 20
0.10 18
0.20 16
0.30 14
0.40 12
0.50 10
0.60 8
0.70 6
0.80 4
0.90 2
1.00 0

Movement Along the Demand Curve

It is important to be clear about the terminology used when referring to market demand. A change in the
price of a good, ceteris paribus, which results in a change in quantity demanded, is represented graphically
as a movement along the demand curve.
If we assume that the price of milk falls, this will lead to an increase in quantity demanded. There are
two reasons for this increase:
1. The income effect. If we assume that incomes remain constant, then a fall in the price of milk means
that consumers can now afford to buy more with their income. In other words, their real income, what a
given amount of money can buy at any point in time, has increased, and part of the increase in quantity
demanded can be put down to this effect.
2. The substitution effect. Now that milk is lower in price compared to other products such as fruit juice,
some consumers will choose to substitute the more expensive drinks with the now cheaper milk. This
switch accounts for the remaining part of the increase in quantity demanded.

Market Demand Versus Individual Demand

The demand curve in Figure 3.1 shows an individual’s demand for a product. The market demand is the
sum of all the individual demands for a particular good or service.
The table in Figure 3.2 shows the demand schedules for milk of two individuals – Rachel and Lars.
Assuming Rachel and Lars are the only two people in the market, the market demand at each price is the
sum of the two individual demands.
Figure 3.2 shows the demand curves that correspond to these demand schedules. To find the total
quantity demanded at any price, we add the individual quantities found on the horizontal axis of the individ-
ual demand curves. The market demand curve shows how the total quantity demanded of a good varies
as the price of the good varies, while all the other factors are held constant.
Remember… A change in quantity demanded refers to the increase or decrease in demand as a
result of a change in the price, holding all other factors influencing demand constant. A change in quantity
demanded is shown by a movement along the demand curve.

Shifts versus Movements along the Demand Curve

The individual and market demand curves shown were drawn under the assumption of ceteris paribus –
other things being equal with the only variable changing being price. If any of the factors affecting demand
change, other than a change in price, this will cause a shift in the position of the demand curve, which is
referred to as a change in demand.
If the price of milk, for example, is €0.30 per litre, a family might buy 5 litres of milk a week. If their
income rises, they can now afford to buy more milk and so might now buy 7 litres a week. The price of
milk has not changed – it is still €0.30 per litre but the amount of milk the family buys has increased. If this
behaviour is reflected elsewhere in the economy by other families whose incomes have changed, then the
market demand curve will shift to the right.
If any of the factors affecting demand other than price change then the amount consumers wish to
purchase changes whatever the price.

A Shift in the Demand Curve

If one or more of the factors influencing demand other than price changes, the demand curve shifts.
For example, suppose a top European medical school published research that suggested people who
regularly drank milk lived longer, healthier lives. The discovery would raise the demand for milk because
consumers’ tastes would be expected to change in favour of drinking more milk. At any given price,
buyers would now want to purchase a larger quantity of milk and the demand curve for milk would shift
to the right.

Figure 3.2
Market Demand as the Sum of Individual Demands
The quantity demanded in a market is the sum of the quantities demanded by all buyers at each price. The market demand curve is
found by adding horizontally the individual demand curves. At a price of €0.50 , Rachel would like to buy 10 litres of milk, but Lars
would only be prepared to buy 5 litres at that price. The quantity demanded in the market at this price, therefore, is 15 litres.

Rachel’s demand + Lars’ demand =

Price of milk 1.00 Price of milk 1.00
per litre (€) 0.90 per litre (€) 0.90
0.80 0.80
0.70 0.70
0.60 0.60
0.50 0.50
0.40 0.40
0.30 0.30
D (Rachel)
0.20 0.20
0.10 0.10
D (Lars)
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Quantity of milk Quantity of milk
demanded (litres) demanded (litres)

Market demand
Price of milk 1.00
per litre (€) 0.90
0.80
0.70
0.60
0.50
0.40
0.30 D (Market)
0.20
0.10

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Quantity of milk
demanded (litres)

Price of milk per litre (€) Rachel 1 Lars 5 Market

0.00 20 10 30
0.10 18 9 27
0.20 16 8 24
0.30 14 7 21
0.40 12 6 18
0.50 10 5 15
0.60 8 4 12
0.70 6 3 9
0.80 4 2 6
0.90 2 1 3
1.00 0 0 0

Figure 3.3 illustrates shifts in demand. Any change that increases the quantity demanded at every price,
such as our imaginary research report, shifts the demand curve to the right and is called an increase in
demand. Any change that reduces the quantity demanded at every price shifts the demand curve to the
left and is called a decrease in demand.

Figure 3.3
Shifts in the Demand Curve Price of milk
Any change that raises the quantity that per litre (€)
buyers wish to purchase at a given price
shifts the demand curve to the right. Any Increase
in demand
change that lowers the quantity that buyers
wish to purchase at a given price shifts the
demand curve to the left.
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of milk
demanded (litres)

The following is a short summary of the main factors affecting demand, changes in which cause a shift
in the demand curve.

Prices of Other (Related) Goods Suppose that the price of milk falls. The law of demand says that you
will buy more milk. At the same time, you will probably buy less fruit juice. Because milk and fruit juice
are both refreshing drinks, they satisfy similar desires. When a fall in the price of one good reduces the
demand for another good, the two goods are called substitutes. Substitutes are often pairs of goods that
are used in place of each other, such as butter and spreads, pullovers and sweatshirts, and cinema tickets
and film streaming. The more closely related substitute products are the more effect we might see on
demand if the price of one of the substitutes changes.

substitutes two goods for which an increase in the price of one leads to an increase in the demand for the other (and vice versa)

Now suppose that the price of breakfast cereals falls. According to the law of demand, more packets
of breakfast cereals will be bought. When this happens, we might expect to see the demand for milk
increase as well, because breakfast cereals and milk are used together. When a fall in the price of one
good raises the demand for another good, the two goods are called complements. Complements are
often pairs of goods that are used together, such as petrol and cars, computers and software, bread and
cheese, strawberries and cream, and bacon and eggs.

complements two goods for which an increase in the price of one leads to a decrease in the demand for the other

Self Test What type of relationship do apps and smartphones have? If the price of smartphones increases,
what would you expect to happen to the demand for apps? Sketch a diagram to illustrate your answer.

Income Changes in incomes affect demand. A lower income means less to spend in total, so you would
have to spend less on some – and probably most – goods. Equally, if income rises then it is likely that
demand for many goods will also rise. If the demand for a good falls when income falls or rises as income
rises, the good is called a normal good.

normal good a good for which, ceteris paribus, an increase in income leads to an increase in demand (and vice versa)

If the demand for a good rises when income falls, the good is called an inferior good. An example of
an inferior good might be bus rides. If your income falls, you are less likely to buy a car or take a taxi and
more likely to take the bus. As income falls, therefore, demand for bus rides tends to increase.

inferior good a good for which, ceteris paribus, an increase in income leads to a decrease in demand (and vice versa)

Tastes A key determinant of demand is tastes. If you like milk, you buy more of it. Understanding the role
of tastes or preferences in consumer behaviour is taking on more importance as research in the fields of
psychology and neurology are applied to economics.

The Size and Structure of the Population Because market demand is derived from individual demands,
it follows that the more buyers there are, the higher the demand is likely to be. The size of the population,
therefore, is a determinant of demand. A larger population, ceteris paribus, will mean a higher demand for
all goods and services.
Changes in the way the population is structured also influence demand. Many countries have an ageing
population, and this leads to a change in demand. If there is an increasing proportion of the population
aged 65 and over, the demand for goods and services used by the elderly, such as the demand for retire-
ment homes, insurance policies suitable for older people, the demand for smaller cars and for health care
services, etc. is likely to increase in demand as a result.

Advertising Firms advertise their products in many different ways, and it is likely that if a firm embarks
on an advertising campaign then the demand for that product will increase.

Expectations of Consumers Expectations about the future may affect the demand for a good or service
today. For example, if it was announced that the price of milk was expected to rise next month, consumers
may be more willing to buy milk at today’s price.

Self Test Make up an example of a demand schedule for pizza and graph the demand curve. Give an
example of something that would cause the demand curve for pizza to shift to the right and to the left.

Remember… A change in any factor affecting demand, other than price, is referred to as a change in
demand. A change in demand is represented graphically as a shift in the demand curve, either to the right
(an increase in demand) or to the left (a decrease in demand).

Supply
We now turn to the other side of the market and examine the behaviour of sellers. Once again, to focus
our thinking, we will continue to consider the market for milk.

The Supply Curve: The Relationship Between Price and Quantity Supplied
The quantity supplied of any good or service is the amount that sellers are willing and able to sell at
different prices. When the price of milk is high, selling milk is profitable, and so sellers are willing to supply
more. Sellers of milk work longer hours, buy more dairy cows and employ extra workers to increase supply
to the market. By contrast, when the price of milk is low, the business is less profitable, and so sellers are
willing to produce less milk. At a low price, some sellers may even choose to shut down, and their quantity
supplied falls to zero. Because the quantity supplied rises as the price rises and falls as the price falls, we
say that the quantity supplied is positively related to the price of the good. As with demand, the perva-
siveness of this relationship between price and quantity supplied led to it being called the law of supply.

quantity supplied the amount of a good that sellers are willing and able to sell at different prices
law of supply the claim that, ceteris paribus, the quantity supplied of a good rises when the price of a good rises

The table in Figure 3.4 shows the quantity that Richard, a milk producer, is willing to supply at various
prices. At a price below €0.10 per litre, Richard does not supply any milk at all. As the price rises, he
is willing to supply a greater and greater quantity. This is the supply schedule, a table that shows the
relationship between the price of a good and the quantity supplied, holding constant everything else that
influences how much producers of the good want to sell.

supply schedule a table that shows the relationship between the price of a good and the quantity supplied

The graph in Figure 3.4 uses the numbers from the table to illustrate the law of supply. The curve relat-
ing price and quantity supplied is called the supply curve. The supply curve slopes upwards from left to
right because, other things equal, a higher price means a greater quantity supplied.

supply curve a graph of the relationship between the price of a good and the quantity supplied

Figure 3.4 Price of milk per 1.00

litre (€)
Richard’s Supply Schedule and 0.90
Supply Curve 0.80
The supply schedule shows the quantity
supplied at each price. This supply curve, 0.70
which graphs the supply schedule, shows 0.60
how the quantity supplied of the good
1. An increase 0.50
changes as its price varies. Because a higher
in price … 0.40
price increases the quantity supplied, the
supply curve slopes upwards. 0.30
0.20
0.10

0 2 4 6 8 10 12 14 16 18 20
Quantity of milk
2. ... increases quantity supplied (000 litres
of milk supplied per month)

Price of milk per litre (€) Quantity of milk supplied (000 litres per month)
0.00 0
0.10 0
0.20 2
0.30 4
0.40 6
0.50 8
0.60 10
0.70 12
0.80 14
0.90 16
1.00 18

A Movement Along the Supply Curve

As with demand, it is important to use the correct terminology and to understand the terminology to avoid
making mistakes. If the price of a good rises, ceteris paribus, there is a change in quantity supplied. This
is represented graphically as a movement along the supply curve.

Market Supply Versus Individual Supply

Just as market demand is the sum of the demands of all buyers, market supply is the sum of the supplies of
all sellers. The table in Figure 3.5 shows the supply schedules for two milk producers – Richard and Megan.
At any price, Richard’s supply schedule tells us the quantity of milk Richard is willing to supply, and Megan’s
supply schedule tells us the quantity of milk Megan is willing to supply. The market supply is the sum of the two
individual supplies (assuming Richard and Megan are the only suppliers in the market).

Figure 3.5
Market Supply as the Sum of Individual Supplies
The quantity supplied in a market is the sum of the quantities supplied by all the sellers at each price. Thus, the market supply curve is
found by adding horizontally the individual supply curves. At a price of €0.50, Richard is willing to supply 8,000 litres of milk per month,
and Megan is willing to supply 5,000 litres per month. The quantity supplied in the market at this price is 13,000 litres per month.

Richard’s supply + Megan’s supply =

Price of milk 1.00 Price of milk 1.00
per litre (€)0.90 per litre (€)0.90 S (Megan)
0.80 0.80
S (Richard)
0.70 0.70
0.60 0.60
0.50 0.50
0.40 0.40
0.30 0.30
0.20 0.20
0.10 0.10
0 2 4 6 8
10 12 14 16 18 20 0 2 4 6 10 12 14 16 18 20
8
Quantity of milk Quantity of milk
supplied (000 litres per month) supplied (000 litres per month)

Market supply
Price of milk 1.00
per litre (€) 0.90
0.80
S (Market)
0.70
0.60
0.50
0.40
0.30
0.20
0.10

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Quantity of milk
supplied (000 litres per month)

Quantity Supplied (000s litres per month)

Price of milk per litre (€) Richard 1 Megan 5 Market
0.00 0 0 0
0.10 0 1 1
0.20 2 2 4
0.30 4 3 7
0.40 6 4 10
0.50 8 5 13
0.60 10 6 16
0.70 12 7 19
0.80 14 8 22
0.90 16 9 25
1.00 18 10 28

The graph in Figure 3.5 shows the supply curves that correspond to the supply schedules. As with
demand curves, we find the total quantity supplied at any price by adding the individual quantities found
on the horizontal axis of the individual supply curves. The market supply curve shows how the total quan-
tity supplied varies as the price of the good varies.
Remember… A change in quantity supplied refers to the increase or decrease in supply as a result
of a change in the price holding, all other factors influencing supply being constant. A change in quantity
supplied is shown by a movement along the supply curve.

Shifts in the Supply Curve

The supply curve will shift if factors affecting producers’ willingness and ability to supply, other than price,
change. For example, suppose the price of animal feed falls. Because animal feed is an input into produc-
ing milk, the fall in the price of animal feed makes selling milk more profitable. This raises the supply of
milk: at any given price, sellers are now willing to produce a larger quantity. Thus, the supply curve for milk
shifts to the right.
Figure 3.6 illustrates shifts in supply. Any change that raises quantity supplied at every price shifts the
supply curve to the right and is called an increase in supply. Similarly, any change that reduces the quantity
supplied at every price shifts the supply curve to the left and is called a decrease in supply.

Figure 3.6
Shifts in the Supply Curve Price of milk
Any change that raises the per litre (€) Supply curve, S3
Supply
quantity that sellers wish to curve, S1
produce at a given price shifts Supply
the supply curve to the right. Any curve, S2
change that lowers the quantity Decrease
in supply
that sellers wish to produce at a
given price shifts the supply curve
to the left.

Increase
in supply

0 Quantity of milk
supplied (litres)

The following provides a brief outline of the factors affecting supply other than price.

Profitability of Other Goods in Production and Prices of Goods in Joint Supply Firms have some flexi-
bility in the supply of products and in some cases can switch production to other goods. For example, dairy
farmers may decide to use some of their land to produce arable crops if the price of those crops rises in
relation to the price of milk. If one crop becomes more profitable, then it may be that the farmer switches
to the more profitable product. In other cases, firms may find that products are in joint supply; an increase
in the supply of lamb, for example, might also lead to an increase in the supply of wool.

Technology Advances in technology increase productivity allowing more to be produced using fewer
factor inputs. As a result, both total and unit costs may fall and supply increases. The development of
fertilizers and more efficient milking parlours, for example, have increased milk yields per cow and helped
reduce costs as a result. By reducing firms’ costs, the advance in technology increases the supply of milk.

Natural/Social Factors There are often many natural or social factors that affect supply. These include
such things as the weather affecting crops, natural disasters, pestilence and disease, changing attitudes
and social expectations (for example, over the production of organic food, the disposal of waste, reducing
carbon emissions, ethical supply sourcing and so on), all of which can have an influence on production
decisions. Some or all of these may have an influence on the cost of inputs into production.

Input Prices: The Prices of Factors of Production To produce any output, sellers use various inputs col-
lectively referred to as land, labour and capital. Dairy farmers, for example, will use fertilizer, feed, silage,
farm buildings, veterinary services and the labour of workers. When the price of one or more of these
inputs rises, producing milk is less profitable and firms supply less milk. If input prices rise substantially,
a firm might shut down and supply no milk at all. If input prices fall for some reason, then production may
be more profitable and there is an incentive to supply more at each price. Thus, the supply of a good is
negatively related to the price of the inputs used to make the good.

Expectations of Producers Output levels can vary according to the expectations of producers about
the future state of the market. The amount of milk a farm supplies today, for example, may depend on its
expectations of the future. If it expects the price of milk to rise in the future, the firm might invest in more
productive capacity or increase the size of the herd.

Number of Sellers If there are more sellers in the market, then it makes sense that the supply would
increase. Equally, if a number of dairy farms closed down then it is likely that the amount of milk supplied
would also fall. The number of sellers in a market will be determined by the profitability of the product in
question and the ease of entry and exit into and from the market.

Self Test Make up an example of a supply schedule for pizza and graph the implied supply curve. Give an
example of something that would shift this supply curve. Would a change in price shift the supply curve?

Remember… A change in any factor affecting supply, other than price, is referred to as a change in
supply. A change in supply is represented graphically as a shift in the supply curve, either to the right (an
increase in supply) or the left (a decrease in supply).

Supply and Demand Together

Having analyzed supply and demand separately, we now combine them to see how they determine the
quantity of a good sold in a market and its price.

Equilibrium
Equilibrium is defined as a state of rest, a point where there is no force acting for change. Economists
refer to supply and demand as being market forces. Figure 3.7 shows the market supply curve and market
demand curve together. In the market model, the relationship between supply and demand exerts force
on price. If supply is greater than demand or vice versa, then there is pressure on price to change. Market
equilibrium occurs when the amount consumers wish to buy at a particular price is the same as the amount
sellers are willing to offer for sale at that price. The price at this intersection is called the equilibrium
or market price, and the quantity is called the equilibrium quantity. In Figure 3.7 the equilibrium price
is €0.40 per litre, and the equilibrium quantity is 7,000 litres of milk bought and sold per day.

equilibrium or market price the price where the quantity demanded is the same as the quantity supplied
equilibrium quantity the quantity bought and sold at the equilibrium price

At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances
the quantity that sellers are willing and able to sell. The equilibrium price is sometimes called the market
clearing price because, at this price, everyone in the market has been satisfied: buyers have bought all
they want to buy, and sellers have sold all they want to sell; there is no shortage in the market where
demand is greater than supply and neither is there any surplus where supply is greater than demand.

Figure 3.7
Price of milk
The Equilibrium of Supply and per litre (€)
Demand Supply
The equilibrium is found where the
supply and demand curves intersect.
At the equilibrium price, the quantity
supplied is the same as the quantity Equilibrium price Equilibrium
demanded. Here the equilibrium price 0.40
is €0.40 per litre of milk: at this price,
sellers are willing to offer 7,000 litres of
milk per day for sale and buyers wish to
purchase 7,000 litres of milk per day.
Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of milk bought and
sold (000 litres per day)

The market will remain in equilibrium until something causes either a shift in the demand curve or a
shift in the supply curve (or both). If one or both curves shift, at the existing equilibrium price, there will
now be either a surplus or a shortage. The market mechanism takes time to adjust – sometimes it can
be very quick (which tends to happen in highly organized markets like stock and commodity markets) and
sometimes it is much slower to react. When the market is in disequilibrium and a shortage or surplus
exists, the behaviour of buyers and sellers acts as a force on price.

surplus a situation in which the quantity supplied is greater than the quantity demanded at the going market price
shortage a situation in which quantity demanded is greater than quantity supplied at the going market price

A Surplus A surplus exists when the amount sellers wish to sell is greater than the amount consumers
wish to buy at a price. When there is a surplus or excess supply of a good, for example milk, suppliers are
unable to sell all they want at the going price. Sellers find stocks of milk increasing, so they respond to the
surplus by cutting their prices. As the price falls, some consumers are persuaded to buy more milk and so
there is a movement along the demand curve. Equally, some sellers in the market respond to the falling
price by reducing the amount they are willing to offer for sale (a movement along the supply curve). Prices
continue to fall until the market reaches a new equilibrium. The effect on price and the amount bought
and sold depend on whether the demand curve or supply curve shifted in the first place (or whether both
shifted). This is why analysis of markets is referred to as comparative statics, because we are comparing
one initial static equilibrium with another once market forces have worked their way through.

comparative statics the comparison of one initial static equilibrium with another

A Shortage A shortage occurs if the amount consumers are willing and able to purchase at a price is
greater than the amount sellers are willing and able to offer for sale. With too many buyers chasing too few
goods, sellers can respond to the shortage by raising their prices without losing sales. As the price rises,
some buyers will drop out of the market and quantity demanded falls (a movement along the demand
curve). Rising prices encourage some farmers to offer more milk for sale as it is now more profitable for
them to do so and the quantity supplied rises. Once again, this process will continue until the market
moves towards equilibrium.
The activities of the many buyers and sellers ‘automatically’ push the market price towards the equilib-
rium price. Individual buyers and sellers don’t consciously realize they are acting as forces for change in the
market when they make their decisions, but the collective act of all the many buyers and sellers tends to
push markets towards equilibrium. This phenomenon is referred to as the law of supply and demand: the
price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance.

law of supply and demand the claim that the price of any good adjusts to bring the quantity supplied and the quantity
demanded for that good into balance

Case Study Why Do Economists Put Price on the Vertical Axis?

