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CHAPTER 1 Economics and the economy Learning outcomes By the end of this chapter, you should be able to: 1 understand that economics is the study of how society resolves the problem of scarcity 2 describe ways in which...

CHAPTER 1 Economics and the economy Learning outcomes By the end of this chapter, you should be able to: 1 understand that economics is the study of how society resolves the problem of scarcity 2 describe ways in which society decides what, how and for whom to produce 3 understand the concept of opportunity cost 4 differentiate between positive and normative economics 5 define microeconomics and macroeconomics Economics is the study of how societies make choices under conditions of scarcity. Scarcity means that we have limited resources to produce all the goods and services that we would like to have. Goods are physical commodities, such as steel or strawberries. Services are activities such as massages or live concerts, consumed or enjoyed only at the instant they are produced. The key economic problem for a society is how to reconcile the conflict between people’s virtually limitless desires for goods and services, and the scarcity of resources (labour, machinery, raw materials, and so on) with which these goods and services can be produced. By emphasizing the role of society, our definition places economics within the social sciences that study and explain human behaviour. Because of scarcity we cannot get everything we want. Choosing to spend more resources to build a new military ship means having fewer resources to build new schools or hospitals instead. Therefore a society faces trade-offs every time it makes choices. The three basic trade-offs that every society faces are: what goods and services to produce, how to produce them and for whom to produce them. In answering what, how and for whom to produce, economics explains how scarce resources are allocated among competing claims on their use. A resource is scarce if the demand of that resource at a zero price would exceed the available supply. Economics is the study of how society makes choices under conditions of scarcity. In many societies the answer to those questions is the result of the independent decisions of many individuals and firms. Individuals decide how much to work, what to buy and how much to buy of various goods and services. Firms decide what to produce, how much to produce of various goods and services and which resources to use in production. Normally those decisions take place in markets. In economics we study how individuals and firms make decisions and how those decisions are combined in markets to determine how resources are allocated. Not all resources are allocated through markets, though. For example, we may all want an unpolluted environment but there is no market for such a good. In some other cases the allocation created by markets may not be what a society would like. When this happens, there is scope for governments to intervene in the economy. Although economics is about human behaviour, we describe it as a science. This reflects the method of analysis, not the subject matter, of economics. Economists develop theories of human behaviour and test them against the facts. Chapter 2 discusses the tools that economists use and explains the sense in which this approach is scientific. This does not mean that economics ignores people as individuals. Moreover, good economics retains an element of art. Only by having a feel for how people actually behave can economists focus their analysis on the right issues.  1.1 How economists think about choices How do societies choose to allocate scarce resources among different alternatives? To answer that question we need to understand how each member of a society, such as individuals and firms, makes economic choices. A fundamental assumption in economic analysis is that individuals behave rationally when making choices. A rational individual is someone who takes full account of all information available to make the best choice for his own interest. In taking decisions a rational individual uses all his available information to compare the benefits and the costs associated with those decisions. Rationality in making choices implies that a given activity should be undertaken only if its benefits are larger than its costs. This idea of a rational choice provides an answer to the questions what to produce, how to produce and for whom to produce. We should produce something for which the benefits of producing it are larger than the costs of producing it. We should produce goods in the least costly way and for the individuals who value those goods most. The benefits of a given activity are what we gain from doing it. In many cases those benefits can be measured in monetary terms. This is the amount of money we get from a given activity. The benefit you receive from a university degree is the boost in your earnings once you graduate. However, in many other cases providing a monetary measure for benefits is less straightforward. For example, suppose we need to choose whether or not to watch the last Spiderman film. What is the monetary benefit of watching that film? Even when benefits cannot be readily available in monetary terms we can still try to provide a monetary value for them. Economists define the benefits of a given action as the willingness to pay for that action. The willingness to pay for something is the maximum amount of money we are willing to pay for it. This is a hypothetical monetary value; we normally do not pay that money. In the case of the last Spiderman film, you can ask yourself the hypothetical question, ‘What is the maximum amount of money I am willing to pay to watch that film?’ If you say, for example, £25, then this value should represent your benefit of watching that film. Notice that different individuals can have different willingness to pay for the same thing. A real fanatic of Spiderman films will be willing to pay a higher amount of money to watch those films than someone who prefers to watch romantic comedies. What about the costs of a given activity? The cost of an activity normally includes the explicit cost, which is the amount of money we need to pay for doing it, and the opportunity cost, which is the value of the best alternative we must sacrifice for doing that activity.1 Therefore the cost of any activity generally has two components. A rational individual must consider both explicit and opportunity costs in making decisions. The opportunity cost of an activity is the value of the best alternative you must sacrifice. As for benefits, different individuals may have different opportunity costs for the same activity simply because they value different best alternatives. The concept of opportunity cost is one of the most important concepts in economic analysis. It provides the direct link between scarcity and choices. Faced with scarcity, we must choose among alternative activities. If we decide to do activity