In outlining the market model, we have noted that the demand and supply of a product is dependent on the
price. Demand and supply are said to be the dependent variables and price the independent variable. In
mathematics the relationship between variables is expressed as a function, such as y 5 f (x ). This states
that the value of y is dependent on the value of x as specified by the particular function f . If the function
is y 5 x 2 , then the value of y will be equal to whatever value x takes squared. The dependent variable is y
and the independent variable is x. In a graphical representation of this function, the dependent variable y
is shown on the vertical axis and the independent variable, x, shown on the horizontal axis. This is stand-
ard representation in mathematics.
In economics, however, the way that the market model is represented is that price, the independent
variable, is shown on the vertical axis, and demand and supply, the dependent variables, shown on the
horizontal axis. Why is this? As with many things in economics, the reason is historical, and it is not
always easy to pin down exactly when and why the flipping of the axes occurred. One thing is certain –
the convention has endured.
One initial point worth mentioning is that a sketch of a market (which is what supply and demand
diagrams are) is just that – a sketch. Sketches are not mathematical representations of equations. It is
entirely possible that a graph can be drawn which represents specific equations of course. It is important
to distinguish between the way we sketch and use graphs today and the way that economists and math-
ematicians may have used these tools in the eighteenth and nineteenth centuries. It is also important to
note that the use of diagrams is a means to describe and apply the basics of a model. Supply and demand
diagrams are used to demonstrate how equilibrium is reached, for example when factors affecting supply
and demand change among other things.
It is often reported that Alfred Marshall pioneered the use of diagrams in which price was on the vertical
axis. Marshall used such diagrams in his Principles of Economics published in 1890, but he was not the first to
use diagrams. Antoine-Augustin Cournot (1801–77) in his 1838 publication Researches into the Mathematical
Principles of the Theory of Wealth used diagrams representing the relationship between price and quantity,
but with price on the horizontal axis. Cournot used these diagrams to show how small changes in price can
affect total revenue and thus implied the concept of price elasticity. Cournot further introduced supply curves
to give the ‘cross’ undergraduate economists are all too familiar with to show how the imposition of a tax
would affect price and quantity. Here, Cournot had price on the vertical axis and quantity on the horizontal.
Karl Henrich Rau (1792–1870) used a supply and demand diagram in his 1841 publication Grundsätze
der Volkswirtschaftslehre (Principles of Economics) to analyze equilibrium in which price was on the ver-
tical axis. In 1870, Fleeming Jenkin used diagrams to show applications of the ‘law of supply and demand’

which also had price on the vertical

axis.
It was, however, Alfred Marshall
who popularized the use of diagrams
to model supply and demand with
price on the vertical axis. In his
1890 book, many of these diagrams
appeared as footnotes rather than as
part of the text, leading historians of
economic methodology to reason that
he saw diagrams as an aid to under-
standing the economics rather than
the primary source of understanding.
Marshall’s text uses models
as a means of showing what can
happen in a market if demand and
supply change. He used the model
as a means of providing different
‘experiments’ to address questions.
In doing so, he showed that the
market outcome could be the same
regardless of the way the model
was manipulated, which would, in
turn, imply that the model’s predic-
tions were stable.
Other explanations suggest that
price can be the dependent variable
in that changes in quantities can
affect price. For example, if there is
a drought, the supply of a product is Alfred Marshall popularized the use of diagrams in which price
affected negatively, which impacts was on the vertical axis but was not the first to use diagrams.
its price as a result of a shift in the supply curve. Quantity is not always determined by price, therefore. If
each time a diagram was drawn, price was on a different axis to match the application being explored,
it might become too confusing and the power of a diagram to aid understanding would be lost. Better,
therefore, to be consistent and have price on the vertical axis.
Finally, in response to a question on the subject on his blog, Greg Mankiw notes that his Harvard
colleague, Robert Barro, refers to an interpretation of demand and supply by the economist John Hicks
which derives from Marshall’s construction of demand and supply. Hicks refers to ‘demand price’ and
‘supply price’ as how much an individual is willing to pay to secure additional units of goods and how
much a supplier must be paid to provide additional output. In this construction, price is the dependent
variable, hence the logic of putting it on the vertical axis.

Prices as Signals
The main function of price in a competitive market is to act as a signal to both buyers and sellers.

Price as a Signal to Buyers

For buyers, price tells them something about what they must give up (usually an amount of money) to
acquire the benefits that having the good will confer on them. These benefits are referred to as the utility
or satisfaction derived from consumption and reflects the willingness to pay.

If an individual is willing to pay €10 to go and watch a film, then the model assumes that the value of
the benefits gained from watching the film is worth that amount of money to the individual. But what
does this mean? How much is €10 worth? Economists would answer this question by saying that if an
individual is willing to give up €10 to watch a film, then the value of the benefits gained (the utility) must
be greater than the next best alternative that the €10 could have been spent on. This reflects the trade-offs
that people face and that the cost of something is what you have to give up in order to acquire it. This is
fundamental to the law of demand.
At higher prices, the sacrifice being made in terms of the value of the benefits gained from alternatives
is greater and so we may be less willing to do so as a result. If the price of a ticket for a film was €15, then it
might have to be a very good film to persuade the individual that giving up what else €15 could buy is worth it.
Price also acts as a signal at the margin. Most consumers will recognize the agony they have experienced
over making some purchasing decisions. Those ‘to die for’ pair of shoes, for example, may be absolutely
perfect, but at €120 they might make the buyer think twice. If they were €100 then it might be considered
a ‘no brainer’. That extra €20 might make all the difference to the decision of whether to buy or not.
Economists and those in other disciplines such as psychology are increasingly investigating the com-
plex nature of purchasing decisions that humans make. The development of magnetic resonance imaging
(MRI) techniques, for example, has allowed researchers to investigate how the brain responds to different
stimuli when making purchasing decisions.

Price as a Signal to Sellers

For sellers, price acts as a signal in relation to the profitability of production. For many sellers, increasing
the amount of a good produced will incur some additional input costs. A higher price is required to com-
pensate for the additional cost and to enable the producer to gain some reward from the risk they are
taking in production. That reward is termed profit.

Rising Prices in a Competitive Market

If prices are rising in a free market, this acts as a different but related signal to buyers and sellers. Rising
prices to a seller means that there is a shortage and thus acts as a signal to expand production, because
the seller knows that they will be able to sell what they produce.
For buyers, a rising price changes the nature of the trade-off they face. Rising prices act as a signal that
more will have to be given up to acquire the good. They must decide whether the value of the benefits
they will gain from acquiring the good is worth the extra price they have to pay and the sacrifice of the
value of the benefits of the next best alternative.
For example, say the price of going to the cinema increases from €10 to €15 per ticket. Some cinema
goers will happily pay the extra because they really enjoy a night out at the cinema, but some people might
start to think that €15 is a bit expensive. They might think that they could have a night out at a restaurant
with friends, a meal and a few drinks for €15 and that would represent more value to them than going
to the cinema. Some of these people would, therefore, stop going to the cinema and go to a restaurant
instead – the price signal to these people has changed.
What we do know is that for both buyers and sellers, there are many complex processes that occur
in decision-making. While we do not fully understand all these processes yet, economists are constantly
searching for new insights that might help them understand the workings of markets more fully. All of us
go through these complex processes every time we make a purchasing decision – we may not realize it,
but we do! Having some appreciation of these processes is fundamental to thinking like an economist.

Analyzing Changes in Equilibrium

So far, we have seen how supply and demand together determine a market’s equilibrium, which in turn
determines the price of the good and the amount of the good that buyers purchase and sellers produce.
Of course, the equilibrium price and quantity depend on the position of the supply and demand curves.

We use comparative static analysis to look at what happens when some event shifts one of these curves
and causes the equilibrium in the market to change.
To do this we proceed in three steps:
1. We decide whether the event in question shifts the supply curve, the demand curve or, in some cases, both.
2. We decide whether the curve shifts to the right or to the left.
3. We use the supply and demand diagram to compare the initial and the new equilibrium, which shows
how the shift affects the equilibrium price and quantity bought and sold.
To see how these three steps work in analyzing market changes, let’s consider various events that
might affect the market for milk. We begin the analysis by assuming that the market for milk is in equi-
librium with the price of milk at €0.50 per litre and 13,000 litres being bought and sold per day. We then
follow our three-step approach.

Example 1: A Change in Demand Suppose that one summer, the weather is very hot. How does this
event affect the market for milk? To answer this question, let’s follow our three steps:
1. The hot weather affects the demand curve by changing people’s taste for milk. That is, the weather
changes the amount of milk that people want to buy at any given price.
2. Because hot weather makes people want to drink more milk, make refreshing milk shakes, or produc-
ers of ice cream buy more milk to make ice cream, the demand curve shifts to the right. Figure 3.8
shows this increase in demand as the shift in the demand curve from D1 to D2. (What you must remem-
ber now is that demand curve D1 does not exist anymore and so we have shown it as a dashed line.)
This shift indicates that the quantity of milk demanded is higher at every price. At the existing market
price of €0.50 buyers now want to buy 19,000 litres of milk, but sellers are only offering 13,000 litres per
day for sale at this price. The shift in demand has led to a shortage of milk in the market of 6,000 litres
per day, represented by the bracket.
3. The shortage encourages producers to increase the output of milk (a movement along the supply
curve). There is an increase in quantity supplied. But the additional production incurs extra costs and
so a higher price is required to compensate sellers. As sellers increase the amount of milk offered for
sale as price rises, consumers behave differently. Some consumers who were willing to buy milk at
€0.50 are not willing to pay more and so drop out of the market. As price creeps up, therefore, there
is a movement along the demand curve representing those consumers who drop out of the market.

Figure 3.8
Price of milk 1.00
S
How an Increase in per litre (€)
0.90
Demand Affects the
Equilibrium 0.80
An event that raises quantity
demanded at any given price 0.70
shifts the demand curve to 0.60
the right. The equilibrium
price and the equilibrium 0.50
quantity both rise. Here,
0.40
an abnormally hot summer
causes buyers to demand 0.30
more milk. The demand curve
0.20
shifts from D1 to D2 , which D2
causes the equilibrium price 0.10
D1
to rise from €0.50 to €0.60
and the equilibrium quantity 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
bought and sold to rise from Quantity of milk
13,000 litres to 16,000 litres supplied (000 litres
per day)
per day. Shortage

The market forces of supply and demand continue to work through until a new equilibrium is reached.
The new equilibrium price is now €0.60 per litre and the equilibrium quantity bought and sold is now 16,000
litres per day. To compare our starting and finishing positions, the hot weather which caused the shift in the
demand curve has led to an increase in the price of milk and the quantity of milk bought and sold.

Example 2: A Change in Supply Suppose that, during another summer, a drought drives up the price of
animal feed for dairy cattle. Let us follow our three steps:
1. The change in the price of animal feed, an input into producing milk, affects the supply curve. By raising
the costs of production, it reduces the amount of milk that firms produce and sell at any given price. Some
farmers may send cattle for slaughter because they cannot afford to feed them anymore, and some farm-
ers may simply decide to sell up and get out of farming altogether. The demand curve does not change
because the higher cost of inputs does not directly affect the amount of milk consumers wish to buy.
2. The supply curve shifts to the left because, at every price, the total amount that farmers are willing and
able to sell is reduced. Figure 3.9 illustrates this decrease in supply as a shift in the supply curve from
S1 to S2. At a price of €0.50 sellers are now only able to offer 2,000 litres of milk for sale per day, but
demand is still 13,000 litres per day. The shift in supply to the left has created a shortage in the market
of 11,000 litres per day. Once again, the shortage will create pressure on price to rise as buyers look to
purchase milk.
3. As Figure 3.9 shows, the shortage raises the equilibrium price from €0.50 to €0.70 per litre and lowers
the equilibrium quantity bought and sold from 13,000 to 8,000 litres per day. As a result of the animal
feed price increase, the price of milk rises, and the quantity of milk bought and sold falls.

Figure 3.9
Price of milk 1.00
How a Decrease in Supply per litre (€) S2 S1
0.90
Affects the Equilibrium
An event that reduces quantity 0.80
supplied at any given price shifts
0.70
the supply curve to the left.
The equilibrium price rises, and 0.60
the equilibrium quantity falls.
0.50
Here, an increase in the price
of animal feed (an input) causes 0.40
sellers to supply less milk. The
0.30
supply curve shifts from s1 to s2 ,
which causes the equilibrium 0.20
price of milk to rise from €0.50
0.10
to €0.70 and the equilibrium D1
quantity to fall from 13,000 litres
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
to 8,000 litres per day.
Quantity of milk
supplied (000 litres per day)
Shortage

Example 3: A Change in Both Supply and Demand (i) Now suppose that the hot weather and the rise
in animal feed occur during the same time period. To analyze this combination of events, we again follow
our three steps:
1. We determine that both curves must shift. The hot weather affects the demand curve for milk because
it alters the amount that consumers want to buy at any given price. At the same time, when the rise
in animal feed drives up input prices, it alters the supply curve for milk because it changes the amount
that firms want to sell at any given price.
2. The curves shift in the same directions as they did in our previous analysis: the demand curve shifts to
the right, and the supply curve shifts to the left. Figure 3.10 illustrates these shifts.

3. As Figure 3.10 shows, there are two possible outcomes that might result, depending on the relative
size of the demand and supply shifts. In both cases, the equilibrium price rises. In panel (a), where
demand increases substantially while supply falls just a little, the equilibrium quantity bought and sold
also rises. By contrast, in panel (b), where supply falls substantially while demand rises just a little, the
equilibrium quantity bought and sold falls. Thus, these events certainly raise the price of milk, but their
impact on the amount of milk bought and sold is ambiguous (that is, it could go either way).

Figure 3.10
A Shift in Both Supply and Demand (i)
The figure shows a simultaneous increase in demand and decrease in supply. In panel (a), the equilibrium price rises from p1 to p2 , and
the equilibrium quantity rises from Q1 to Q 2 . In panel (b), the equilibrium price again rises from p1 to p2 , but the equilibrium quantity falls
from Q1 to Q 2 .
Price of milk
Price of milk
per litre (€)
per litre (€)

Large
increase in Small S2
demand New increase in
S2 demand S1
equilibrium
S1
New
P2 equilibrium
P2
Large
Small decrease
decrease in supply
P1
D2 in supply P1
Initial D2
Initial equilibrium equilibrium
D1 D1
0 Q1 Q2 0 Q2 Q1
Quantity of milk Quantity of milk
bought bought
and sold (litres and sold (litres
(a) Price rises, quantity rises per day) (b) Price rises, quantity falls per day)

Example 4: A Change in Both Supply and Demand (ii) We are now going to look at a slightly different
scenario but with both supply and demand changing together. Assume that forecasters have predicted
a heatwave for some weeks. We know that the hot weather is likely to increase demand for milk and so
the demand curve will shift to the right. However, sellers’ expectations that sales of milk will increase as
a result of the forecasts mean that they take steps to expand production of milk. This would lead to a shift
of the supply curve to the right – more milk is now offered for sale at every price. To analyze this particular
combination of events, we again follow our three steps:
1. We determine that both curves must shift. The hot weather affects the demand curve because it alters
the amount of milk that consumers want to buy at any given price. At the same time, the expectations
of producers alter the supply curve for milk because they change the amount that firms want to sell at
any given price.
2. Both demand and supply curves shift to the right: Figure 3.11 illustrates these shifts.
3. Figure 3.11 shows three possible outcomes that might result, depending on the relative size of the
demand and supply shifts. In panel (a), where demand increases substantially while supply rises just a
little, the equilibrium price and quantity both rise. By contrast, in panel (b), where supply rises substantially
while demand rises just a little, the equilibrium price falls but the equilibrium quantity rises. In panel (c),
the increases in demand and supply are identical and so equilibrium price does not change. Equilibrium
quantity will increase, however. Thus, these events have different effects on the price of milk, although
the amount bought and sold in each case is higher. In this instance the effect on price is ambiguous.

Figure 3.11
A Shift in Both Supply and Demand (ii)
In panel (a) the equilibrium price rises from p1 to p2 and the equilibrium quantity rises from Q1 to Q 2 . In panel (b), the equilibrium price
falls from p1 to p2 but the equilibrium quantity rises from Q1 to Q 2 . In panel (c), there is no change to the equilibrium price, but the
equilibrium quantity rises from Q1 to Q 2 .

Price of milk Price of milk

S S
S1
S1
P2

P1 P1

P2
D1

D1
D D
0 Q1 Q2 0 Q1 Q2
Quantity of milk Quantity of milk
bought and sold bought and sold
(a) (b)

Price of milk
S S1

D
0 Q1 Q2 Quantity of milk
bought and sold
(c)

Summary
We have just seen four examples of how to use the model of the market which uses demand and supply
curves to analyze a change in equilibrium. Whenever an event shifts the demand curve, the supply curve,
or perhaps both curves, you can use the model to predict how the event will alter the amount bought
and sold in equilibrium and the price at which the good is bought and sold. Table 3.1 shows the predicted
outcome for any combination of shifts in the two curves. To make sure you understand how to use the
model of the market, pick a few entries in this table and make sure you can explain to yourself why the
table contains the prediction it does.
As an example, consider the allocation of property on the beach. Because the amount of this property
is limited, not everyone can enjoy the luxury of living by the beach. Who gets this resource? The answer
is: whoever is willing and able to pay the price. The price of seafront property adjusts until the quantity of
property demanded balances the quantity supplied. In market economies, prices can be the mechanism
for rationing scarce resources.

What Happens to Price and Quantity When Demand or Supply Shifts?

Table 3.1
As a test, make sure you can explain each of the entries in this table using a supply and demand diagram.
No change in supply An increase in supply A decrease in supply
No change in demand P same P down P up
Q same Q up Q down
An increase in demand P up P ambiguous P up
Q up Q up Q ambiguous
A decrease in demand P down P down P ambiguous
Q down Q ambiguous Q down

One thing to note is that this particular outcome may not be considered ‘fair’ by everyone – individuals
who have money are in a more powerful position to occupy these desirable seafront properties and
the market outcome in economies may be skewed to benefit those who have wealth and power at the
expense of those who do not. This consideration of power is an important one which economists are also
concerned with and involves assessing value judgements and a consideration of what is ‘fair’. These are
challenging questions which we should not shy away from and it is useful to have them in mind as we
develop the analysis of market systems in subsequent chapters.

Elasticity
So far, we have noted that changes in price can have effects on demand and supply but have not been
specific about the extent to which such changes affect demand and supply: how far demand and supply
change in response to changes in price and other factors. When studying how some event or policy affects
a market, we discuss not only the direction of the effects but their magnitude as well. Elasticity is a
measure of how much buyers and sellers respond to changes in market conditions, and knowledge of this
concept allows us to analyze supply and demand with greater precision.

elasticity a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

The Price Elasticity of Demand

Businesses cannot directly control demand. They can seek to influence demand (and do) by utilizing a
variety of strategies and tactics, but ultimately the consumer invariably decides whether to buy a product
or not. One important way in which consumer behaviour can be influenced is through a firm changing the
prices of its goods. Many firms do have some control over the price they can charge, although as we have
seen, in the assumptions of the perfectly competitive market model, this is not the case as the firm is a
price-taker. An understanding of the price elasticity of demand is important in anticipating and analyzing
the likely effects of changes in price on demand.

The Price Elasticity of Demand and Its Determinants

The price elasticity of demand measures how much the quantity demanded responds to a change in
price. Demand for a good is said to be price elastic or price sensitive if the quantity demanded responds
substantially to changes in price. Demand is said to be price inelastic or price insensitive if the quantity
demanded responds only slightly to changes in price.

price elasticity of demand a measure of how much the quantity demanded of a good responds to a change in the price
of that good, computed as the percentage change in quantity demanded divided by the percentage change in price

The price elasticity of demand for any good measures how willing consumers are to move away from
the good as its price rises. Thus, the elasticity reflects the many economic, social and psychological forces
that influence consumer tastes and preferences. Based on experience, however, we can state some gen-
eral rules about what determines the price elasticity of demand.

Availability of Close Substitutes Goods with close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that good to others. For example, butter and spreads
are easily substitutable. A relatively small increase in the price of butter, assuming the price of spread is
held fixed, causes the quantity of butter sold to fall by a relatively large amount. As a general rule, the
closer the substitute the more price elastic the good is because it is easier for consumers to switch from
one to the other. By contrast, because eggs are a food without a close substitute, the demand for eggs is
less price elastic than the demand for butter.

Necessities versus Luxuries Necessities tend to have relatively price inelastic demands, whereas lux-
uries have relatively price elastic demands. People use gas and electricity to heat their homes and cook
their food. If the price of gas and electricity rose together, people would not demand dramatically less of
them. They might try and be more energy efficient and reduce their demand a little, but they would still
need hot food and warm homes. By contrast, when the price of sailing dinghies rises, the quantity of sail-
ing dinghies demanded falls substantially. The reason is that most people view hot food and warm homes
as necessities and a sailing dinghy as a luxury.
Of course, whether a good is a necessity or a luxury depends not on the intrinsic properties of the
good but on the preferences of the buyer. For an avid sailor with little concern over health issues, sailing
dinghies might be a necessity with inelastic demand, and hot food and a warm place to sleep less of a
necessity having a more price elastic demand as a result.

Definition of the Market The elasticity of demand in any market depends on how we draw the bound-
aries of the market. Narrowly defined markets tend to be associated with a more price elastic demand
than broadly defined markets, because it is easier to find close substitutes for narrowly defined goods. For
example, food, a broad category, has a fairly price inelastic demand because there are no good substitutes
for food. Ice cream, a narrower category, has a more price elastic demand because it is easy to substitute
other desserts for ice cream. Vanilla ice cream, a very narrow category, has a very price elastic demand in
comparison because other flavours of ice cream are very close substitutes for vanilla.

Proportion of Income Devoted to the Product Some products have a relatively high price and take a
larger proportion of income than others. Buying a new suite of furniture for a lounge, for example, tends
to take up a large amount of income whereas buying an ice cream might account for only a tiny proportion
of income. If the price of a three-piece suite rises by 10 per cent, therefore, this is likely to have a greater
effect on demand for this furniture than a 10 per cent increase in the price of an ice cream. The higher the
proportion of income devoted to the product the greater the price elasticity is likely to be.

Time Horizon Goods tend to have more price elastic demand over longer time horizons. If the price of a
unit of electricity rises much above an equivalent energy unit of gas, demand may fall only slightly in the
short run because many people already have electric cookers or electric heating appliances installed in
their homes and cannot easily switch. If the price difference persists over several years, however, people
may find it worth their while to replace their old electric heating and cooking appliances with new gas
appliances and so the demand for electricity will fall.

Computing the Price Elasticity of Demand

Economists compute the price elasticity of demand as the percentage change in the quantity demanded
divided by the percentage change in the price. That is:
Percentage change in quantity demanded
Price elasticity of demand 5
Percentage change in price

For example, suppose that a 10 per cent increase in the price of a packet of breakfast cereal causes the
amount bought to fall by 20 per cent. Because the quantity demanded of a good is negatively related to
its price, the percentage change in quantity will always have the opposite sign to the percentage change
in price. In this example, the percentage change in price is a positive 10 per cent (reflecting an increase),
and the percentage change in quantity demanded is a negative 20 per cent (reflecting a decrease). For
this reason, price elasticities of demand are sometimes reported as negative numbers. In this book we
follow the common practice of dropping the minus sign and reporting all price elasticities as positive num-
bers. (Mathematicians call this the absolute value.) With this convention, a larger price elasticity implies a
greater responsiveness of quantity demanded to price.
In our example, the price elasticity of demand is calculated as:
20%
Price elasticity of demand 5 52
10%
A price elasticity of demand of 2 reflects the fact that the change in the quantity demanded is proportion-
ately twice as large as the change in the price.
Elasticity can have a value which lies between 0 and infinity:
●● Between 0 and 1, elasticity is said to be price inelastic, that is the percentage change in quantity
demanded is less than the percentage change in price.
●● If elasticity is greater than 1 it said to be price elastic – the percentage change in quantity demanded is
greater than the percentage change in price.
●● If the percentage change in quantity demanded is the same as the percentage change in price then the
price elasticity is equal to 1 and is called unit or unitary elasticity.

Relative Elasticities We have and will use the term ‘relatively’ elastic or inelastic throughout our anal-
ysis. The use of this term is important. We can look at goods, for example, both of which are classed as
‘inelastic’ but where one is more inelastic than the other. If we are comparing good x , which has a price
elasticity of 0.2, and good y , which has a price elasticity of 0.5, then both are price inelastic, but good y is
more price elastic in comparison. As with so much of economics, careful use of terminology is important
in conveying a clear understanding.

Calculating Price Elasticity

In this next section we will describe two methods commonly used to calculate price elasticity, the midpoint
or arc elasticity of demand, and point elasticity of demand. Some institutions may focus on only one of these
methods, in which case you can (if you wish) skip the method below which your institution does not cover.

Using the Midpoint (Arc Elasticity of Demand) Method If you try calculating the price elasticity of
demand between two points on a demand curve, you will notice that the elasticity from point A to point B
seems different from the elasticity from point B to point A. For example, consider these numbers:
Point A : Price 5 €4 Quantity 5 120
Point B : Price 5 €6 Quantity 5 80
The standard way to compute a percentage change is to divide the change by the initial level and
multiply by 100. Going from point A to point B, the price rises by 50 per cent, and the quantity falls by
33 per cent, indicating that the price elasticity of demand is 33/50 or 0.66. By contrast, going from point B
to point A, the price falls by 50 per cent, and the quantity rises by 50 per cent, indicating that the price
elasticity of demand is 50/33 or 1.5 (to one decimal place).
The midpoint method overcomes this problem by computing a percentage change by dividing the
change by the midpoint (or average) of the initial and final levels. We can express the midpoint method with
the following formula for the price elasticity of demand between two points, denoted (Q1, P1) and (Q2 , P2 ):
(Q2 2 Q1) / [(Q2 1 Q1) / 2]
Price elasticity of demand 5
(P2 2 P1) / [(P2 1 P1) / 2]

The numerator and denominator reflect the proportionate change in quantity and price computed using
the midpoint method.

Using the example above, €5 is the midpoint of €4 and €6. Therefore, according to the midpoint method,
a change from €4 to €6 is considered a 40 per cent rise, because (6 2 4)/5 3 100 5 40. Similarly, a change
from €6 to €4 is considered a 40 per cent fall.
The midpoint method gives the same answer regardless of the direction of change and facilitates the
calculation of the price elasticity of demand between two points. In our example, when going from point A
to point B, the price rises by 40 per cent, and the quantity falls by 40 per cent. Similarly, when going from
point B to point A, the price falls by 40 per cent, and the quantity rises by 40 per cent. In both directions,
the price elasticity of demand equals 1.

Using the Point Elasticity of Demand Method Rather than measuring elasticity between two points
on the demand curve, point elasticity of demand measures elasticity at a particular point on the demand
curve. Let us take our general formula for price elasticity given by:
%DQd
Price elasticity of demand 5
%DP
Where the Greek letter delta (D) means ‘change’. To calculate the percentage change in quantity demanded
and the percentage change in price we use the following formulas:
DQd
Percentage change in quantity demanded 5 3 100
Qd
And:
DP
Percentage change in price 5 3 100
P
We can substitute these two formulas into our elasticity formula to get:
DQd DP
Price elasticity of demand 5 /
Qd P
This can be rearranged to give:
P DQd
Price elasticity of demand 5 3 (1)
Qd DP
The slope of the demand curve is given by:
DP
Slope 5
DQd
The ratio Qd is the reciprocal of the slope of the demand curve, so the formula for the price elasticity of
DP
demand can also be written as:
P 1
Price elasticity of demand 5 3 (2)
Qd DP
DQd

Using either equation 1 or equation 2 will lead to the same answer (the difference will be taking into
account the negative sign, which as we have seen can be dropped when we are using absolute numbers).
Using calculus, the formula is:
P dQd
Price elasticity of demand 5 3
Qd dP
This considers the change in quantity and the change in price as the ratio tends to the limit, in other words
how quantity demanded responds to an infinitesimally small change in price.

The Variety of Demand Curves

Because the price elasticity of demand measures how much quantity demanded responds to changes in
the price, it is closely related to the slope of the demand curve. The following heuristic (rule of thumb) is a
useful guide when the scales of the axes are the same: the flatter the demand curve that passes through a
given point, the greater the price elasticity of demand. The steeper the demand curve that passes through
a given point, the smaller the price elasticity of demand.

Figure 3.12 shows five cases, each of which uses the same scale on each axis. This is an important
point to remember, because simply looking at a graph and the shape of the curve without recognizing the
scale can result in incorrect conclusions about elasticity.
In the extreme case of a zero elasticity shown in panel (a), demand is perfectly inelastic, and the
demand curve is vertical. In this case, regardless of the price, the quantity demanded stays the same.

Figure 3.12
The Price Elasticity of Demand
The steepness of the demand curve indicates the price elasticity of demand (assuming the scale used on the axes are the same).
Note that all percentage changes are calculated using the midpoint method and rounded.
(a) Perfectly inelastic demand: Elasticity equals 0 (b) Inelastic demand: Elasticity is less than 1
Price Price
Demand

€5 €5
4 4
1. An 1. A 22% Demand
increase increase
in price ... in price ...

0 100 Quantity 0 90 100 Quantity

2. ... leaves the quantity demanded unchanged. 2. ... leads to an 11% decrease in quantity demanded.

€5 €5
4 4 Demand
1. A 22% Demand 1. A 22%
increase increase
in price ... in price ...

0 80 100 Quantity 0 50 100 Quantity

2. ... leads to a 22% decrease in quantity demanded. 2. ... leads to a 67% decrease in quantity demanded.

(e) Perfectly elastic demand: Elasticity equals infinity

Price

1. At any price
above €4, quantity
demanded is zero.
€4 Demand

2. At exactly €4,
consumers will
buy any quantity.

0 Quantity
3. At a price below €4,
quantity demanded is infinite.

Panels (b), (c) and (d) present demand curves that are flatter and flatter, and represent greater degrees of
elasticity. At the opposite extreme shown in panel (e), demand is perfectly elastic. This occurs as the price
elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the fact that
very small changes in the price lead to huge changes in the quantity demanded.

Total Expenditure, Total Revenue and the Price Elasticity of Demand

When studying changes in demand in a market, we are interested in the amount paid by buyers of the
good which will in turn represent the total revenue that sellers receive. Total expenditure is given by
the total amount bought multiplied by the price paid. We can show total expenditure graphically, as in
Figure 3.13. The height of the box under the demand curve is P and the width is Q. The area of this
box, P 3 Q , equals the total expenditure in this market. In Figure 3.13, where P 5 €4 and Q 5 100, total
expenditure is €4 3 100 or €400.

total expenditure the amount paid by buyers, computed as the price of the good times the quantity purchased

Figure 3.13
Price
Total Expenditure
The total amount paid by buyers, and received as
revenue by sellers, equals the area of the box under
the demand curve, P 3 Q . Here, at a price of € 4, the
quantity demanded is 100, and total expenditure is
€400. €4

P × Q = €400
P (expenditure) Demand

0 100 Quantity
Q

Business Decision-Making and Price Elasticity For businesses that are not price-takers, having some
understanding of the price elasticity of demand is important in decision-making. If a firm is thinking of
changing price, how will the demand for its product react? The firm knows that there is an inverse relation-
ship between price and demand, but the effect on its revenue will be dependent on the price elasticity of
demand. It is entirely possible that a firm could reduce its price and increase total revenue. Equally, a firm
could raise price and find its total revenue falling. At first glance this might sound counter-intuitive, but it
all depends on the price elasticity of demand for the product.
If demand is price inelastic, as in Figure 3.14, then an increase in the price causes an increase in total
expenditure. Here an increase in price from €1 to €3 causes the quantity demanded to fall from 100 to 80,
and so total expenditure rises from €100 to €240. An increase in price raises P 3 Q because the fall in Q
is proportionately smaller than the rise in P .
If demand is price elastic an increase in the price causes a decrease in total expenditure. In Figure 3.15,
for instance, when the price rises from €4 to €5, the quantity demanded falls from 50 to 20, and so
total expenditure falls from €200 to €100. Because demand is price elastic, the reduction in the quantity
demanded more than offsets the increase in the price. That is, an increase in price reduces P 3 Q because
the fall in Q is proportionately greater than the rise in P .

Figure 3.14
How Total Expenditure Changes When Price Changes: Inelastic Demand
With a price inelastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller.
Therefore, total expenditure (the product of price and quantity) increases. Here, an increase in the price from €1 to € 3 causes the
quantity demanded to fall from 100 to 80, and total expenditure rises from €100 to €240.

Price Price

€3

Expenditure = €240
€1
Expenditure = €100 Demand Demand

0 100 Quantity 0 80 Quantity

Figure 3.15
How Total Expenditure Changes When Price Changes: Elastic Demand
With a price elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger.
Therefore, total expenditure (the product of price and quantity) decreases. Here, an increase in the price from € 4 to €5 causes the
quantity demanded to fall from 50 to 20, so total expenditure falls from €200 to €100.

Price Price

€5

€4

Demand
Demand

Expenditure = €100
Expenditure = €200

0 50 Quantity 0 20 Quantity

Although the examples in these two figures are extreme, they illustrate a general rule:
●● When demand is price inelastic (a price elasticity less than 1), price and total expenditure move in the
same direction.
●● When demand is price elastic (a price elasticity greater than 1), price and total expenditure move in
opposite directions.
●● If demand is unit price elastic (a price elasticity exactly equal to 1), total expenditure remains constant
when the price changes.

Elasticity and Total Expenditure along a Linear Demand Curve

Demand curves can be linear (straight) or curvilinear (curved). The elasticity at any point along a demand
curve will depend on the shape of the demand curve. A linear demand curve has a constant slope.
Slope is defined as ‘rise over run’, which here is the ratio of the change in price (‘rise’, or the change in
the y axis) to the change in quantity (‘run’, or the change in the x axis). The slope of the demand curve
in Figure 3.16 is constant because each €1 increase in price causes the same 2-unit decrease in the
quantity demanded.

Figure 3.16
Elasticity of a Linear Demand Curve
The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the
price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At
points with a high price and low quantity, the demand curve is elastic.

Total revenue Per cent change Per cent change Price Quantity
Price Quantity (Price × Quantity) in price in quantity elasticity description
€7 0 €0 15 200 13.0 Elastic
6 2 12 18 67 3.7 Elastic
5 4 20 22 40 1.8 Elastic
4 6 24 29 29 1.0 Unit elastic
3 8 24 40 22 0.6 Inelastic
2 10 20 67 18 0.3 Inelastic
1 12 12 200 15 0.1 Inelastic
0 14 0

Price Elasticity is
€7 larger
6 than 1.

5
Elasticity is
4 smaller
3 than 1.
2
1

0 2 4 6 8 10 12 14
Quantity

Even though the slope of a linear demand curve is constant, the elasticity is not. The reason is that the
slope is the ratio of changes in the two variables, whereas the elasticity is the ratio of percentage changes
in the two variables. The table in Figure 3.16 shows the demand schedule for the linear demand curve in
the graph. The table uses the midpoint method to calculate the price elasticity of demand. At points with a
low price and high quantity, the demand curve is price inelastic. At points with a high price and low quan-
tity, the demand curve is price elastic.
The table also presents total expenditure at each point on the demand curve. These numbers illustrate
the relationship between total expenditure and price elasticity. When the price is €1, for instance, demand
is inelastic and a price increase to €2 raises total expenditure. When the price is €5, demand is elastic, and
a price increase to €6 reduces total expenditure. Between €3 and €4, demand is exactly unit price elastic
and total expenditure is the same at these two prices.

Other Demand Elasticities

In addition to the price elasticity of demand, economists also use other elasticities to describe the behav-
iour of buyers in a market.

The Income Elasticity of Demand

The income elasticity of demand measures how quantity demanded changes as consumer income
changes. It is calculated as the percentage change in quantity demanded divided by the percentage
change in income. That is:
Percentage change in quantity demanded
Income elasticity of demand 5
Percentage change in income

income elasticity of demand a measure of how much quantity demanded of a good responds to a change in
consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income

Many goods are normal goods: higher income raises quantity demanded. Because quantity demanded
and income change in the same direction, normal goods have positive income elasticities. Inferior goods,
where higher income lowers the quantity demanded, sees quantity demanded and income move in oppo-
site directions; inferior goods have negative income elasticities.
Even among normal goods, income elasticities vary substantially in size. Necessities, such as food and
clothing, tend to have small income elasticities because consumers, regardless of how low their incomes,
choose to buy some of these goods. Luxuries, such as caviar and diamonds, tend to have high income
elasticities because consumers feel that they can do without these goods altogether if their income is
too low.

The Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures how the quantity demanded of one good changes as
the price of another good changes. It is calculated as the percentage change in quantity demanded of
good 1 divided by the percentage change in the price of good 2. That is:
Percentage change in quantity demanded of good 1
Cross -price elasticity of demand 5
Percentage change in the price of good 2

cross-price elasticity of demand a measure of how much the quantity demanded of one good responds to a change
in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the
percentage change in the price of the second good

Whether the cross-price elasticity is a positive or negative number depends on whether the two goods
are substitutes or complements. Substitutes are goods that are typically used in place of one another,
such as Pepsi and Coca-Cola. An increase in the price of Pepsi induces some buyers to switch to Coca-Cola
instead. Because the price of Pepsi and the quantity of Coca-Cola demanded move in the same direction,
the cross-price elasticity is positive.

Conversely, complements are goods that are typically used together, such as smartphones and pay-
ment plans. In this case, the cross-price elasticity is negative, indicating that an increase in the price of
smartphones reduces the quantity of payment plans demanded. As with price elasticity of demand, cross-
price elasticity may increase over time: a change in the price of electricity will have little effect on demand
for gas in the short run but much stronger effects over several years.

Self Test Define the price elasticity of demand. Explain the relationship between total expenditure and the
price elasticity of demand.

Price Elasticity of Supply

The price elasticity of supply measures how much the quantity supplied responds to changes in the
price. Supply of a good is said to be price elastic (or price sensitive) if the quantity supplied responds
substantially to changes in the price. Supply is said to be price inelastic (or price insensitive) if the quantity
supplied responds only slightly to changes in the price.

price elasticity of supply a measure of how much the quantity supplied of a good responds to a change in the price of
that good, computed as the percentage change in quantity supplied divided by the percentage change in price

The Price Elasticity of Supply and Its Determinants

The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they
produce in response to changes in price. For example, seafront property has a price inelastic supply
because it is very difficult to produce more of it quickly – supply is not very sensitive to changes in price.
By contrast, manufactured goods, such as books, cars and television sets, have relatively price elastic
supplies, because the firms that produce them can run their factories longer in response to a higher price
– supply is sensitive to changes in price.
Elasticity can take any value greater than or equal to 0. The closer to 0 the more price inelastic, and the
closer to infinity the more price elastic. The following subsections look at the key determinants of the price
elasticity of supply.

The Time Period In most markets, a key determinant of the price elasticity of supply is the time period
being considered. Supply is usually more price elastic in the long run than in the short run. Over very short
periods of time, firms may find it impossible to respond to a change in price by changing output. In the
short run, firms cannot easily change the size of their factories or productive capacity to make more or
less of a good but may have some flexibility. For example, it might take a month to employ new labour
and access more supplies of raw materials, and after that time some increase in output can be accommo-
dated. By contrast, over longer periods, firms can build new factories or close old ones, employ new staff
and buy in more capital and equipment. In addition, new firms can enter a market and old firms can shut
down. Thus, in the long run, the quantity supplied can respond substantially to price changes.

Productive Capacity Most businesses, in the short run, will have a finite capacity – an upper limit to the
amount that they can produce at any one time determined by the amount of factor inputs they possess.
How far they are using this capacity depends, in turn, on the state of the economy. In periods of strong
economic growth, firms may be operating at or near full capacity. If demand is rising for the product they
produce and prices are rising, it may be difficult for the firm to expand output to meet this new demand
and so supply may be price inelastic.

When the economy is growing slowly or is contracting, some firms may find they must cut back output
and may only be operating at 60 per cent of full capacity, for example. In this situation, if demand later
increased and prices started to rise, it may be much easier for the firm to expand output relatively quickly
and so supply would be more elastic.

The Size of the Firm/Industry It is possible that, as a general rule, supply may be more price elastic in
smaller firms or industries than in larger ones. For example, consider a small independent furniture man-
ufacturer. Demand for its products may rise, and in response the firm may be able to buy in raw materials
(wood, for example) to meet this increase in demand. While the firm will incur a cost in buying in this
timber, it is unlikely that the unit cost for the material will increase substantially.
Compare this to a situation where a steel manufacturer increases its purchase of raw materials (iron
ore, for example). Buying large quantities of iron ore on global commodity markets can drive up unit price
and, by association, unit costs.
The response of supply to changes in price in large firms/industries, therefore, may be less elastic than
in smaller firms/industries. This is also related to the number of firms in the industry – the more firms there
are in the industry the easier it is to increase supply, ceteris paribus.

The Mobility of Factors of Production Consider a farmer whose land is currently devoted to producing
wheat. A sharp rise in the price of rape seed might encourage the farmer to switch use of land from wheat
to rape seed in the next planting cycle. The mobility of the factor of production land, in this case, is rela-
tively high and so the supply of rape seed may be relatively price elastic.
A number of multinational firms that have plants in different parts of the world now build each plant to
be identical. What this means is that if there is disruption to one plant the firm can more easily transfer
operations to another plant elsewhere and continue production ‘seamlessly’, and equally can expand
supply by utilizing these plants more swiftly. Car manufacturers provide an example of this interchangea-
bility of parts and operations. The chassis may be identical across a range of branded car models. This is
the case with some Audi, Volkswagen, Seat and Skoda models. This means that supply may be more price
elastic as a result.
Compare this to the supply of highly skilled oncology consultants. An increase in the wages of oncology
consultants (suggesting a shortage exists) will not mean that a renal consultant or other doctors can sud-
denly switch to take advantage of the higher wages and increase the supply of oncology consultants. In
this example, the mobility of labour to switch between different uses is limited and so the supply of these
specialist consultants is likely to be relatively price inelastic.

Ease of Storing Stock/Inventory In some firms, stocks can be built up to enable the firm to respond
more flexibly to changes in prices. In industries where inventory build-up is relatively easy and cheap,
supply is more price elastic than in industries where it is much harder to do this. Consider the fresh fruit
industry, for example. Storing fresh fruit is not easy because it is perishable, and so the price elasticity of
supply in this industry may be more inelastic.

Computing the Price Elasticity of Supply

Computing the price elasticity of supply is similar to the process we adopted for calculating the price
elasticity of demand and the two methods of calculating price elasticity of demand, the midpoint or arc
method and the point elasticity method, also apply to supply.
The price elasticity of supply is the percentage change in the quantity supplied divided by the percent-
age change in the price. That is:
Percentage change in quantity supplied
Price elasticity of supply 5
Percentage change in price

For example, suppose that a 10 per cent increase in the price of bicycles causes the amount of bicycles
supplied to the market to rise by 15 per cent. We calculate the elasticity of supply as:
15
Price elasticity of supply 5
10
Price elasticity of supply 5 1.5

In this example, the price elasticity of 1.5 reflects the fact that the quantity supplied moves proportionately
one and a half times as much as the price.

The Midpoint (Arc) Method of Calculating the Elasticity of Supply As with the price elasticity of
demand, the midpoint method for the price elasticity of supply between two points, denoted (Q1, P1) and
(Q2 , P2 ), has the following formula:
(Q2 2 Q1) / [(Q2 1 Q1) / 2]
Price elasticity of supply 5
(P2 2 P1) / [(P2 1 P1) / 2]

The numerator is the percentage change in quantity supplied computed using the midpoint method, and
the denominator is the percentage change in price computed using the midpoint method.

Point Elasticity of Supply Method As with point elasticity of demand, point elasticity of supply meas-
ures elasticity at a particular point on the supply curve. Exactly the same principles apply as with point
elasticity of demand, so the formula for point elasticity of supply is given by:
P 1
Price elasticity of supply 5 3
Qs DP
DQs

Using calculus, the formula is:

P dQs
Price elasticity of supply 5 3
Qs dP

The Variety of Supply Curves

Because the price elasticity of supply measures the responsiveness of quantity supplied to changes in
price, it is reflected in the appearance of the supply curve (again, assuming we are using the same scales
on the axes of diagrams being used). Figure 3.17 shows five cases. In the extreme case of a zero elasticity,
as shown in panel (a), supply is perfectly inelastic and the supply curve is vertical. In this case, the quantity
supplied is the same regardless of the price. In panels (b), (c) and (d) the supply curves are increasingly
flatter, associated with increasing price elasticity, which shows that the quantity supplied responds more
to changes in the price. At the opposite extreme, shown in panel (e), supply is perfectly elastic. This occurs
as the price elasticity of supply approaches infinity and the supply curve becomes horizontal, meaning that
very small changes in the price lead to very large changes in the quantity supplied.
In some markets, the elasticity of supply is not constant but varies over the supply curve. Figure 3.18
shows a typical case for an industry in which firms have factories with a limited capacity for produc-
tion. For low levels of quantity supplied, the elasticity of supply is high, indicating that firms respond
substantially to changes in the price. In this region, firms have capacity for production that is not being
used, such as buildings and machinery sitting idle for all or part of the day. Small increases in price
make it profitable for firms to begin using this idle capacity. As the quantity supplied rises, firms begin
to reach capacity. Once capacity is fully used, increasing production further requires the construction of
new factories. To induce firms to incur this extra expense, the price must rise substantially, so supply
becomes less elastic.
Figure 3.18 presents a numerical example of this phenomenon. In each case below we have used the
midpoint method and the numbers have been rounded for convenience. When the price rises from €3 to
€4 (a 29 per cent increase, according to the midpoint method), the quantity supplied rises from 100 to 200
(a 67 per cent increase). Because quantity supplied moves proportionately more than the price, the supply
curve has elasticity greater than 1.

Figure 3.17
The Price Elasticity of Supply
The price elasticity of supply determines whether the supply curve is steep or flat (assuming that the scale used for the axes is the
same). Note that all percentage changes are calculated using the midpoint method and rounded.
(a) Perfectly inelastic supply: Elasticity equals 0 (b) Inelastic supply: Elasticity is less than 1
Price Supply Price
Supply

€5 €5
4 4
1. An 1. A 22%
increase increase
in price ... in price ...

0 100 Quantity 0 100 110 Quantity

2. ... leaves the quantity supplied unchanged. 2. ... leads to a 10% increase in quantity supplied.

Price Price

Supply Supply
€5 €5
4 4
1. A 22% 1. A 22%
increase increase
in price ... in price ...

0 100 125 Quantity 0 100 200 Quantity

2. ... leads to a 22% increase in quantity supplied. 2. ... leads to a 67% increase in quantity supplied.

(e) Perfectly elastic supply: Elasticity equals infinity

Price

1. At any price
above €4, quantity
supplied is infinite.
€4 Supply

2. At exactly €4,
producers will
supply any quantity.

0 Quantity
3. At a price below €4,
quantity supplied is zero.

Self Test Define the price elasticity of supply. Explain why the price elasticity of supply might be different
in the long run from in the short run.

Figure 3.18
Price
How the Price Elasticity of Supply Can Vary €15
Elasticity is small
Because firms often have a maximum capacity for production,
(less than 1).
the elasticity of supply may be very high at low levels of quantity 12
supplied and very low at high levels of quantity supplied. Here, an
increase in price from € 3 to € 4 increases the quantity supplied from
100 to 200. Because the increase in quantity supplied of 67 per cent
(computed using the midpoint method) is larger than the increase Elasticity is large
in price of 29 per cent, the supply curve is elastic in this range. By (greater than 1).
contrast, when the price rises from €12 to €15, the quantity supplied
4
rises only from 500 to 525. Because the increase in quantity
3
supplied of 5 per cent is smaller than the increase in price of
22 per cent, the supply curve is inelastic in this range.
0 100 200 500 525 Quantity

By contrast, when the price rises from €12 to €15 (a 22 per cent increase), the quantity supplied rises
from 500 to 525 (a 5 per cent increase). In this case, quantity supplied moves proportionately less than the
price, so the elasticity is less than 1.

Total Revenue and the Price Elasticity of Supply

When studying changes in supply in a market we are often interested in the resulting changes in the total
revenue received by producers. In any market, total revenue received by sellers is P 3 Q , the price of
the good times the quantity of the good sold. This is highlighted in Figure 3.19, which shows an upwards
sloping supply curve with an assumed price of €5 and a supply of 100 units. The height of the box under
the supply curve is P and the width is Q. The area of this box, P 3 Q , equals the total revenue received in
this market. In Figure 3.19, where P 5 €5 and Q 5 100, total revenue is €5 3 100 or €500.

total revenue the amount received by sellers of a good, computed as the price of the good times the quantity sold

Figure 3.19
Price
The Supply Curve and Total Revenue Supply
The total amount received by sellers equals the area of the box
under the demand curve, P 3 Q . Here, at a price of €5, the
quantity supplied is 100 and the total revenue is €500.

€5

P × Q = €500
(Total revenue)

0 100
Quantity

Total revenue will change as price changes, depending on the price elasticity of supply. If supply is price
inelastic, as in Figure 3.20, then an increase in price which is proportionately larger causes an increase in
total revenue. Here, an increase in price from €4 to €5 causes the quantity supplied to rise only from 80 to
100, and so total revenue rises from €320 to €500 (assuming the firm sells the additional supply).

Figure 3.20
How Total Revenue Changes When Price Changes: Inelastic Supply
With an inelastic supply curve, an increase in price leads to an increase in quantity supplied that is proportionately smaller. Therefore,
total revenue (the product of price and quantity) increases. Here, an increase in price from € 4 to €5 causes the quantity supplied to rise
from 80 to 100, and total revenue rises from € 320 to €500.

Price Price
Supply
Supply

Revenue = €500
Revenue = €320

€5
€4

0 80 Quantity 0 100 Quantity

If supply is price elastic then a similar increase in price brings about a much larger than proportionate
increase in supply. In Figure 3.21, we assume a price of €4 and a supply of 80 with total revenue of €320.
Now a price increase from €4 to €5 leads to a much greater than proportionate increase in supply from 80
to 150 with total revenue rising to €750 – again, assuming the firm sells the additional supply.

Figure 3.21
How Total Revenue Changes When Price Changes: Elastic Supply
With a price elastic supply curve, an increase in price leads to an increase in quantity supplied that is proportionately larger. Therefore,
total revenue (the product of price and quantity) increases. Here, an increase in the price from € 4 to €5 causes the quantity supplied to
rise from 80 to 150, and total revenue rises from € 320 to €750 .

Price Price

Supply Supply

€5
€4

Revenue = €320 Revenue = €750

0 80 Quantity 0 150 Quantity

Applications of Supply and Demand Elasticity

Why is it the case that travel on the trains at certain times during the day is a different price than at other
times? Why, despite the increase in productivity in agriculture, have farmers’ incomes gone down, on aver-
age, over recent years? At first, these questions might seem to have little in common. Yet both questions
are about markets and the forces of supply and demand. An understanding of elasticity is a key part of the
answer to these and many other questions.

Why Does the Price of Train Travel Vary at Different Times of the Day?
In many countries the price of a train journey varies at different times during the day and the week. A ticket for a
seat on a train from Birmingham to London between 6.00am and 9.00am is around £85 (€96), whereas for the
same journey leaving at midday the price is between £6 and £32 (€6.80 and €36.50). Train operators know that
the demand for rail travel between 6.00am and 9.00am is higher than during the day time, but they also know
that few commuters have choices about when they arrive at work or to meetings, conferences and so on.
An individual can use other forms of transport such as their car or a coach, but the train is often very conven-
ient, so the number of substitutes is considered low. The price elasticity of demand for train travel early in the
morning, therefore, is relatively low compared to at midday. In the morning, train operators know that seats
on trains will be mostly taken and there will be very few left empty, whereas during the day it is much more
likely that trains will be running with empty seats. Knowing that there is a different price elasticity of demand
means that train operators can maximize revenue at these different times by charging different prices.
Figure 3.22 shows the situation in the market for train travel. Panel (a) shows the demand and supply for
tickets between Birmingham and London between 6.00am and 9.00am. The demand curve Di is relatively
steep, indicating that the price elasticity of demand is relatively low. At a price of £80, 1,000 tickets are
bought and as a result the total revenue for the train operator is £80,000.
Panel (b) shows a demand curve De with a similar supply curve. Ceteris paribus, the train operator has
the same number of trains available at all times during the day, but notice that the supply curve is relatively
steep and therefore inelastic because although the operator has some flexibility to increase the number
of trains available, and thus seats for passengers, there is a limit as to how far the capacity can be varied
throughout the day.

Figure 3.22
Price Sensitivity in the Passenger Train Market
Panel (a) represents the market for train travel between 6.00am and 9.00am between two major cities. The demand for train travel at
this time is relatively price inelastic – passengers are insensitive to price at this time because they have few alternatives and have to
get into work and to meetings. The train operators generate revenue of £80,000 by selling 1,000 tickets at £80 each.
Panel (b) shows the market after 9.00am. Train operators face a different demand curve at this time and passengers are more price
sensitive. If the train operator continued to charge £80, demand would be just 100 and revenue would be £8,000. If the train operator
reduces the price to £40, demand would be 800 and the total revenue would be £32,000.

Price of S Price of S
train train
tickets (£) tickets (£)
80 80

Di De
0 0
1,000 Quantity of train tickets 100 800 Quantity of train tickets
bought and sold bought and sold

Panel (a) Panel (b)

If the train operator charged a price of £80 after 9.00am, the demand for tickets would be relatively
low at 100. Total revenue, therefore, would be £8,000 and there would be many seats left empty. This is
because the train operator effectively faces a different market during the day. Those who travel by train

during the day may have a choice – they might be travelling for leisure or to see friends and they do not
need to travel by train, unlike those in the morning who must get to work at a certain time.
These passengers are price sensitive – charge too high a price and they will not choose to travel by
train, but offer a price that these passengers see as being attractive, and which to them represents value
for money, and they may choose to buy a train ticket. If the train operator, therefore, set the price for train
tickets after 9.00am at £40, the demand for train tickets would be 800 and total revenue would be £32,000.
If we assume that train operators are acting rationally then they would prefer to generate revenue of
£32,000 rather than £8,000, and so it would be more sensible for them to charge a lower price to capture
these more price sensitive passengers.

Why Have Farmers’ Incomes Fallen Despite Increases in Productivity?

In many developed countries, agricultural production has increased over the last 100 years. One of the
reasons is that farmers can use more machinery, and advances in science and technology have meant that
productivity, the amount of output per acre of land, has increased.
Assume a farmer has 1,000 acres of land and grows wheat, and that 20 years ago each acre of land
yielded an average of 2 tonnes of wheat. We say ‘an average’ because output can be dependent on
factors outside the farmer’s control such as the weather, pests, diseases and so on. Assume that
the price of wheat is €200 per tonne. Twenty years ago, the average income for our farmer would be
2,000 tonnes 3 €200 5 €400,000. Ceteris paribus, if productivity increases meant that average output per
acre was now 3 tonnes per acre, income would rise to €600,000.
However, this assumes other things are equal. Research suggests that the demand for food is relatively
price and income inelastic. Over the 20-year period we are assuming in our analysis, the demand for wheat
may only have risen by a relatively small amount and is price and income inelastic. People may earn more
money now than they did 20 years ago, but evidence suggests that as people’s incomes increase, they
spend a smaller proportion of income on food. This is called ‘Engel’s law’.
Figure 3.23 shows a representation of this situation. In the first time period, the supply curve, repre-
senting output per acre of 2 tonnes, intersects the demand curve D1 at a price of €200 per tonne giving
the farmer an income of €400,000.
Twenty years later, the productivity improvements at the farm see the supply curve shifting to S2 repre-
senting an average output per acre of 3 tonnes. However, over the 20-year period, demand has increased,
but only by a small amount as people spend a smaller proportion of their income on food as they get richer.
The fact that food is relatively price inelastic is indicated by the relatively steep demand curve, and the
result is that the market price has fallen to €100 per tonne, with the farmer now selling 3,000 tonnes. The
farmer’s income has fallen to €300,000.

Figure 3.23
The Effect of Increases in Demand and Supply of Price of
Wheat on Farm Incomes wheat per S1 S2
Twenty years ago, the supply of wheat is represented as supply tonne (€)
curve s1 with output per acre at 2 tonnes per acre. The demand
for wheat at that time is represented as demand curve D1. If the
market price of wheat is € 200 per tonne, the farmer’s income is
200
€ 400,000.
The output of wheat per acre rises with increases in
productivity and, as a result, the supply of wheat today
100
increases and is represented by supply curve s2 with output per
acre now 3 tonnes per acre. However, as demand is both price
D1
and income inelastic, the demand for food has increased only D2
slightly in that 20-year period; the new demand curve is shown
0
as D2 . The combination of a considerable rise in supply and only 2,000 3,000 Quantity of wheat
a small rise in demand means farmers get a lower price per bought and sold
tonne and income is actually lower. (tonnes)

Self Test What must firms who charge different prices for the same product at different times be able to
do for the pricing tactic to work? (Hint: can you use off-peak tickets for a train journey during peak hours?)

Summary
●● Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there
are many buyers and sellers, each of whom has little or no influence on the market price.
●● The demand curve shows how the quantity of a good demanded depends on the price. According to the law of
demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downwards.
●● In addition to price, other determinants of how much consumers want to buy include income, the prices of sub-
stitutes and complements, tastes, expectations, the size and structure of the population, and advertising. If one of
these factors changes, the demand curve shifts.
●● The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply,
as the price of a good rises the quantity supplied rises. Therefore, the supply curve slopes upwards.
●● In addition to price, other determinants of how much producers want to sell include the price and profitability of
goods in production and joint supply, input prices, technology, expectations, the number of sellers, and natural and
social factors. If one of these factors changes, the supply curve shifts.
●● The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the
quantity demanded equals the quantity supplied.
●● The behaviour of buyers and sellers drives markets towards their equilibrium. When the market price is above the
equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is
below the equilibrium price, there is a shortage, which causes the market price to rise.
●● To analyze how any event influences a market, we use the supply and demand diagram to examine how the event
affects the equilibrium price and quantity. To do this we follow three steps.
s First, we decide whether the event shifts the supply curve or the demand curve (or both).
s Second, we decide which direction the curve (or curves) shifts.
s Third, we compare the new equilibrium with the initial equilibrium.
●● In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources.
For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price
then determines how much of the good buyers choose to purchase and how much sellers choose to produce.
●● The price elasticity of demand measures how much the quantity demanded responds to changes in the price.
Demand tends to be more price elastic if close substitutes are available, if the good is a luxury rather than a neces-
sity, if the market is narrowly defined or if buyers have substantial time to react to a price change.
●● The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the per-
centage change in price. If the price elasticity is less than 1, so that quantity demanded moves proportionately less
than the price, demand is said to be price inelastic. If the elasticity is greater than 1, so that quantity demanded
moves proportionately more than the price, demand is said to be price elastic.
●● The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This
elasticity often depends on the time horizon under consideration. In most markets, supply is more price elastic in
the long run than in the short run.
●● The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percent-
age change in price. If price elasticity is less than 1, so that quantity supplied moves proportionately less than the
price, supply is said to be price inelastic. If the elasticity is greater than 1, so that quantity supplied moves propor-
tionately more than the price, supply is said to be price elastic.
●● Total revenue, the total amount received by sellers for a good, equals the price of the good times the quantity
sold. For price inelastic demand curves, total revenue rises as price rises. For price elastic demand curves, total
revenue falls as price rises.
●● The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’
income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds
to changes in the price of another good.

In the News

The Apple iPhone and Bluetooth Headphones

In 2016, Apple launched the latest version of its iPhone, the iPhone 7. Unlike previous versions, this new phone came
without a socket for headphones. Needless to say, Apple had a solution for this with its AirPods product, a pair of wireless
ear phones which ‘instantly turn on and connect to your iPhone, Apple Watch, iPad, or Mac’, and ‘automatically plays as
soon as you put them in your ears and pauses when you take them out’. The AirPods work through a Bluetooth connection.
For people who had previously listened to their audio with wired headphones, the new iPhone meant that they
either had to buy new headphones which would connect with their new iPhone or choose another type of phone
which retained the headphone socket. Can economics and the market model offer a prediction of what would happen
in this market? After all, the smartphone market is not at all reflective of the competitive market model; there are only
a few large suppliers of smartphones, products are differentiated in various ways (for example, through operating
system), and producers are price-setters, not price-takers. There are millions of small consumers who are effectively
price-takers, however, and maybe smartphones are more homogenous than might be thought.
The market model might look at the innovation by Apple and consider what the impact would be on substitutes and
complements to the product. In particular, the removal of the headphone socket might prompt a change in the market
for Bluetooth headphones. The market model might suggest, given Apple’s popularity, that manufacturers of head-
phones would seek to exploit technology to focus production more on Bluetooth headphones. Competitors to Apple
might also abandon headphone sockets and go down
the Bluetooth route with their new models. This would
imply a shift in the demand curve for Bluetooth head-
sets with prices in the short run rising. Rising prices
would encourage more producers to switch to produc-
ing Bluetooth headsets and the supply of Bluetooth
headsets to increase.
It might well be the case that the price elasticity
of supply for Bluetooth headsets is relatively elastic.
Equally, our model might also predict a fall in demand
for wired headphones as more Bluetooth devices
become available. Prices would begin to fall for these
The market model can help us look at innovation by
headsets and suppliers would gradually abandon pro-
companies like Apple and consider what the impact would
duction as they became less popular. be on substitutes and complements to the product.
Critical Thinking Questions
1 The article suggests several predictions about the market for headphones as a result of Apple’s decision with its
iPhone 7. Use the market model to sketch what might happen to the market for wired headphones and the market
for Bluetooth headphones. In sketching your graphs, try to take into account the price elasticity of demand and
supply as this might affect the outcome of your analysis and predictions.
2 Any model and theory has to be subject to empirical rigour. Do some research around the price and sales of
wired and Bluetooth headphones to see if there is any evidence to support the predictions made by your analysis
in Question 1. Does the evidence give weight to the market model or not? Explain.
3 What is the relationship between Bluetooth headphones and smartphones which do not have headphone sock-
ets? What effect has this relationship on the price elasticity of demand, income elasticity of demand and cross-
price elasticity of demand for wired and Bluetooth headphones?
4 What would you suggest was the price elasticity of supply for manufacturers of Bluetooth headphones? In think-
ing about your answer, take into consideration the fact that existing producers of wired headphones will proba-
bly also be the manufacturers of Bluetooth headphones. What would the price elasticity of supply depend upon?
5 How closely do you think the market for wired and Bluetooth headphones matches the assumptions of the com-
petitive market model? In your answer, ensure that you justify your judgements and give your reasoning.

Questions for Review

1 a. What are the demand schedule and the demand curve, and how are they related? Why does the demand curve slope
downwards from left to right?
b. What are the supply schedule and the supply curve, and how are they related? Why does the supply curve slope
upwards?
2 a. Does a change in consumers’ tastes lead to a movement along the demand curve or a shift in the demand curve?
b. Does a change in price lead to a movement along the demand curve or a shift in the demand curve?
c. Does a change in producers’ technology lead to a movement along the supply curve or a shift in the supply curve?
d. Does a change in price lead to a movement along the supply curve or a shift in the supply curve?
3 Francine’s income declines and, as a result, she buys more cabbage. Are cabbages an inferior or a normal good? What
happens to Francine’s demand curve for cabbages?
4 Define the equilibrium of a market. Describe the forces that move a market towards its equilibrium. Describe the role of
prices in market economies.
5 Define the price elasticity of demand and the income elasticity of demand. How is the price elasticity of supply
calculated? Explain what this measures.
6 a. List and explain some of the determinants of the price elasticity of demand. Think of some examples to use to illustrate
the factors you cover.
b. What are the main factors that affect the price elasticity of supply? Think of some examples to use to illustrate the
factors you cover.
7 If the price elasticity is greater than 1, is demand elastic or inelastic? If the price elasticity equals 0, is demand perfectly
elastic or perfectly inelastic?
8 Is the price elasticity of supply usually larger in the short run or in the long run? Why?
9 A business person reads that the price elasticity of demand for the product they sell is 1.25. If the person wishes to
increase revenue, should they increase or reduce price? Explain.
10 What factors might affect the price elasticity of supply for a commodity such as rubber in the short run and the long run?
Explain.

Problems and Applications

1 Explain each of the following statements using supply and demand diagrams.
a. When there is a drought in southern Europe, the price of soft fruit rises in supermarkets throughout Europe.
b. When a report is published linking a product with an increased risk of cancer, the price of the product concerned
tends to fall.
c. The United States announces that it intends to impose new sanctions on the Islamic Republic of Iran. The price of
petrol in Europe rises and the price of a used Mercedes falls.
2 Using supply and demand diagrams, show the effect of the following events on the market for sweatshirts.
a. A drought in Egypt damages the cotton crop.
b. The price of leather jackets falls.
c. All universities require students to attend morning exercise classes in appropriate attire.
d. New knitting machines are invented.
3 Think about the market for cigars.
a. Are cigars substitutes or complements for cigarettes?
b. Using a supply and demand diagram, show what happens in the markets for cigars if the tax on cigarettes is increased.
c. If policymakers wanted to reduce total tobacco consumption, what policies could they combine with the cigarette
tax?
4 Consider the following events: Scientists reveal that eating oranges decreases the risk of diabetes, and at the same
time, farmers in Spain use a new fertilizer which increases the yield of oranges per tree. Illustrate and explain what
effect these changes have on the equilibrium price and quantity of oranges. Remember to note the relative size of the
changes you describe and how these could affect outcomes.

5 Suppose that the price of tickets to see your local football team play at home is determined by market forces. Currently,
the demand and supply schedules are as follows:
Price (€) Quantity demanded Quantity supplied
10 50,000 30,000
20 40,000 30,000
30 30,000 30,000
40 20,000 30,000
50 10,000 30,000

a. Draw the demand and supply curves. What is unusual about this supply curve? Why might this be true?
b. What are the equilibrium price and quantity of tickets?
c. Your team plans to increase total capacity in its stadium by 5,000 seats next season. What admission price should it
charge if it wants to maximize total revenue?
d. What is the price elasticity of demand and supply for an increase in price from €30 to €40? (Use whatever method you
think is most appropriate for this example.)
e. As a result of the calculation made in 5d. above, what would you recommend the owners of the club do if there are
consistently empty seats in the stadium and they want to maximize revenue?
6 Market research has revealed the following information about the market for chocolate bars: Qd 5 1,600 2 300P , and
the supply schedule is Qs 5 1,400 1 700P . Calculate the equilibrium price and quantity in the market for chocolate bars.
7 Seafront properties along the south coast of France have a price inelastic supply, and cars have a price elastic supply.
Suppose that a rise in population doubles the demand for both products (that is, the quantity demanded at each price is
twice what it was).
a. What happens to the equilibrium price and quantity in each market?
b. Which product experiences a larger change in price?
c. Which product experiences a larger change in quantity?
d. What happens to total consumer spending on each product?
8 Suppose that business travellers and holidaymakers have the following demand for airline tickets from Munich to Naples:
Quantity demanded Quantity demanded
Price (€) (business travellers) (holidaymakers)
150 2,100 1,000
200 2,000 800
250 1,900 600
300 1,800 400

a. As the price of tickets rises from €200 to €250, what is the price elasticity of demand for (i) business travellers and
(ii) holidaymakers? (Use either the midpoint or point method in your calculations.)
b. Why might holidaymakers have a different price elasticity to business travellers?
9 Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a packet of cigarettes is currently
priced at €6 and the government wants to reduce smoking by 20 per cent, by how much should it increase the price
through levying a tax?
b. If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one
year from now or five years from now? Explain.
c. Studies also find that teenagers have a higher price elasticity of demand for cigarettes than do adults. Why might
this be true?
10 Explain why the following might be true: a drought around the world raises the total revenue that farmers receive from
the sale of grain, but a drought only in France reduces the total revenue that French farmers receive.

I n this chapter we look in more detail at the behaviour of consumers. The standard theory of consumer
choice is based on a series of assumptions about how humans behave. As with other theories, it
provides some predictions about the outcomes of behaviour which enables us to derive the demand
curve and analyze the role of price and other factors in both the position and shifts in the demand
curve.
The standard theory has been the subject of criticism that its assumptions are unrealistic and not
reflective of the way in which humans make choices. Research, originally by psychologists, has highlighted
different approaches to looking at consumer behaviour. We will begin by looking at the standard theory of
consumer choice.

The Standard Economic Model

When you walk into a shop or look to make a purchase online, you are confronted with a range of goods
that you might buy. Of course, because your financial resources are limited, you cannot buy everything
you want. The assumption is that you consider the prices of the various goods being offered for sale and
buy a bundle of goods that, given your resources, best suits your needs and desires. In other words, you
are behaving rationally. In economic terminology, you are seeking to maximize your utility subject to the
constraint of a limited income.
This model is called the classical theory of consumer behaviour or the standard economic model (SEM)
and is fundamentally based on an assumption that humans behave rationally when making consumption
choices.
The SEM provides a theory of consumer choice which provides a more complete understanding of
demand. It examines the trade-offs that people face in their role as consumers. When a consumer buys
more of one good, they can afford less of other goods. When they spend more time enjoying leisure and
less time working, they have lower income and can afford less consumption. When they spend more
of their income in the present and thus save less, they must accept a lower level of consumption in the
future.
The theory of consumer choice examines how consumers facing these trade-offs make decisions and
how they respond to changes in their environment. These trade-offs involve a consideration of opportu-
nity cost. When making a consumption choice with the constraint of limited incomes, consumers make
sacrifices and, in doing so, provide information about the relative value they put on their choices. If a con-
sumer chooses good (I) above good (II), it suggests that good (I) provides more utility than the next best
alternative sacrificed.
When making trade-offs, there are assumptions that are made about consumers. These include:
●● Buyers (or economic agents) are rational (they do the best they can, given their circumstances).
●● More is preferred to less (this is termed monotonicity).
●● Buyers seek to maximize their utility.
●● Consumers act in self-interest and do not consider the utility of others.

Value
A key concept in consumer behaviour and across many other areas of economics is value. Value is a
subjective term – what one individual thinks represents value is often different from that of another
individual. Value can be seen as the worth to an individual of owning an item represented by the satisfaction
derived from its consumption and their willingness to pay to own it. In broad terms, consumption in this
case does not just mean the final consumer. Value can be related to the purchase of a product which is a
gift, or something used by a business for production.

value the worth to an individual of owning an item represented by the satisfaction derived from its consumption and their
willingness to pay to own it

The Water–Diamond Paradox What makes a good valuable? Do companies mine for gold because it
is valuable or is the value of gold determined by the work done by mining companies in extracting and
refining gold? This type of question occupied the minds of early classical economists and is encapsulated
in the so-called water–diamond paradox. Adam Smith noted that water is an extremely important product,
but the price of water is relatively low, whereas diamonds have little practical worth but command very
high prices in comparison.
Smith distinguished between value in use, reflecting the situation with water which is vital to life, and
value in exchange, linked to diamonds which have limited value in use but have a high exchange value.
Smith ascribed the value of a product to the labour which went into producing it. The value of gold, for
example, is therefore determined by the factor inputs in production.
Around 100 years later, William Stanley Jevons proposed that products like gold have value because of
the utility that gold gives to buyers. Classical economists used the term ‘utility’ to refer to the satisfaction
derived from consumption.

utility the satisfaction derived from the consumption of a certain quantity of a product

This implies that companies will mine for gold because of this value. Jevons developed a theory of
marginal utility which was capable of providing an answer to the water–diamond paradox.
Utility is an ordinal concept; what this means is that it can be used as a means of ranking consumer
choices but cannot have any meaningful arithmetic operations performed on it. For example, if a group of
five people were asked to rank different films in order of preference using a 10-point scale (with each point
referred to as a util) we might be able to conclude that film 5 was the most popular, followed by film 3
and film 8. If, however, person 1 ranked film 5 at 10 utils, while person 2 ranked the same film at 5 utils,
we cannot say that person 1 values film 5 twice as much as person 2, only that they place it higher in their
preferences. Value can be measured by ranking but there are limitations to such ranking.

Willingness to Pay One way in which we can overcome this limitation is to look at value in terms of the
amount consumers are prepared to pay to secure the benefits of consuming the product. This is called the
willingness to pay (WTP) principle. How much of our limited income we are prepared to pay is a reflection
of the value we put on acquiring a good. It might not tell us much about the satisfaction from consuming
the good (the buyer, as we have seen, might not be the final consumer), but it does give some idea of value.
For example, two friends, Alexa and Monique, are in a store looking at a pair of shoes. Alexa picks up
a pair of leopard print, high heeled shoes priced at €75. Monique looks at her friend and frowns – why on
earth is she thinking of buying those? No way would Monique pay that sort of money for such an awful
pair of shoes. A discussion ensues about the shoes; clearly there is a difference of opinion about them.
It is here we can distinguish between ‘price’ and ‘value’. If Alexa buys the shoes, they must have some
value to her. We could surmise that this value must be at least €75 because that is what she must give
up in money terms in order to acquire them. We also must consider the opportunity cost of the purchase

in that Alexa has also given up the opportunity of buying whatever else €75 would buy. We could make a
reasonable assumption that Alexa’s friend, Monique, believed there was a way in which she could allocate
€75 to get more value – in other words, the alternative that €75 could buy (whatever that might be) repre-
sented greater value than purchasing those shoes.
It is possible that Alexa would have been prepared to pay much more for the shoes, in which case she
is getting some additional benefit which she is not paying for. Economists call this consumer surplus and
we will look in more detail at this later in the book. Alexa sticks to her guns and buys the shoes; Monique
leaves the store baffled at her friend’s purchasing decision. Monique clearly feels that giving up €75 to buy
those shoes was a ‘waste of money’. Monique’s willingness to pay for this particular pair of shoes is much
less than her friend and might even be zero.
The amount buyers are prepared to pay for a good, therefore, tells us something about the value they
place on it.

Self Test Think about your purchasing decisions. Sometimes you will think you have got a ‘bargain’, and
other times you turn away from a purchase because you think it will be a ‘waste of money’. In economics, what
do you think is the difference and why?

The Budget Constraint: What the Consumer Can Afford

One of the assumptions the SEM makes is that more is preferred to less (called monotonicity). Most
people would like to increase the quantity or quality of the goods they consume – to take longer holidays,
drive fancier cars or buy a bigger house. People consume less than they desire because their spending is
constrained, or limited, by their income.
We will use a simple model which examines the decisions facing a consumer who buys only two
goods, cola and pizza, to derive some insights about consumer choice in the SEM. Assume that the con-
sumer has an income of €1,000 per month and that they spend the entire income each month on cola and
pizza. The price of a litre of cola is €2 and the price of a pizza is €10.
The table in Figure 4.1 shows some of the many combinations of cola and pizza that the consumer can
buy with their income. The first row in the table shows that if the consumer spends all their income on
pizza, they can eat 100 pizzas during the month, but would not be able to buy any cola at all. The second
row shows another possible consumption bundle: 90 pizzas and 50 litres of cola. And so on. Each con-
sumption bundle in the table uses up the consumer’s income – exactly €1,000.
The graph of this data is given in Figure 4.1. The line connecting points A to B is called the budget
constraint and shows the consumption bundles that the consumer can afford given a specified income.
Five points are marked on this figure. At point A, the consumer buys no cola and consumes 100 pizzas.
At point B, the consumer buys no pizza and consumes 500 litres of cola. At point C, the consumer buys
50 pizzas and 250 litres of cola. At point C, the consumer spends an equal amount (€500) on cola and pizza.

budget constraint the limit on the consumption bundles that a consumer can afford

Point D is inside the budget constraint. The consumer can afford to buy any combination inside the
budget constraint. In this example, point D shows a combination of 270 litres of cola and 15 pizzas; and if
the consumer chose to purchase this combination, they would not be using all their income, only spending
€690 on this combination. The assumption of the SEM is that the consumer would wish to maximize their
utility and could do so by spending all their income.
Point E is outside the budget constraint. No points outside the budget constraint are possible – the
consumer does not have the income to be able to afford any combination of pizza and cola to the right
of the budget constraint. Of course, these are only four of the many combinations of cola and pizza that
the consumer can choose given a specified income. All the points on and inside the line from A to B are
possible. In this case, it shows the trade-off between cola and pizza that the consumer faces.

Figure 4.1
The Consumer’s Budget Constraint
The budget constraint shows the various bundles of goods that the consumer can afford for a given income. Here the consumer buys
bundles of cola and pizza. The table and graph show what the consumer can afford if their income is €1,000, the price of cola is € 2 and
the price of pizza is €10.

Litres Spending Number Spending Total Quantity

of cola on cola (€) of pizzas on pizza (€) spending (€) of cola

0 0 100 1,000 1,000 500 B

50 100 90 900 1,000
100 200 80 800 1,000
150 300 70 700 1,000 E
200 400 60 600 1,000 D
270
250 500 50 500 1,000 250 C
300 600 40 400 1,000
350 700 30 300 1,000 Consumer’s
budget constraint
400 800 20 200 1,000
450 900 10 100 1,000
500 1,000 0 0 1,000 A
0 15 50 100 Quantity
of pizza

For example, assume the consumer is at point A, consuming 100 pizzas and zero cola. If the consumer
wants to purchase a drink to go with their pizza, they must give up some pizza to buy some cola – they
must trade-off the benefits of consuming cola against the benefits foregone of reducing their consump-
tion of pizza. We can quantify this trade-off. If the consumer moves to point C, then they must forego the
benefits that 50 pizzas would provide to gain the benefits that 250 litres of cola would bring. The consumer
would have to decide about whether it is worth giving up those 50 pizzas to get the benefits of the cola. In
making these decisions, the consumer must consider opportunity cost. The opportunity cost is the slope
of the budget constraint measuring the rate at which the consumer can trade one good for the other.
Remember, the slope between two points is calculated as the change in the vertical distance divided
by the change in the horizontal distance (‘rise over run’). From point A to point B, the vertical distance is
500 litres, and the horizontal distance is 100 pizzas. Because the budget constraint slopes downwards, the
slope is a negative number – this reflects the fact that to get one extra pizza, the consumer must reduce
their consumption of cola by 5 litres. In fact, the slope of the budget constraint (ignoring the minus sign)
equals the relative price of the two goods – the price of one good compared to the price of the other. A
pizza costs five times as much as a litre of cola, so the opportunity cost of a pizza is 5 litres of cola. The
budget constraint’s slope of 5 reflects the trade-off the market is offering the consumer: 1 pizza for 5 litres
of cola. It is useful to use a rule of thumb (a heuristic) here; the opportunity cost of a good on the horizontal
axis (pizza in our example) is the slope of the budget constraint (5 in this example). What is the opportu-
nity cost of 1 extra litre of cola in our example? The opportunity cost of the good on the vertical axis is the
inverse of the slope of the budget constraint, which in this case is 15 or 0.2. To acquire 1 extra litre of cola
the consumer must sacrifice one-fifth of a pizza.
It is also useful to think of opportunity cost by using the formula introduced in Chapter 1:
Sacrifice of pizza
Opportunity cost of cola 5
Gain in cola

In moving from point A to point C, the consumer would have to sacrifice 50 pizzas to gain 250 units of
cola. The opportunity cost of additional units of cola consumed is the amount of pizza sacrificed. Substi-
tuting the figures into the formula, the opportunity cost is 0.2, which indicates that the opportunity cost
of 1 additional unit of cola is 0.2 units of pizza sacrificed. Notice that throughout this analysis we are not
referring to money costs here – the cost is expressed in terms of the sacrifice of the next best alternative
(pizza in this example).

In some examples of budget constraints, you might find the opportunity cost calculation does not make
much sense. If the two goods being considered were cola and tins of soup you could not ask the shop to
chop up the tin of soup into five! What is important to remember is that the slope is related to the ratio
Px
of prices of the goods being considered (the relative prices), where Py is the price of the good on the
Py
vertical axis and Px is the price of the good on the horizontal axis. This may seem counter-intuitive as the
slope is given by ‘rise over run’, but note that the budget line in Figure 4.1 shows quantities on the y and
x axis. Price and quantity have an inverse relationship and so the slope of the budget line expressed as
relative prices of our two goods is the price of the good on the x axis to the price of the good on the y
10
axis. In our example the ratio of the prices is , which is equal to 5.
2

Self Test Draw a budget constraint for a person with income of €5,000 if the price of food is €10 per unit
and the price of leisure is €15 per hour. What is the slope of this budget constraint? What is the opportunity cost
of an extra hour of leisure in terms of food?

A Change in Income
Over time people’s incomes change – sometimes they earn more but sometimes they earn less, such as
if they are made redundant, for example. If our consumer gets a pay rise and now earns €1,500 per month,
they can now afford to buy more of both pizza and cola assuming the prices of these two goods do not
change. The effect on the budget constraint is to cause it to shift to the right, as shown in Figure 4.2. If
the consumer devoted all their income to buying cola, they could now buy 750 litres of cola compared to
500 litres when their income was €1,000 per month. If the consumer devoted all their income to buying
pizza, they could now afford to buy 150 pizzas a month. Any point along the new budget constraint shows
that the consumer can now buy more of both goods. If the consumer’s income were to fall to €500 per
month because they lost their job, for example, then the budget constraint would shift to the left, indicat-
ing that the consumer could now afford to buy less of both goods with their income.

Figure 4.2 Quantity

The Effect on the Budget Constraint of a Change in Income of cola
(litres per
An increase in income from €1,000 per month to €1,500 per month means the month)
consumer can now buy more of both goods assuming the price of cola and pizza 750
remain the same. The result is a shift in the budget constraint to the right.

500

0 100 150 Quantity

of pizza
(per month)

Notice, however, that while the budget constraint in Figure 4.2 has shifted to the right, the slope is still
the same. This is because the prices of the two goods have not changed. What happens to the budget
constraint if one or more of the prices of cola and pizza changes?

A Change in Prices
A Change in the Price of Cola Assume the consumer’s income is €1,000 per month, the price of cola is
€2 per litre and the price of pizza is €10. The budget constraint would look like that shown in Figure 4.1.
Now assume that the price of cola rises to €5 per litre. The consumer would now only be able to afford to
buy 200 litres of cola if they devoted all their income to cola. The budget constraint would, therefore, pivot
inwards as shown in Figure 4.3.
The slope of the budget constraint has now changed. The ratio of the price of cola to the price of pizza
is now 5 10 so the slope of the budget constraint is 22. For every 1 litre of cola the consumer acquires they
must give up half a pizza, and for every 1 extra pizza bought the consumer now must sacrifice 2 litres of
cola. Notice that as the price of cola has risen, the consumer must now sacrifice fewer litres of cola to
purchase every additional pizza, but if the consumer is switching from cola to pizza they must give up more
pizza to buy an additional litre of cola.
If the price of cola were to fall but the price of pizza stayed the same, the budget constraint would pivot
outwards as shown in Figure 4.3. If the price of cola fell to €1.60, the consumer would now be able to
afford to buy more cola with their income. If all income was devoted to buying cola, the consumer would
now be able to purchase 625 litres of cola.

Figure 4.3 Quantity

of cola
A Change in the Price of Cola (litres per
If the price of cola rises from € 2 per litre to €5 per litre, the consumer could 625
month)
now afford to buy less cola with their income. The budget constraint pivots
inwards, and if the consumer devoted all their income to cola, they would only 500
be able to buy 200 litres compared to 500 litres before the price changed. If the
price of cola falls from € 2 per litre to €1.60 per litre, the consumer could afford
to buy more cola with their income. The budget constraint pivots outwards,
and the consumer could now buy 625 litres of cola per month if they devoted
200
all their income to cola.

0 100 Quantity
of pizza
(per month)

A Change in the Price of Pizza The opposite happens if the price of pizza were to change but the price of
cola stayed the same. Assume the price of cola is €2 but the price of pizza rises to €12.50. If the consumer
devotes all their income to pizza, they can now afford to buy only 80 pizzas with their €1,000 income. The
budget constraint would pivot inwards and its slope would change. The ratio of the price of cola to the
2
price of pizza is now and the slope is 6.25. The inverse of the slope is 0.16. For every 1 litre of cola
12.5
the consumer acquires they must give up 0.16 of a pizza, and for every 1 extra pizza bought the consumer
now has to sacrifice 6.25 litres of cola. If the price of pizza falls to €8 then the consumer would be able to
purchase more pizza (125) with their income and so the budget constraint would pivot outwards as shown
in Figure 4.4.

A Change in the Price of Both Goods If the price of both goods changes then the shape of the budget
constraint would depend on the relative change in the prices of the two goods. The slope would still be
the ratio of the price of cola to the price of pizza. Figure 4.5 shows a rise in the price of cola from €2 to €4
and a fall in the price of pizza from €10 to €8. If the consumer devoted all their €1,000 per month income
to cola, they could now afford to buy 250 litres of cola, and if they devoted all their income to pizza, they
could now buy 125 pizzas per month. The ratio of the price of cola to the price of pizza would be 4 8, and so
the slope of the budget constraint would now be 2.

Figure 4.4
A Change in the Price of Pizza Quantity
of cola
A change in the price of pizza, ceteris paribus, would cause a pivot in the (litres per
budget constraint. If the price of pizza fell, the budget constraint would pivot month)
outwards, and if the price of pizza rose, the budget constraint would pivot 500
inwards.

0 80 100 125 Quantity

of pizza
(per month)

Figure 4.5
A Change in the Price of Both Cola and Pizza Quantity
The effect of a change in the price of both goods on the budget constraint of cola
(litres per
depends on the relative change in the prices of the two goods. In this example month)
the price of cola has risen and the price of pizza has fallen, causing the budget
constraint to change shape. The slope is now 2 . 500

250

0 100 125 Quantity

of pizza
(per month)

Preferences: What the Consumer Wants

The budget constraint shows what combination of goods the consumer can afford given their income and
the prices of goods, but a consumer’s choices also depend on their preferences. We will continue our anal-
ysis using cola and pizza as the consumer’s choice set – the set of alternatives available to the consumer.

choice set the set of alternatives available to the consumer

Representing Preferences with Indifference Curves

The consumer’s preferences allow them to choose between different bundles of cola and pizza. The SEM
assumes that consumers behave rationally and that, if you offer two different bundles, they chose the
bundle that best suits their tastes. Remember, we measure the level of satisfaction in terms of the utility
it yields. We can represent consumer preferences in relation to the utility that different bundles of goods

provide. If a consumer prefers one bundle of goods to another, the assumption of the SEM is that the first
provides more utility than the second. If two bundles yield the same utility then the consumer is said to
be indifferent between them. We can represent these preferences as indifference curves. An indifference
curve shows the bundles of consumption that yield the same utility, i.e. makes the consumer equally
happy. You can think of an indifference curve as an ‘equal-utility’ curve.

indifference curve a curve that shows consumption bundles that give the consumer the same level of satisfaction

In our example we are going to use indifference curves that show the combination of cola and pizza
with which the consumer is equally satisfied.
This model of preferences includes particular assumptions based on two axioms (points of reference
or starting points).
●● The Axiom of Comparison Given any two bundles of goods, A and B, representing consumption
choices, a consumer can compare these bundles such that A is preferred to B, B is preferred to A or the
consumer is indifferent between A and B.
●● The Axiom of Transitivity Given any three bundles of goods, A, B and C, if the consumer prefers A to
B and prefers B to C then they must prefer A to C. Equally, if the consumer is indifferent between A and
B and is also indifferent between B and C then they must be indifferent between A and C.

Representing Indifference Curves Graphically

We can represent indifference curves graphically. The quantity of cola is on the vertical axis and the quan-
tity of pizza is on the horizontal axis. The graph is sometimes called an indifference map. The map contains
an infinite number of indifference curves. Figure 4.6 shows two of the consumer’s many indifference
curves.
The points A, B and C on indifference curve I1 in Figure 4.6 all represent different combinations of
cola and pizza. The consumer is indifferent between these combinations. However, indifference curve
I2 is further to the right than curve I1 and, given the monotonicity assumption (that more is preferred
to less), the consumer would prefer to be on the highest indifference curve possible. Any point on I2,
therefore, is preferred to any point on I1 because any combination of goods on I2 gives higher utility than
any point on I1.

Figure 4.6
The Consumer’s Preferences Quantity
The consumer’s preferences are represented with indifference curves of cola
which show the combinations of cola and pizza that make the consumer (litres per
equally satisfied. Because of the assumption that more is preferred month)
to less, points on a higher indifference curve (I 2 here) are preferred to A
E
points on a lower indifference curve (I1 ) . A point along an indifference
curve such as point B on indifference curve I1 , represents a bundle or
combination of goods, cola and pizza in this case. The consumer is D
indifferent between any point along an indifference curve such as A, B
B or C along indifference curve I1 . Points D and E on indifference curve
I 2 also represent combinations of goods between which the consumer I2
C
is indifferent, but any point on indifference curve l 2 is preferred to any I1
point on indifference curve l1 .
0 Quantity
of pizza
(per month)

We can use indifference curves to rank any two bundles of goods. For example, the indifference curves
tell us that point D is preferred to point B because point D is on a higher indifference curve than point B.
This conclusion may be obvious, given that point D offers the consumer both more pizza and more cola.
However, point D is also preferred to point A because even though point D has less cola than point A, it
has more than enough extra pizza to make the consumer prefer it. By seeing which point is on the higher
indifference curve, we can use the set of indifference curves to rank any combinations of cola and pizza.

Four Properties of Indifference Curves

Because indifference curves represent a consumer’s preferences, they have certain properties that reflect
those preferences.

Property 1: Higher Indifference Curves (Further to the Upper Right) Are Preferred to Lower Ones This
is because of the monotonicity assumption that consumers prefer more of something to less of it. Higher
indifference curves represent larger quantities of goods than lower indifference curves. Thus the con-
sumer prefers being on higher indifference curves.

Property 2: Indifference Curves Are Downwards Sloping The slope of an indifference curve reflects the
rate at which the consumer is willing to substitute one good for the other. In most cases, the consumer
likes both goods. Therefore if the quantity of one good is reduced, the quantity of the other good must
increase for the consumer to be equally happy. For this reason, most indifference curves slope downwards.

Property 3: Indifference Curves Do Not Cross To see why this is true, suppose that two indifference
curves did cross, as in Figure 4.7. Notice that point A is on the same indifference curve as point B; the two
points would make the consumer equally happy. In addition, because point B is on the same indifference
curve as point C, these two points would make the consumer equally happy. These conclusions imply
that points A and C would also make the consumer equally happy, even though point C has more of both
goods. This contradicts the axiom of transitivity and thus indifference curves cannot cross.

Figure 4.7
Intersecting Indifference Curves Quantity
of cola
Intersecting indifference curves would violate the axiom of (litres per
transitivity and under the assumptions of the model could not occur. month) C
According to these indifference curves, the consumer would be
equally satisfied at points A, B and C, even though point C has more A
of both goods than point A.
B
I2
I1

0 Quantity
of pizza
(per month)

Property 4: Indifference Curves Are Bowed Inwards (Convex) The slope of an indifference curve is the
marginal rate of substitution (MRS), which we will cover in more detail later. The marginal rate of substi-
tution usually depends on the amount of each good the consumer is currently consuming. In particular,
because people are more willing to trade away goods that they have in abundance and less willing to trade
away goods of which they have little, indifference curves are bowed inwards, or are convex. The assump-
tion is, therefore, that consumers would prefer averages to extremes. As an example, consider Figure 4.8.
At point A, because the consumer has a lot of cola and only a little pizza, they are very hungry but not very
thirsty. To induce the consumer to give up 1 pizza, the consumer must be given 6 litres of cola: the marginal
rate of substitution is 6 litres of cola per pizza. By contrast, at point B, the consumer has little cola and a lot
of pizza, so they are very thirsty but not very hungry. At this point, they would be willing to give up 1 pizza

to get 1 litre of cola: the marginal rate of substitution is 1 litre of cola per pizza. Thus the bowed or convex
shape of the indifference curve reflects the consumer’s greater willingness to give up a good that they
already have in a large quantity.

Figure 4.8
Quantity
Bowed or Convex Indifference Curves of cola
Indifference curves are usually bowed inwards (litres per
(convex). This shape occurs because at point A, the month) 14
consumer has little pizza and much cola, so they
require a lot of extra cola to induce them to give MRS = 6
up one of the pizzas: 6 litres of cola per pizza, to be
A
precise. At point B, the consumer has much pizza 8
1
and little cola, so they require only a little extra
cola to induce them to give up one of the pizzas,
4 MRS = 1 B
1 litre of cola in this example. 3
1 Indifference
curve
0 2 3 6 7 Quantity
of pizza
(per month)

Total and Marginal Utility

Remember the assumption of monotonicity, that consumers prefer more to less. This does not mean
that if a consumer eats more and more pizza or drinks more and more cola that the utility on an additional
unit consumed is always the same. We need to distinguish between total utility and marginal utility.
Total utility is the satisfaction consumers’ gain from consuming a product. The marginal utility of con-
sumption is the increase in utility the consumer gains from an additional (marginal) unit of that good.

total utility the satisfaction gained from the consumption of a good

marginal utility the addition to total utility as a result of consuming one extra unit of a good

Imagine that you have been working hard and now realize that you are very hungry. You head to the
university canteen and buy a pizza. You eat the first slice of pizza very quickly because you are so hungry.
If you were asked to rate the satisfaction (out of 10) from consuming that first slice, you might rate it as
10 out of 10. You then turn to the second slice, that too is good, but when you come to rate it you don’t
give it quite as many out of 10 as the first slice – say you give the second slice 9 out of 10. The total utility
of the two slices of pizza is 19 but the additional utility of the first slice was 10 and of the second slice, 9.
You now consume the third slice. By now your immediate hunger has been satisfied, and you find the third
slice is not as satisfying, and you rate this as 7 out of 10. Total utility has risen to 26, but the marginal utility
of the third slice is 7. As you finish off the remaining three slices, you find you did not really enjoy the last
slice – you might even have decided to leave part of it, as you are now full. If someone now offered to buy
you a second pizza you might refuse – eating one extra slice might just result in you being sick – and in this
case, you might even rate this next slice as having negative utility.
The tendency for the total utility from consumption to rise but at a slower rate with additional units of
consumption is called diminishing marginal utility. Diminishing marginal utility refers to the tendency
for the additional satisfaction from consuming extra units of a good to fall. Most goods are assumed to
exhibit diminishing marginal utility; the more of the good the consumer already has, the lower the marginal
utility provided by an extra unit of that good.

diminishing marginal utility the tendency for the additional satisfaction from consuming extra units of a good to fall

The Marginal Rate of Substitution

Figure 4.9 shows an indifference curve and three combinations of cola and pizza represented by points A,
B and C. We know that the consumer is indifferent between these combinations. Assume the consumer
starts at the combination of cola and pizza represented by point A with a combination of 20 pizzas and
5 litres of cola. If the consumer’s consumption of pizza is reduced from point A to point B, the consumer
is willing to give up 10 pizzas to increase consumption of cola from 5 litres to 12 litres. We know, however,
that the additional consumption of cola will be subject to diminishing marginal utility. Moving from point B
to point C, the consumer is willing to give up only 5 pizzas to gain an additional 8 litres of cola such that
the bundle 5 pizzas and 20 litres of cola yields the same utility as at points B and A.

Figure 4.9
Quantity
The Marginal Rate of Substitution of cola
The slope of an indifference curve is not constant throughout (litres per
month)
its length, but changes at every point. The marginal rate of
substitution measures the rate at which a consumer is prepared 20 C
to substitute one good for another.

12 B

A
5 I1

0 5 10 20 Quantity
of pizza
(per month)

In our example, the consumer starts off with a relatively large amount of pizza and a relatively small
amount of cola. It is logical to assume that the consumer would be willing to give up relatively large
amounts of pizza to acquire some additional cola. However, moving from point B to point C is a slightly
different matter. The situation is almost reversed – to gain additional litres of cola the consumer is now
willing to sacrifice fewer pizzas.
The rate at which consumers are willing to substitute one good for another is called the marginal rate of
substitution. The slope at any point on an indifference curve equals the rate at which the consumer is will-
ing to substitute one good for the other. The marginal rate of substitution (MRS) between two goods
depends on their marginal utilities. In this case, the marginal rate of substitution measures how much cola
the consumer requires to be compensated for a one unit reduction in pizza consumption. For example,
if the marginal utility of cola is twice the marginal utility of pizza, then a person would need 2 units of pizza
to compensate for losing 1 unit of cola, and the marginal rate of substitution equals 22. More generally,
the marginal rate of substitution is the slope of the indifference curve.

marginal rate of substitution the rate at which a consumer is willing to trade one good for another

Notice that because the indifference curves are not straight lines, the marginal rate of substitution is
not the same at all points on a given indifference curve.

Two Extreme Examples of Indifference Curves

The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the
other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when
the goods are hard to substitute, the indifference curves are very bowed. To see why this is true, let’s
consider the extreme cases.

Perfect Substitutes Suppose that someone offered you bundles of 50 cent coins and 10 cent coins. How
would you rank the different bundles?
Most probably, you would care only about the total monetary value of each bundle. If so, you would
judge a bundle based on the number of 50 cent coins plus five times the number of 10 cent coins. In
other words, you would always be willing to trade one 50 cent coin for five 10 cent coins, regardless of
the number of coins in either bundle. Your marginal rate of substitution between 10 cent coins and 50 cent
coins would be a fixed number: 5.
We can represent your preferences over 50 cent coins and 10 cent coins with the indifference curves in
panel (a) of Figure 4.10. Because the marginal rate of substitution is constant, the indifference curves are
straight lines. In this extreme case of straight indifference curves, we say that the two goods are perfect
substitutes.

perfect substitutes two goods with straight line indifference curves

Perfect Complements Suppose now that someone offered you bundles of shoes. Some of the shoes fit
your left foot, others your right foot. How would you rank these different bundles?
In this case, you might care only about the number of pairs of shoes. In other words, you would judge a
bundle based on the number of pairs you could assemble from it. A bundle of five left shoes and seven right
shoes yields only five pairs. Getting one more right shoe has no value if there is no left shoe to go with it.
We can represent your preferences for right and left shoes with the indifference curves in panel (b) of
Figure 4.10. In this case, a bundle with five left shoes and five right shoes is just as good as a bundle with
five left shoes and seven right shoes. It is also just as good as a bundle with seven left shoes and five right
shoes. The indifference curves, therefore, are right angles. In this extreme case of right angle indifference
curves, we say that the two goods are perfect complements.

perfect complements two goods with right angle indifference curves

Figure 4.10
Perfect Substitutes and Perfect Complements
When two goods are easily substitutable, such as 50 cent and 10 cent coins, the indifference curves are straight lines, as shown in
panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as
shown in panel (b).

(a) Perfect substitutes (b) Perfect complements

10 cent Left
shoes
15

10
I2
7

5 I1
5

I1 I2 I3
0 1 2 3 50 cent 0 5 7 Right shoes

In the real world, of course, most goods are neither perfect substitutes nor perfect complements. More
typically, the indifference curves are bowed inwards, but not so bowed as to become right angles.

Self Test Why is the amount of a good a person is consuming at a given point in time an important factor in
determining the marginal rate of substitution? What happens to the total and marginal utility of two goods, y and x,
if a consumer has a large quantity of good x but hardly any of good y and then opts to consume more of good x?

Optimization: What the Consumer Chooses

One of the working assumptions of the SEM is that the consumer will seek to maximize utility subject to
the constraint of a limited income. This is an example of a constrained optimization problem. How is this
constrained optimization problem solved?

The Consumer’s Optimal Choices

Using our cola and pizza example, taking into account the constraint of income as shown by the budget
constraint, the consumer would like to end up with a combination of cola and pizza on the highest possible
indifference curve.
Figure 4.11 shows the consumer’s budget constraint (BC1 ) and four of their many indifference curves.
The highest indifference curve that the consumer can reach (I3 in the figure) is the one that just barely
touches the budget constraint. The point at which this indifference curve and the budget constraint touch
is called the optimum. The consumer would prefer point A, but they cannot afford that point because it
lies above their budget constraint. The consumer can afford point B, but that point is on a lower indiffer-
ence curve and, therefore, provides the consumer less satisfaction. Taking into account the assumptions
of the model, there is an alternative consumption choice, given their income, which would be preferable.
The combination of cola and pizza at point C is affordable, being just on the budget constraint, but the
consumer is not in equilibrium because there is an incentive for them to change their consumption choice
and reach a higher indifference curve. What this means is that the consumer can reallocate their spending
decisions and get more utility from their limited income. There is an incentive for them to reduce con-
sumption of pizza and increase consumption of cola at point D on indifference curve I2. By doing this the
consumer is getting more utility from an additional euro spent on more cola compared to the marginal
utility spent on another pizza. This is entirely logical. If you could spend one euro on more cola and get an
extra 7 utils of utility compared to an extra 5 utils you would get from more pizza with the same euro, it
makes sense to buy more cola (assuming rational behaviour).

Figure 4.11
Quantity
The Consumer’s Optimum of cola
The consumer chooses the point on their budget constraint (litres per
that lies on the highest achievable indifference curve. month)
At this point, called the optimum, the marginal rate of
substitution equals the relative price of the two goods. Here B
the highest indifference curve the consumer can reach is l 3 . Optimum

A
D I4
I3
I2
C I1
BC1
0 Quantity
of pizza
(per month)

However, this is still not the optimum because the consumer can continue to reallocate their
spending decisions reaching ever higher indifference curves (remember there are an infinite amount
on the map) until the marginal utility of the last euro spent on cola is equal to the marginal utility of
the last euro spent on pizza. The optimum represents the best combination of consumption of cola
and pizza available to the consumer given their income and the assumptions of consumer behaviour
in the model.
At the point of consumer equilibrium (the optimum), the slope of the indifference curve equals the
slope of the budget constraint. We say that the indifference curve is tangential to the budget constraint.
The slope of the indifference curve is the marginal rate of substitution between cola and pizza, and the
slope of the budget constraint is the relative price of cola and pizza. Thus the consumer chooses con-
sumption of the two goods at the optimum so that the marginal rate of substitution equals the relative
price.
That is:

Px
MRS 5
Py

Because the marginal rate of substitution equals the ratio of marginal utilities, we can write this condi-
tion for optimization as:

MU x P
5 x
MUy Py

This expression can be rearranged to become:

MU x MUy
5
Px Py

At the optimum, the marginal utility per euro spent on good x equals the marginal utility per euro
spent on good y . At any other point, the consumer is not in equilibrium. Why? As we saw above, this
is because the consumer could increase utility by changing behaviour, switching spending from the
good that provided lower marginal utility per euro to the good that provided higher marginal utility per
euro.
At the consumer’s optimum, the consumer’s valuation of the two goods (as measured by the marginal
rate of substitution) equals the market’s valuation (as measured by the relative price). As a result of this
consumer optimization, market prices of different goods reflect the value that consumers place on those
goods.

How Changes in Income Affect the Consumer’s Choices

When income increases, there is a parallel shift of the budget constraint with the same slope as the
initial budget constraint because the relative price of the two goods has not changed. The increase
in income means there is an incentive for the consumer to reallocate their spending decisions to
increase utility and choose a better combination of cola and pizza. The consumer reallocates income
until they reach a new optimum labelled ‘new optimum’ on a higher indifference curve, as shown in
Figure 4.12.
Notice that in Figure 4.12 the consumer chooses to consume more cola and more pizza, although
the logic of the model does not require increased consumption of both goods in response to increased
income. Remember, if a consumer wants more of a good when their income rises, economists call it a
normal good. The indifference curves in Figure 4.12 are drawn under the assumption that both cola and
pizza are normal goods.
Figure 4.13 shows an example in which an increase in income induces the consumer to buy more pizza
but less cola.
If a consumer buys less of a good when their income rises, economists call it an inferior good. Figure 4.13
is drawn under the assumption that pizza is a normal good and cola is an inferior good.

Figure 4.12
Quantity
An Increase in Income New budget constraint
of cola
When the consumer’s income rises, the
(litres per
budget constraint shifts out to the right. If
month)
both goods are normal goods, the consumer
responds to the increase in income by buying 1. An increase in income shifts the
budget constraint outward ...
more pizza and more cola.
New optimum

3. ... and cola

consumption. Initial
optimum I2

Initial
budget
constraint I1

0 Quantity
2. ... raising pizza consumption ... of pizza
(per month)

Figure 4.13
Quantity
An Inferior Good of cola New budget constraint
A good is an inferior good if the consumer (litres per
buys less of it when their income rises. month)
Here cola is an inferior good: when
the consumer’s income increases and the 1. When an increase in income
budget constraint shifts outwards, the shifts the budget constraint
consumer buys more pizza but less cola. outward ...
3. ... but cola Initial
consumption optimum
falls, making
cola an inferior
New optimum
good.

Initial
budget I1 I2
constraint
0 Quantity
of pizza
2. ... pizza consumption rises, (per month)
making pizza a normal good ...

How Changes in Prices Affect the Consumer’s Choices

Suppose that the price of cola falls from €2 to €1 a litre. We have seen how a change in the price of any
good causes the budget constraint to pivot. With their available income of €1,000 the consumer can now
buy twice as many litres of cola than before, but the same amount of pizza. Figure 4.14 shows that point
A stays the same (100 pizzas). Yet if the consumer spends their entire income of €1,000 on cola, they can
now buy 1,000 rather than only 500 litres. Thus the end point of the budget constraint pivots outwards from
point B to point C.

The pivoting of the budget constraint changes its slope. Because the price of cola has fallen to €1 from
€2, while the price of pizza has remained €10, the consumer can now trade a pizza for 10 rather than 5 litres
of cola. As a result, the new budget constraint is more steeply sloped. How such a change in the budget
constraint alters the consumption of both goods depends on the consumer’s preferences. For the indiffer-
ence curves drawn in Figure 4.14, the consumer buys more cola and less pizza.

Figure 4.14
Quantity
A Change in Price of cola
When the price of cola (litres per month)
falls, the consumer’s budget C New budget constraint
1,000
constraint pivots outwards and
changes slope. The consumer
moves from the initial optimum
to the new optimum, which
changes their purchases of both New optimum
cola and pizza. In this case, B 1. A fall in the price of cola rotates
the quantity of cola consumed 500
the budget constraint outward ...
rises and the quantity of pizza 3. ... and raising
consumed falls. Initial optimum
cola consumption.

Initial I2
budget I1
constraint A
0 100 Quantity
of pizza
2. ... reducing pizza
consumption ... (per month)

Income and Substitution Effects

In Chapter 3 we took a brief look at the income effect and the substitution effect as reasons why a fall in
price leads to a rise in quantity demanded.

income effect the change in consumption that results when a price change moves the consumer to a higher or lower
indifference curve
substitution effect the change in consumption that results when a price change moves the consumer along a given
indifference curve to a point with a new marginal rate of substitution

Consider this thought experiment. If the price of cola falls, you are now able to purchase more cola with
your income – you are in effect richer and can buy both more cola and more pizza. For example, assume
your income is €1,000 and the initial price of cola is €2 and pizza is €10. You currently buy 250 litres of cola
and 50 pizzas. If the price of cola falls to €1 per litre you can adjust your spending and now buy 300 litres
of cola (spending €300) and use the remaining €700 to buy more pizza than before (70 pizzas). This is the
income effect.
Second, note that now the price of cola has fallen, you get more litres of cola for every pizza you give
up. Because pizza is now relatively more expensive, you might decide to buy less pizza and more cola.
This is the substitution effect.
Both of these effects occur when prices change. The decrease in the price of cola makes the consumer
better off. If cola and pizza are both normal goods, the consumer will want to spread this improvement in
their purchasing power over both goods. This income effect tends to make the consumer buy more pizza
and more cola. Yet, at the same time, consumption of cola has become less expensive relative to con-
sumption of pizza. This substitution effect tends to make the consumer choose more cola and less pizza.

The end result of these two effects is that the consumer certainly buys more cola, because the income
and substitution effects both act to raise purchases of cola. But it is ambiguous whether the consumer
buys more pizza, because the income and substitution effects work in opposite directions. This conclusion
is summarized in Table 4.1.

Income and Substitution Effects When the Price of Cola Falls

Table 4.1
Good Income effect Substitution effect Total effect
Cola Consumer is richer, Cola is relatively cheaper, so Income and substitution effects act in same
so they buy more cola. consumer buys more cola. direction, so consumer buys more cola.

Pizza Consumer is richer, Pizza is relatively more Income and substitution effects act in
so they buy more pizza. expensive, so consumer opposite directions, so the total effect on
buys less pizza. pizza consumption is ambiguous.

We can interpret the income and substitution effects using indifference curves:
●● The income effect is the change in consumption that results from the movement to a new indifference curve.
●● The substitution effect is the change in consumption that results from moving to a new point on the
same indifference curve with a different marginal rate of substitution.

Decomposing the Income and Substitution Effect Figure 4.15 shows graphically how to decompose the
change in the consumer’s decision into the income effect and the substitution effect.
When the price of cola falls, the consumer moves from the initial optimum, point A, to the new opti-
mum, point C. We can view this change as occurring in two steps:
●● First, the consumer moves along the initial indifference curve I1 from point A to point B – this is the
substitution effect. The consumer is equally happy at these two points, but at point B the marginal rate
of substitution reflects the new relative price. (The dashed line through point B reflects the new relative
price by being parallel to the new budget constraint.)
●● Next, the consumer shifts to the higher indifference curve I2 by moving from point B to point C – this is
the income effect. Even though point B and point C are on different indifference curves, they have the
same marginal rate of substitution. That is, the slope of the indifference curve I1 at point B equals the
slope of the indifference curve I2 at point C.

Figure 4.15
Quantity
Income and Substitution Effects of cola
The effect of a change in price can be broken (litres per
down into an income effect and a substitution month) New budget constraint
effect. The substitution effect – the movement
along an indifference curve to a point with
a different marginal rate of substitution – is
shown here as the change from point A to C
point B along indifference curve I1 . The income New optimum
Income
effect – the shift to a higher indifference B
effect
curve – is shown here as the change from Initial optimum
point B on indifference curve I1 to point C on Substituion Initial
indifference curve I 2 . effect budget
constraint A
I2

I1
0 Quantity
Substitution effect of pizza
Income effect (per month)

Although the consumer never actually chooses point B, this hypothetical point is useful to clarify the
two effects that determine the consumer’s decision. Notice that the change from point A to point B rep-
resents a pure change in the marginal rate of substitution without any change in the consumer’s welfare.
Similarly, the change from point B to point C represents a pure change in welfare without any change in
the marginal rate of substitution. Thus the movement from A to B shows the substitution effect, and the
movement from B to C shows the income effect.

Income and Substitution Effects: A Numerical Example In the March 2016 Budget, the UK Chancellor
of the Exchequer introduced a tax on sugary drinks. The tax added around 24p to a litre of these drinks,
and we can use this to estimate the income and substitution effect of the change in price. Assume that
the individual demand function for sugary drinks is given by:
Y
D1 5 10 1
10(Px )
Further assume that the individual’s income is £500 per week and the initial price of sugary drinks per
litre is £3. Substituting these figures into the demand function gives:
500
D1 5 10 1
10(3)
500
D1 5 10 1
30
D1 5 10 1 16.7
D1 5 26.67 litres per week (2dp).

Now assume that the after-tax price of sugary drinks rises to £3.25 per litre but income stays the same
at £500 per week. The new demand for sugary drinks will now be:
500
D2 5 10 1
10(3.25)
500
D2 5 10 1
32.5
D2 5 25.38 litres per week (2dp).

The overall effect of the tax is to reduce the demand for sugary drinks by this individual by 1.29 litres per week.
To find how much of this reduction in demand was due to the income effect and how much to the substitu-
tion effect, we find what demand would be if income was adjusted to keep purchasing power constant. Taking
D1 and multiplying it by the difference in the price as a result of the tax gives us 26.67(3.25 2 3.00) 5 6.67.
To keep purchasing power constant, therefore, income would need to be £506.67. We can find the substi-
tution effect by substituting the equivalized income and new price into the demand function:
506.67
D3 5 10 1
10(3.25)
506.67
D3 5 10 1
32.5
D3 5 25.6

The substitution effect is 25.6 2 26.67 5 21.07.

The income effect will be 1.29 2 1.07 5 0.22.

Self Test Draw a budget constraint line and indifference curves for cola and pizza. Show what happens to
the budget constraint and the consumer’s optimum when the price of pizza rises. In your diagram, decompose
the change into an income effect and a substitution effect.

Deriving the Demand Curve

Using the logic we have developed so far, we can now look at how the demand curve is derived. The demand
curve shows the quantity demanded of a good for any given price. We can view a consumer’s demand curve
as a summary of the optimal decisions that arise from their budget constraint and indifference curves.

Figure 4.16 considers the demand for pizza. Assume the price of pizza is €10 indicated by the budget
constraint BC1 and a consumer optimum with indifference curve I1 giving a quantity of pizza bought as Q1.
A series of other budget constraints labelled BC2 to BC5 indicate successive lower prices of pizza and
the different consumer optimums indicated by the varying quantities of pizza purchased. The consumer
optimums associated with each price of pizza are shown as the price–consumption curve. The price–
consumption curve shows the consumer optimum for two goods as the price of one of the goods changes
ceteris paribus.

price–consumption curve a line showing the consumer optimum for two goods as the price of one of the goods
changes, assuming incomes and the price of the good are held constant

Figure 4.16 represents the relationship between the change in the price of pizza and the quantity
demanded. The price–quantity relationship is plotted on the lower graph to give the familiar demand curve.
As the price of pizza falls the quantity demanded rises – the reasons being partly due to the income effect
and partly to the substitution effect. The theory of consumer choice, therefore, provides the theoretical
foundation for the consumer’s demand curve, which we first introduced in Chapter 3.

Figure 4.16
Quantity
Deriving the Demand Curve of cola
The upper graph shows that when the price
of pizza falls, the consumer’s optimum
changes. These changes are shown as the
price–consumption curve. The demand
curve in the lower graph reflects the
relationship between the price of pizza and
the quantity demanded. Price-consumption curve
I5

I3 I 4
I2
BC1 BC2 I1 BC3 BC4 BC5
Q1 Q2 Q3 Q4 Q5 Quantity
of pizza
Price of
pizza

P5 D

Q1 Q2 Q3 Q4 Q5 Quantity
of pizza

Do All Demand Curves Slope Downwards? The law of demand implies that when the price of a good rises,
people buy less of it. This law is reflected in the downwards slope of the demand curve. As a matter of eco-
nomic theory, however, demand curves can sometimes slope upwards, violating the law of demand where
consumers buy more of a good when the price rises. To see how this can happen, consider Figure 4.17.
In this example, the consumer buys two goods – meat and potatoes. Initially, the consumer’s budget
constraint is the line from point A to point B. The optimum is point C. When the price of potatoes rises, the
budget constraint shifts inwards and is now the line from point A to point D. The optimum is now point E.
Notice that a rise in the price of potatoes has led the consumer to buy a larger quantity of potatoes.
The consumer might respond in this seemingly perverse way if the good in question, potatoes in
this example, are a strongly inferior good. When the price of potatoes rises, the consumer is poorer. The
income effect makes the consumer want to buy less meat and more potatoes. At the same time, because
potatoes have become more expensive relative to meat, the substitution effect makes the consumer want
to buy more meat and less potatoes. In this particular case, however, the income effect is so strong that
it exceeds the substitution effect. In the end, the consumer responds to the higher price of potatoes by
buying less meat and more potatoes.
Economists use the term ‘Giffen good’ to describe a good that violates the law of demand. (The term
is named after the British economist Robert Giffen, who noted this possibility.) In our example, potatoes
are a Giffen good. Giffen goods are inferior goods for which the income effect dominates the substitution
effect. Therefore, they have demand curves that slope upwards.

Giffen good a good for which an increase in the price raises the quantity demanded

Figure 4.17
Quantity of
A Giffen Good potatoes Initial budget constraint
In this example, when the price of B
potatoes rises, the consumer’s optimum
shifts from point C to point E; the
consumer responds to a higher price of Optimum with high
potatoes by buying less meat and more price of potatoes
potatoes. Optimum with low
D price of potatoes
E
2. ... which increases 1. An increase in price of
potato consumption C potatoes rotates the budget
if potatoes are a constraint inwards ...
Giffen good.
I1
New budget I2
constraint
0 A Quantity
of meat

Economists disagree about whether any Giffen good has ever been discovered. Some historians sug-
gest that potatoes were in fact a Giffen good during the Irish potato famine of the nineteenth century.
Potatoes were such a large part of people’s diet (historians estimate that the average working man might
have eaten up to 14 pounds (6.3 kg) of potatoes a day) that when the price of potatoes rose, it had a large
income effect. People responded to their reduced living standard by cutting back on the luxury of meat
and buying more of the staple food of potatoes. Thus it is argued that a higher price of potatoes raised the
quantity of potatoes demanded.
Whether or not this historical account is true, it is safe to say that Giffen goods are very rare. Some
economists (for example, Dwyer and Lindsey (1984) and Rosen (1999)) have claimed that a legend has
built up around Robert Giffen and that the evidence does not support his idea. Jensen and Miller (2008)
suggested that rice and wheat in parts of China might exhibit Giffen qualities.

References: Dwyer, G.P. and Lindsay, C.M. (1984) ‘Robert Giffen and the Irish Potato’. The American Economic
Review, 74: 188–92.
Jensen, R. and Miller, N. (2008) ‘Giffen Behavior and Subsistence Consumption’. American Economic Review, 97:
1553–77.
Rosen, S. (1999) ‘Potato Paradoxes’. The Journal of Political Economy, 107: 294–313.

The Income Expansion Path

Having looked at conclusions that can be drawn from assuming a change in price (holding all other things
constant), we now turn our attention to what happens if we change income (ceteris paribus).
How does the rational consumer respond to a change in income? We have noted that, for a normal
good, a rise in income is associated with a rise in demand but, for an inferior good, a rise in income means
a fall in demand. We now have the analytical tools to understand why this is the case.

Normal Goods Figure 4.18 shows a series of increases in income represented by three budget con-
straints BC1, BC2 and BC3 for cola and pizza. The consumer optimums in each case are indicated by points
A, B and C.
If we connect these points we get the income expansion path which reflects the response of a rational
consumer to a change in income. In this example, the increase in income has led to an increase in the
consumption of both pizza and cola, and as a result we can conclude that both goods are normal goods.
In both goods, the income effect outweighs the substitution effect.

Figure 4.18
Quantity
The Income Expansion Path of cola
As income increases, shown by the shifts in the budget constraint
from BC1 to BC3 , the consumer optimum changes as shown by the
income expansion path. In this example, both cola and pizza are
normal goods – as income rises the demand for cola and pizza rises.

Income expansion path

C
B
A
I3
I2
BC2 BC3
BC1 I1
Quantity
of pizza

Where Pizza Is an Inferior Good Figure 4.19 shows a situation where as a result of the increase in
income, represented by a shift of the budget constraint from BC1 to BC2, there is a change in the consumer
optimum from point A to point B. The income expansion path indicates that as income rises, demand for
cola increases (it is a normal good) but the demand for pizza has decreased indicating that it is an inferior
good. In this case the substitution effect on pizza of the rise in income has outweighed the income effect.

Where Cola Is an Inferior Good Figure 4.20 shows a situation again where, as a result of the increase in
income, the budget constraint shifts from BC1 to BC2, and the consumer optimum is represented by points
A and B. In this case the income expansion path shows that as income rises, demand for cola decreases,
showing that it is an inferior good. The demand for pizza has increased as a result of the increase in income
indicating that it is a normal good. In this case the substitution effect of the rise in income on cola is greater
than the income effect.

Figure 4.19
Quantity
The Income Expansion Path Where Pizza Is an of cola
Inferior Good
The increase in income has caused the consumer optimum to
change from point A to point B. The demand for cola has risen,
but the demand for pizza has fallen indicating that pizza is an
Income expansion path
inferior good in this example.

A
I1
BC1 BC2
Quantity
of pizza

Figure 4.20
Quantity
The Income Expansion Path Where Cola Is an of cola
Inferior Good
The increase in income has caused the consumer optimum
to change from point A to point B. The demand for cola
has fallen, but the demand for pizza has risen indicating
that cola is an inferior good in this example.

A
B
Income expansion path

BC2 I2
BC1 I1
Quantity
of pizza

The Engel Curve

The income expansion path allows us to see an interesting discovery made by German statistician, Ernst
Engel (1821–96). Engel spent some time investigating the relationship between changes in income and
spending on broad categories of goods such as food. In 1857, Engel proposed a theory referred to as
‘Engel’s law’. Engel observed that as income rises the proportion of income spent on food decreases,
whereas the proportion of income devoted to other goods, such as leisure, increases.
For example, imagine a family of four has a combined annual income of €45,000 and spends €15,000 of
that income on food. This represents a third of the family’s income spent on food. If the combined income
then doubled to €90,000 it is unlikely that spending on food will rise to €30,000; it might rise to €20,000
and if it did then the proportion spent on food would now be just over 22 per cent.
Engel’s findings have been observed and supported many times since his discovery and have important
implications for government policy and for businesses. For example, if incomes are rising, firms selling
food will not see their revenues rising in proportion to the change in incomes. In economies where per
capita income is very low, any increase in incomes may see higher proportions initially spent on food,
but then start to decline as these economies change to become emerging economies. Equally, in many

countries the poor will spend a higher proportion of their income on food than will those on middle and
high incomes. Businesses selling other goods, such as those in the leisure industry, may find that as
incomes rise expenditure on their goods and services increases.
Note that as incomes increase, families may spend a small proportion of their income on food, but
that does not mean to say that food is not a normal good. At low levels of income, spending on food is
important – families must live. As income increases spending on food increases, but the rate at which
it increases starts to fall. The income elasticity of demand for food is likely to become more inelastic
as income increases. Conversely, the income elasticity of demand for other goods (which we shall call
luxuries) increases as income increases and at a faster rate – the income elasticity of demand for luxuries
becomes more elastic as income rises.
The upper graph in Figure 4.21 shows two goods: food on the vertical axis and luxuries on the horizontal
axis. As income increases, as shown by the three budget constraints BC1 to BC3, the change in consumer
optimum is shown by the three points A, B and C. As income increases, the demand for food and luxuries
both increase – both are normal goods. However, the amount of food demanded is increasing at a diminish-
ing rate, whereas the increase in demand for luxuries is greater as income increases. The implication, there-
fore, is that the demand for food is income inelastic whereas the demand for luxuries is income elastic.

Figure 4.21
Quantity
The Engel Curve of food
The upper graph shows the income–consumption curve for two
goods, food and luxuries, which are both normal goods. The lower
graph plots the change in demand for luxuries against changes in
income.

B C
Income–consumption curve
A

I3
BC2
BC1 BC3 I2
I1
Quantity of
luxuries
Income (€)

Engel curve
Y3
C

Y2 B

Y1 A

Q1 Q2 Q3 Demand for
luxuries

The relationship between income and the demand for luxuries is plotted on the lower graph in Figure 4.21
showing how the demand for luxuries increases as income increases. The line joining points A, B and C
is the Engel curve. The Engel curve is a line showing the relationship between demand and levels of
income.

Engel curve a line showing the relationship between demand and levels of income

In this example the increase in demand for luxuries is greater between income levels Y2 and Y3 than it
was between Y1 and Y2, suggesting that the income elasticity of demand is getting greater as income rises.
However, we can see that the proportionate increase in quantity demanded of luxuries between Y1 and Y2
is less than the proportionate increase in income, which suggests that the demand for luxuries is income
inelastic between these income levels.

Case Study Environmental Engel Curves

The widespread concern about the extent to which human behaviour is affecting the climate has led some
economists to apply the principle behind ‘Engel’s law’ to the relationship between incomes and pollution.
An environmental Engel curve (EEC) plots the relationship between changes in household income and the
goods consumed and the pollution that results from the production of those goods.
Research has shown that EECs are upwards sloping, suggesting that as incomes increase, con-
sumption patterns change such that the goods consumed are associated with higher levels of pollution.
A simple example is that as household income increases, there is a tendency to substitute travel on public
transport (seen as the inferior good) with travel by car. The more people acquire and use cars, the higher
the level of pollution associated with the use of those cars. People with higher incomes tend to consume
more electricity, and if this electricity is generated by using fossil fuels then the indirect impact on pollu-
tion is greater.
If the EEC is upwards sloping, then
policymakers aiming to reduce pollu-
tion must take this into account and
implement other policies to offset the
effects of rising incomes on pollution.
This might include a more diversified
mix of energy supply, not simply relying
on fossil fuel generated electricity, for
example, and applying technologies
to the production process to reduce
the pollution effects of production.
A study by Arik Levinson and James
O’Brien in the United States suggested
that assuming upwards sloping EECs,
the increase in income in the United The widespread concern about the extent to which human behaviour
States between 1984 and 2002 (the is affecting the climate has led some economists to apply the
principle behind ‘Engel’s law’ to the relationship between incomes
period studied) would have also led
and pollution.
to an increase in pollution. However,
Levinson and O’Brien showed that overall pollution in the United States had declined, and that other factors
had more than compensated for the increase in income. They concluded that these other effects had led to
a shift inwards in the EEC and also a movement around the EEC.
Reference: Levinson, A. and O’Brien, J. (2015) Environmental Engel Curves. National Bureau of Economic Research Working
Paper 20914. www.nber.org/papers/w20914, accessed 18 May 2019.

Conclusion: Do People Really Behave This Way?

The SEM describes how people make decisions based on certain assumptions. It has broad applicability
and can explain how a person chooses between cola and pizza, food and leisure, and so on.
At this point, however, you might be tempted to treat the theory of consumer choice with some
scepticism. After all, you are a consumer. You decide what to buy every time you walk into a shop. And you
know that you do not decide by writing down budget constraints and indifference curves.
It is important to remember that the SEM does not try to present a literal account of how people make
decisions. It is a model, and, as we have discussed, models are not intended to be completely realistic.
The model does have some merits; consumers are aware that their choices are constrained by their
financial resources. Many, given those constraints, will do the best they can to achieve the highest level
of satisfaction.
There is, however, considerable evidence that the SEM has limitations in explaining how consumers
actually behave. We might like to think we behave rationally, but research has shown that our ability
to make judgements and decisions in doing the best we can are subject to systematic and consistent
flaws – biases – that mean consumer behaviour as represented by the SEM is, at the very best, a limited
model of consumer behaviour.
Much of the research on this area has been inspired by the work of two psychologists, Daniel K
ahneman
and Amos Tversky. Indeed, such has been their impact that Kahneman was awarded the Nobel Prize for
Economics in 2002 (Tversky sadly died at the relatively young age of 59 in 1996). We now present a brief
overview of behavioural approaches to consumer behaviour.

Behavioural Approaches to Consumer Behaviour

Many of the things we do in life and the decisions we make cannot be explained as those of rational
beings – individuals doing the best they can, given their circumstances. Rational beings are sometimes
referred to by economists as homo economicus. Humans can, however, be forgetful, impulsive, confused,
emotional and short-sighted. Economists have suggested that humans are only ‘near rational’ or that
they exhibit ‘bounded rationality’. Bounded rationality is the idea that humans make decisions under
the constraints of limited, and sometimes unreliable, information, that they face limits to the amount of
information they can process and that they face time constraints in making decisions.

bounded rationality the idea that humans make decisions under the constraints of limited, and sometimes unreliable,
information

The SEM has an implied assumption that to make a rational decision which maximizes utility, con-
sumers can know everything about the consumption decision that they make and can process all this
information very quickly. Research has suggested that this is far from the case. Humans make systematic
and consistent mistakes in decision-making. We will now outline some of the main errors in judgement
and decision-making.

People Are Overconfident

Imagine that you were asked some numerical questions, such as the number of African countries in the
United Nations, the height of the tallest mountain in Europe and so on. Instead of being asked for a single
estimate, however, you were asked to give a 90 per cent confidence interval – a range such that you were
90 per cent confident the true number falls within it. When psychologists run experiments like this, they
find that most people give ranges that are too small: the true number falls within their intervals far less
than 90 per cent of the time. That is, most people are too sure of their own abilities.

People Give Too Much Weight to a Small Number of Vivid Observations

Imagine that you are thinking about buying a new smartphone from company X. To learn about its reliability,
you read Consumer Reports, which has surveyed 1,000 owners of the particular smartphone that you are
looking at. Then you run into a friend who owns such a phone and they tell you that they are really unhappy
with it. How do you treat your friend’s observation? If you think rationally, you will realize that they have only
increased your sample size from 1,000 to 1,001, which does not provide much new information. In addition,
a process called the reticular activation system (RAS) works to bring your attention to instances of this
smartphone – you will suddenly start to notice more of them. The RAS is an automatic mechanism in the
brain that brings relevant information to our attention. Both these effects – your friend’s story and noticing
more of these smartphones around – mean that you may be tempted to attach a disproportionate weight
to them in decision-making.

People Are Reluctant to Change Their Minds

People tend to interpret evidence to confirm beliefs they already hold. In one study, subjects were asked
to read and evaluate a research report on whether capital punishment deters crime. After reading the
report, those who initially favoured the death penalty said they were surer in their view, and those who
initially opposed the death penalty also said they were surer in their view. The two groups interpreted the
same evidence in exactly opposite ways.

People Have a Natural Tendency to Look for Examples

Which Confirm Their Existing View or Hypothesis
People identify, select or observe past instances and quote them as evidence for a viewpoint or hypothesis.
Nassim Nicholas Taleb, author of the book The Black Swan, calls this ‘naïve empiricism’. For example,
every extreme weather event that is reported is selected as evidence of climate change, or a rise in the
price of petrol of 10 per cent is symptomatic of a broader increase in prices of all goods.

People Use Rules of Thumb: Heuristics

The SEM implies that to act rationally buyers will consider all available information in making purchasing
decisions and weigh up this information to arrive at a decision which maximizes utility subject to the
budget constraint. In reality it is likely that many consumers will: (a) not have access to sufficient informa-
tion to be able to make a fully rational choice; and (b), even if they did they would not be able to process
this information fully partly due to a lack of mental facility (not everyone can do arithmetic quickly in their
head or make statistical calculations on which to base their choices). Instead, when making decisions,
many people will use short cuts that help simplify the decision-making process. These short cuts are
referred to as heuristics or rules of thumb. Some of these heuristics can be deep seated and firms can
take advantage of them to influence consumer behaviour.

heuristics short cuts or rules of thumb that people use in decision-making

There are a number of different types of heuristics.

Anchoring This refers to the tendency for people to start with something they are familiar with or know
and make decisions or adjustments based on this anchor. For example, a consumer may base the price
they expect to pay for a restaurant meal on the last two prices they paid when eating out. If the price at
the next restaurant is higher than this anchor price it may be that the consumer thinks the restaurant is
‘expensive’ or ‘not good value for money’, and may choose not to go again, whereas if the price they pay
is lower than the anchor price they might see the restaurant as being good value for money and choose
to return again. Often these anchors are biased and so the adjustment or decision is flawed in some way.

The Availability Heuristic Cases where decisions are made based on an assessment of the risks of
the likelihood of something happening are referred to as availability heuristics. If examples readily come
to mind as a result of excessive media coverage, for example, decisions may be taken with a skewed
assessment of the risks. If a consumer brings to mind the idea that the last couple of winters have been
particularly bad, then they might be more likely to buy equipment to help them combat adverse weather
for the next winter. Consumers who use commuter trains are more likely to give negative feedback about
the service they have received if their recent experience has been of some delays or cancellations, even
if the overall level of punctuality of the train operator has been very high.

The Representativeness Heuristic In this instance people tend to make judgements by comparing how
representative something is to an image or stereotype that they hold. For example, people may be more
prepared to pay money to buy a lottery ticket if a close friend has just won a reasonable amount of money
on the lottery, or make an association that if Bose headphones, for example, are good quality then its
Bluetooth portable speakers are also going to be good quality.

Persuasion Heuristics These are linked to various attributes that a consumer attaches to a product or a
brand. For example, it has been shown that size does matter to consumers, and so marketers can exploit
this by making more exaggerated claims in adverts or using facts and figures to make the product more
compelling in the mind of the consumer. The more that the marketers can highlight the positive attributes
of their product (and the negative ones of their rivals) the more likely consumers are to make choices in
favour of their product.
In addition, consumers are also persuaded by people they like and respect. This may be utilized by firms
through the people they use in adverts and celebrity endorsements, but may also be important in terms
of the people a firm employs to represent them in a sales or marketing capacity. It may also be relevant
in cases where friends or colleagues talk about products, and is one of the reasons why firms are keen to
build a better understanding of how social media can be exploited.
Persuasion heuristics can also manifest themselves in the ‘bandwagon’ effect – if a large number of
people go and see a film and rave about it, then there is even more incentive for others to go and see it as
well. Firms may look to try to create a bandwagon effect to utilize this persuasion heuristic in their marketing.

Simulation Heuristics These occur where people use mental processes to establish the likely outcome
of something. The easier it is to simulate or visualize that outcome the more likely the individual is to make
decisions based on it. For example, if it is easy to imagine a product which makes you look good, then
you are more likely to buy it. Pharmaceutical firms know that consumers are more likely to buy and take
medicines that deal with known and experienced symptoms (things like headaches, strained muscles,
sore throats and runny noses) than for something like high cholesterol – because it is hard to build a mental
process for the effects of high cholesterol.

Expected Utility Theory and Framing Effects In our analysis of the SEM we noted that indifference
curves implied that consumers can rank preferences from best to worst (or vice versa). This is referred to
as expected utility theory.

expected utility theory the idea that preferences can and will be ranked by buyers

Expected utility theory is important because consumers must make decisions based on ranking pref-
erences on a regular basis. Imagine you are faced with the choice between two types of surgery in a
hospital. The surgeon is discussing your treatment with you and presents you with the following:
●● Surgery type 1: 90 per cent of patients survive the surgery and live more than one year.
●● Surgery type 2: 10 per cent of patients die within the first year.
Which surgery type would you choose?
Expected utility theory says that consumers can consistently rank the preference between these two
options. Work done by Kahneman and Tversky suggest that the majority of people would choose surgery

type 1, but the two surgery types offer essentially the same chance of a successful outcome. Expected
utility theory implies that a rational economic agent would be indifferent between the two surgery types,
but Kahneman and Tversky’s work suggests that the way in which such choices are presented can affect
our judgements and the rational decision is violated.
Firms are careful to frame the way they present products and information to consumers to try to influence
purchasing decisions and exploit these differences in perception. This is referred to as the framing effect
whereby people respond to choices in differing ways depending on how such choices are presented to
them. For example, firms selling insurance know that people make judgements about the extent to which
they are exposed to risk in deciding whether to take out insurance and how much cover they need. Adverts
and marketing, therefore, may be framed to give the impression to consumers that they face increased risk.

framing effect the differing response to choices depending on the way in which choices are presented

Summary
●● The analysis of consumer choice looks at how consumers make decisions. There are a number of assumptions
underpinning the model which include that people behave rationally to maximize utility from their given resources.
●● A consumer’s budget constraint shows the possible combinations of different goods they can buy given their
income and the prices of goods. The slope of the budget constraint equals the relative price of the goods.
●● The consumer’s indifference curve represents their preferences. An indifference curve shows the various b undles
of goods that make the consumer equally happy. Points on higher indifference curves are preferred to points
on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of
substitution – the rate at which the consumer is willing to trade one good for the other.
●● The consumer optimizes by choosing the point on their budget constraint that lies on the highest indifference
curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals
the slope of the budget constraint (the relative price of the goods).
●● When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect
and a substitution effect. The income effect is the change in consumption that arises because a lower price makes
the consumer better off. The substitution effect is the change in consumption that arises because a price change
encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in
the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a move-
ment along an indifference curve to a point with a different slope.
●● The theory of consumer choice can be applied in many situations. It can explain why demand curves can poten-
tially slope upwards, why higher wages could either increase or decrease the quantity of labour supplied, and why
higher interest rates could either increase or decrease saving.

In the News

Nonsense Economics
There is no shortage of people, both economists and non-economists, who are keen to highlight how the standard
theory as outlined in the first part of this chapter is ‘dead’ and should be consigned to history. Some quotes on the
subject include the following.
Nicholas Hanley, Professor of Environmental Economics at the University of St Andrews introduces an article in
The Conversation thus: ‘For years, economists and psychologists have argued about whether the standard model that
economists use to explain how people make decisions is correct.’ Also in The Conversation, Brendan Markey-Towler,

(Continued )

Industry Research Fellow at the Australian Institute for Business and Economics and School of Economics, The
University of Queensland, comments on the high price that Apple charges for its latest iPhone and notes that ‘The
answer comes down to behavioural economics.’ Derek Thompson writing in The Atlantic runs the headline: ‘Richard
Thaler wins the Nobel Prize for Economics for Killing Homo Economicus.’ He goes on to note: ‘Renowned for his use
of data to observe and predict how people behave in the real world, Thaler’s career has been a lifelong war on Homo
economicus, that mythical species of purely rational hominids who dwell exclusively in the models of classical eco-
nomic theory.’ Richard Partington writing in The Guardian on Thaler winning the Nobel Prize notes: ‘Unlike the field
of classical economics, in which decision-making is entirely based on cold-headed logic, behavioural economics
allows for irrational behaviour and attempts to understand why this may be the case.’
However, there are some who note that the standard model can provide some illumination on human
decision-making. Dean Pearson, National Australia Bank’s head of behavioural economics, writes in the Sydney
Morning Herald that many people who complain of being short of time could benefit themselves by releasing valuable
time spent on tasks which other people could do by paying for mundane household tasks to be done for them, such as
mowing lawns and cleaning the house. Doing so would release time to spend doing things we really enjoy and value.
This could be interpreted as a classic case of a consumer changing their decision-making to improve utility and doing
the best they can, given their circumstances.
Consider how you chose your university.
You were no doubt constrained by a number of
factors, money, qualifications, ability to travel,
accommodation and so on. You might also have
considered several different course types and
universities before arriving at your choice. To
what extent did your decisions reflect the idea

©iStockphoto.com/Tero Vesalaine
of a rational human doing the best they can,
given their circumstances, and to what extent
was your decision based on behavioural traits
alone? You may not have used the terminology
we have introduced in this chapter in your deci-
sion-making, but is there any part of the model
of consumer behaviour we have presented Consider how you chose your university. You were no doubt
which reflects your behaviour in choosing your constrained by a number of factors, money, qualifications, ability
university? to travel, accommodation and so on.

Critical Thinking Questions

1 Would you consider this article to be a defence of the standard economic model or a balanced view on the
merits of both the standard model and behavioural theories of consumer behaviour?
2 Consider the quote by Nicholas Hanley. Comment on the use of the word ‘correct’ in the context of the quote.
3 When a company like Apple releases a product and charges a very high price for it, the suggestion by Brendan
Markey-Towler is that this can be explained by behavioural economics. Present an argument that the high price
for a product like a smartphone could equally be explained by the standard economic model.
4 Richard Thaler, the 2017 Nobel Prize winner for Economics, has been referred to as ‘one of the fathers of behav-
ioural economics’. In the quotes presented in the article, he is presented as spending his life being ‘at war’ with
homoeconomicus, and by implication with economists who subscribe to the standard economic model. What
role does the language used by the writers in their quotes play in framing the arguments being presented? (You
might want to get hold of a copy of Thaler’s book Misbehaving and judge for yourself whether he has spent his
entire career ‘at war’ with the economics profession.)
5 Consider the comment regarding outsourcing mundane domestic chores to someone else and releasing time,
and your own decision-making process in choosing a university (in choosing a university you are a consumer of
higher education). Comment on the extent to which these two examples reflect elements of the standard eco-
nomic model or whether they both reflect behavioural economic explanations of consumer behaviour. Is your
answer an ‘either/or’? What light do you think your analysis sheds on the debate between the standard model
and other explanations of consumer behaviour?

Questions for Review

1 What are the main assumptions of the standard economic model?
2 A consumer has income of €3,000. Wine is priced at €3 a glass and cheese is priced at €6 a kilo. Draw the consumer’s
budget constraint. What is the slope of this budget constraint?
3 Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference
curves.
4 Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the
marginal rate of substitution tell us?
5 Show a consumer’s budget constraint and indifference curves for wine and cheese. Show the optimal consumption
choice. If the price of wine is €3 a glass and the price of cheese is €6 a kilo, what is the marginal rate of substitution at
this optimum?
6 A person who consumes wine and cheese gets a rise, so their income increases from €3,000 to €4,000. Use diagrams to
show what happens if both wine and cheese are normal goods. Now show what happens if cheese is an inferior good.
7 The price of cheese rises from €6 to €10 a kilo, while the price of wine remains at €3 a glass. For a consumer with
a constant income of €3,000, show what happens to consumption of wine and cheese. Decompose the change into
income and substitution effects.
8 Can an increase in the price of cheese possibly induce a consumer to buy more cheese? Explain.
9 Explain why the assumptions of the standard economic model might not hold.
10 What are heuristics and how might they affect consumer decision-making?

Problems and Applications

1 Jacqueline divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil
causes a large increase in the price of coffee in France.
a. Show how this early frost might affect Jacqueline’s budget constraint.
b. Show how this early frost might affect Jacqueline’s optimal consumption bundle, assuming that the substitution
effect outweighs the income effect for croissants.
c. Show how this early frost might affect Jacqueline’s optimal consumption bundle, assuming that the income effect
outweighs the substitution effect for croissants.
2 Compare the following two pairs of goods:
a. Coke and Pepsi
b. Skis and ski bindings
c. In which case do you expect the indifference curves to be fairly straight, and in which case do you expect the
indifference curves to be very bowed? In which case will the consumer respond more to a change in the relative
price of the two goods?
3 Surette buys only orange juice and yoghurt.
a. In 2019, Surette earns €20,000, orange juice is priced at €2 a carton and yoghurt is priced at €4 a tub. Draw Surette’s
budget constraint.
b. Now suppose that all prices increase by 10 per cent in 2020 and that Surette’s salary increases by 10 per cent as well.
Draw Surette’s new budget constraint. How would Surette’s optimal combination of orange juice and yoghurt in 2020
compare to her optimal combination in 2019?
4 Economist George Stigler once wrote that, according to consumer theory, ‘if consumers do not buy less of a commodity
when their incomes rise, they will surely buy less when the price of the commodity rises’. Explain this statement using
the concepts of income and substitution effects.
5 A consumer has an income of €30,000 a year and divides this income between buying food and spending on leisure.
The average price of a unit of food is €15 and the average price of a unit of leisure is €10. Draw the consumer’s budget
constraint and draw an indifference curve to show the consumer’s optimum.

Assume that the price of food rises in three stages over the year in €10 increments but that the price of leisure stays the
same. Draw the consumer’s new budget constraints, identify the new optimum and show the price–consumption path.
Use the price–consumption path to derive the demand curve for food.
6 Indifference curves are convex to the origin (i.e. bow inwards). Using your knowledge of the properties of indifference
curves, explain why indifference curves cannot be concave to the origin (i.e. bow outwards).
7 Using an example, explain why the consumer optimum occurs where the ratio of the prices of two goods is equal to the
marginal rate of substitution.
8 Sketch a diagram to show the effect on demand of a change in income on a good which has an income elastic demand.
9 Choose three products you purchased recently. Think about the reasons that you made the particular purchase decision
in each case. To what extent do you think you made the purchase decision in each case in line with the assumptions of
the SEM? If you deviated from the SEM, think about why you did so.
10 Look at the following two statements:
a. Which would you prefer: a 50 per cent chance of winning €150 or a 50 per cent chance of winning €100?
b. Would you prefer a decision that guarantees a €100 loss, or would you rather take a gamble where the chance of
winning €50 was rated at 50 per cent but the chance of losing €200 was rated also at 50 per cent?
What would your choice be in a?
What would your choice be in b?
What is the difference between these two sets of statements and how do they illustrate the concept of framing?

Abm Applied Economics Reading Materials
100% (1)
Abm Applied Economics Reading Materials
5 pages
Disciplines and Ideas in The Social Sciences: Quarter 2 - Module 1
100% (2)
Disciplines and Ideas in The Social Sciences: Quarter 2 - Module 1
21 pages
Fundamentals of Economics Lec 1
No ratings yet
Fundamentals of Economics Lec 1
19 pages
Ten Principles of Economics: in This Chapter You Will - .
No ratings yet
Ten Principles of Economics: in This Chapter You Will - .
7 pages
FY Business Economics I Compiled Notes 2024-25
No ratings yet
FY Business Economics I Compiled Notes 2024-25
109 pages
Introduction To Economics
100% (2)
Introduction To Economics
57 pages
Parkin Econ Ch01-Notes
No ratings yet
Parkin Econ Ch01-Notes
5 pages
BSP 110 Lecture 1
No ratings yet
BSP 110 Lecture 1
9 pages
Principles of Microeconomics 10-35-127
No ratings yet
Principles of Microeconomics 10-35-127
93 pages
Ten Principles of Economy
No ratings yet
Ten Principles of Economy
18 pages
Week 1m
No ratings yet
Week 1m
60 pages
Chapter 1 Lecture Notes
No ratings yet
Chapter 1 Lecture Notes
3 pages
Objective 1 Define Economics and Examine The Relationship Between Scarcity and The Need For Choices. What Is Economics?
No ratings yet
Objective 1 Define Economics and Examine The Relationship Between Scarcity and The Need For Choices. What Is Economics?
9 pages
Merged File of All Units EDITED
100% (1)
Merged File of All Units EDITED
170 pages
Lecture 1
No ratings yet
Lecture 1
24 pages
Introduction To Economic
No ratings yet
Introduction To Economic
16 pages
Unit I Economics YKK
No ratings yet
Unit I Economics YKK
131 pages
Lec - 01 - Ch01 - What Is Economics
No ratings yet
Lec - 01 - Ch01 - What Is Economics
39 pages
Lecture Notes Introduction To Microeconomics 2012
No ratings yet
Lecture Notes Introduction To Microeconomics 2012
4 pages
Module 1
No ratings yet
Module 1
8 pages
Basic Concepts of Economics
No ratings yet
Basic Concepts of Economics
19 pages
Module 1: The Economic Problem: Learning Outcomes
No ratings yet
Module 1: The Economic Problem: Learning Outcomes
32 pages
MBA - Principles - of - Economics - and - Markets - UNIT 01
100% (1)
MBA - Principles - of - Economics - and - Markets - UNIT 01
12 pages
Not Mine, Someone's Else's The Movie
No ratings yet
Not Mine, Someone's Else's The Movie
10 pages
LU 1 Introduction To Micro
No ratings yet
LU 1 Introduction To Micro
83 pages
Basic Microeconomics MODULE 1
No ratings yet
Basic Microeconomics MODULE 1
10 pages
CHAPTER 1 - Principles of Economics - N. Gregory Mankiw
No ratings yet
CHAPTER 1 - Principles of Economics - N. Gregory Mankiw
15 pages
Notes - Economics
No ratings yet
Notes - Economics
69 pages
Introduction To Economics
No ratings yet
Introduction To Economics
31 pages
Econ Gr10 - Lessons 1 and 2
0% (1)
Econ Gr10 - Lessons 1 and 2
20 pages
BL-ECON-6110-LEC-1923T INTRODUCTORY TO ECONOMICS Lesson 1 - Defining Economics
No ratings yet
BL-ECON-6110-LEC-1923T INTRODUCTORY TO ECONOMICS Lesson 1 - Defining Economics
15 pages
Esset Erjona
No ratings yet
Esset Erjona
6 pages
Lesson 1
No ratings yet
Lesson 1
31 pages
Chapter 23 & Introduction - Measuring A Nation's Income
No ratings yet
Chapter 23 & Introduction - Measuring A Nation's Income
75 pages
Lecture 1
No ratings yet
Lecture 1
26 pages
Prelim Handout
No ratings yet
Prelim Handout
12 pages
Economics Study Guide
No ratings yet
Economics Study Guide
2 pages
Lesson 1 Nature of Economics
No ratings yet
Lesson 1 Nature of Economics
56 pages
Economics Reading #2
No ratings yet
Economics Reading #2
4 pages
Module 1 - Intro To Economics
No ratings yet
Module 1 - Intro To Economics
7 pages
Intro To Economics 2013
No ratings yet
Intro To Economics 2013
28 pages
To Idiots
No ratings yet
To Idiots
45 pages
1 Intro To Microeconomics
50% (2)
1 Intro To Microeconomics
49 pages
Chapter 1 Intro. To Economics (HiLCoE)
No ratings yet
Chapter 1 Intro. To Economics (HiLCoE)
52 pages
Lougdr
No ratings yet
Lougdr
44 pages
Week One
No ratings yet
Week One
8 pages
Lesson 1
No ratings yet
Lesson 1
68 pages
BEM - Introduction of Economics
No ratings yet
BEM - Introduction of Economics
23 pages
Chapter 1 Economics
No ratings yet
Chapter 1 Economics
13 pages
Introduction To Economics
No ratings yet
Introduction To Economics
5 pages
Principles of Economics Prelim 01
No ratings yet
Principles of Economics Prelim 01
6 pages
Chapter One Summary Notes
No ratings yet
Chapter One Summary Notes
4 pages
Economics PDF
100% (1)
Economics PDF
50 pages
Applied Economics
No ratings yet
Applied Economics
23 pages
E Book
No ratings yet
E Book
73 pages
The Nature of Economics
No ratings yet
The Nature of Economics
30 pages
Compulsory Reading - Week 1
No ratings yet
Compulsory Reading - Week 1
12 pages
Ch01 - Introduction - To - Economics
No ratings yet
Ch01 - Introduction - To - Economics
45 pages
Public Consulting XL by Slidesgo
No ratings yet
Public Consulting XL by Slidesgo
23 pages
Micro Economics 1-3 PDF
No ratings yet
Micro Economics 1-3 PDF
93 pages
Corporate Critical Density
From Everand
Corporate Critical Density
Jayaraman Iyer
No ratings yet
Bounded Rationality and Political Science
No ratings yet
Bounded Rationality and Political Science
18 pages
Fidp Q1 Diss Revised R
No ratings yet
Fidp Q1 Diss Revised R
14 pages
Lesson 5: Theory of Consumer Behavior
100% (1)
Lesson 5: Theory of Consumer Behavior
21 pages
DISS11 Q2 W1 Rational-Choice-Theory Benguet Maximo-FINAL-1
No ratings yet
DISS11 Q2 W1 Rational-Choice-Theory Benguet Maximo-FINAL-1
20 pages
Network Theory and Agent Based Modeling in Economics and Finance 1st Ed 2019 978 981-13-8318 2 978 981 13 8319 9 Compress
0% (1)
Network Theory and Agent Based Modeling in Economics and Finance 1st Ed 2019 978 981-13-8318 2 978 981 13 8319 9 Compress
454 pages
Robert E. Cole - Managing Quality Fads - How American Business Learned To Play The Quality Game (1999)
No ratings yet
Robert E. Cole - Managing Quality Fads - How American Business Learned To Play The Quality Game (1999)
297 pages
Principles of Economics - Ec111
No ratings yet
Principles of Economics - Ec111
5 pages
MIT14 03F16 Lec3
No ratings yet
MIT14 03F16 Lec3
15 pages
Holzinger 2004
No ratings yet
Holzinger 2004
29 pages
Preferences and Indifference Curves
No ratings yet
Preferences and Indifference Curves
28 pages
Psychoanalysis and Rational Choice Theory
100% (1)
Psychoanalysis and Rational Choice Theory
13 pages
Theory of Consumer Behavior-1
No ratings yet
Theory of Consumer Behavior-1
45 pages
Game Theory Introduction
No ratings yet
Game Theory Introduction
9 pages
Theory of Consumer Behaviour: Chapter Three
No ratings yet
Theory of Consumer Behaviour: Chapter Three
37 pages
Rational Choice Theory (Yoshimichi Sato) Critical Review
No ratings yet
Rational Choice Theory (Yoshimichi Sato) Critical Review
4 pages
Case - Chapter 16
No ratings yet
Case - Chapter 16
4 pages
Emanination - Panergalin, Umali
No ratings yet
Emanination - Panergalin, Umali
10 pages
The New Institutional Economics: Its Start, Its Meaning, Its Prospects
No ratings yet
The New Institutional Economics: Its Start, Its Meaning, Its Prospects
35 pages
2020BALLB19 (Economics)
No ratings yet
2020BALLB19 (Economics)
22 pages
Graham Allison Models
No ratings yet
Graham Allison Models
9 pages
Marginal Rate of Substitution
No ratings yet
Marginal Rate of Substitution
26 pages
Essence of Decision
No ratings yet
Essence of Decision
4 pages
Busi1702 Odm Lecture 3 2022-23
No ratings yet
Busi1702 Odm Lecture 3 2022-23
23 pages
Law of Equi Marginal Utility
No ratings yet
Law of Equi Marginal Utility
4 pages
Bureaucratic Theory Meets Reality Public Choice
No ratings yet
Bureaucratic Theory Meets Reality Public Choice
21 pages
Diss-Reviewer-4 Th-Quarter
100% (1)
Diss-Reviewer-4 Th-Quarter
10 pages
Introduction: Concepts and Theories in Politics Language and Politics
No ratings yet
Introduction: Concepts and Theories in Politics Language and Politics
19 pages
Jon Elster, Aanund Hylland Foundations of Social Choice Theory Studies in Rationality and Social Change PDF
No ratings yet
Jon Elster, Aanund Hylland Foundations of Social Choice Theory Studies in Rationality and Social Change PDF
259 pages
Rationality: Lawrence E. Blume and David Easley
No ratings yet
Rationality: Lawrence E. Blume and David Easley
19 pages

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.