A, then we are spending resources on that activity. We could have spent those resources on doing activity B. Therefore by choosing one activity we sacrifice the other. In making choices we need to take into account the opportunity that we are sacrificing. CONCEPT 1.1 OPPORTUNITY COSTS AND CHOICES: AN EXAMPLE To understand how opportunity costs play a crucial role in determining how individuals make choices, we can consider a simple example. Suppose you want to spend a day at the beach with your friends. The cost of spending the day at the beach with your friends is £30 (this includes the cost of transportation, the cost of food and drink and so on). Suppose that you really like spending a day with your friends and that you will be willing to pay £60 to do so. This is the maximum amount you are willing to pay for that activity and it represents its benefit in monetary terms. Given these two facts, should you go to the beach with your friends? At first sight the answer appears to be yes. The benefit is larger than the cost. However, the cost of going to the beach is not only £30. By deciding to go to the beach you are losing the opportunity of doing something else. Suppose that the best alternative of going to the beach is to work at the campus shop at your university. A day of work at the campus shop gives you £70. This represents the benefit, in monetary terms, of working at the campus shop. Suppose you like working at the campus shop but only if they pay you at least £30. This is the minimum payment that will make you work at the shop. If they pay you less than £30, then you will be unwilling to work there. What is the value of working at the campus shop for you? The answer is simply £70 minus £30; that is, £40. If faced with the choice between ‘going to the beach with your friends’ and ‘working at the campus shop’, you need to take into account that by choosing one alternative you are giving up the other. Therefore the cost of spending the day at the beach is not only the explicit cost of £30; it also reflects the implicit cost given by the best alternative you are sacrificing. In this case, the value of the best alternative is £40. This represents the opportunity cost of ‘going to the beach with your friends’. If we take into account this opportunity cost, then the cost of ‘going to the beach with your friends’ is £30, which is the explicit cost, plus £40, which is the opportunity cost, meaning it is £70. Given that the benefit of ‘going to the beach with your friends’ is £60 and it is lower than the cost (explicit cost plus the opportunity cost), as a rational individual you should choose not to do it; instead you should work at the campus shop. While this example appears very simple, the basic principle behind it is very general. Every individual, firm, government and, therefore, every society, when making choices must compare the benefits and costs of those choices. Failing to take into account opportunity costs in our decision process will result in wrong choices. You may now think that the way in which economists describe how individuals make choices is not very realistic. Probably you do not make explicit calculations about opportunity costs when you make choices. Generally you do not ask yourself how much you are willing to pay to do something. Nevertheless it turns out that, even if individuals do not make explicit calculations about benefits and costs every time they make choices, they behave in many cases as if they do. Therefore our way of thinking about individuals— choices can help us explain many facts about their economic behaviour. Choices and incentives We have seen that rational individuals compare benefits and costs (including opportunity costs) in making decisions. Another important aspect of economic analysis is that in making choices rational individuals respond to incentives. Incentives are rewards or penalties that affect individuals— choices. Incentives can be monetary or not and can affect the benefits or the costs of our decisions. For example, smokers may have an incentive to smoke less if the government imposes high taxes on the price of cigarettes. In this case the high tax on cigarettes affects the cost of smoking and thus the choice of smoking. Recently the UK government has increased the tuition fees for undergraduate degrees from £3000 to £9000. This increase in tuition fees can affect the incentives of individuals to enrol on undergraduate degrees in the UK. Incentives are important to help us understand how markets work. The prices of goods and services create incentives that affect the decisions of individuals and firms. As the price of beef increases, buyers have an incentive to buy less beef and maybe to switch to a cheaper kind of meat, like chicken. On the other hand, beef producers have an incentive to produce more since the price of their product has increased. CASE 1.1 MOST OUTPUT IS SERVICE Societies must decide what to produce. This represents one of the basic three trade-offs societies face. The table below shows what is produced by different economies in 2010.  In advanced countries, agriculture represents about 1 per cent of national output and industry less than 25 per cent. The rest is services, which include banking, transport, entertainment, communications, tourism and public services (defence, police, education, health). In countries such as China and India, agriculture remains a higher share of GDP and services are not yet fully developed. Everywhere, services are the fastest growing part of output and of exports. Success in exporting banking, fashion and entertainment helps make the UK the second-largest exporter of services in the world. In developed countries, services have for a long time been the largest component of national output. Until recently most international trade was trade in goods. The Internet has changed all that. Accounting services can be outsourced to India and the advice of Indian accountants is as rapidly received by email in the UK as face to face in India. % of national output UK US France China India Agriculture 1 1 2 10 19 Industry 22 20 19 46 26 Services 77 79 79 44 55 Source: World Bank, World Development Indicators. © 2012 The World Bank Group. All rights reserved. 1.2 Economic issues Trying to understand what economics is about by studying definitions is like trying to learn to swim by reading an instruction manual. Formal analysis makes sense only once you have some practical experience. In this section we discuss two examples of how society allocates scarce resources between competing uses. In each case we see the importance of the questions what, how and for whom to produce. The 2007 financial crisis The crisis that started in the US in 2007 is now considered to be the worst economic crisis since the 1929 Great Depression. Because of the crisis many economies entered a recession. A recession is a period of time (at least two consecutive quarters) in which the amount of goods and services produced by an economy (called the gross domestic product, or GDP) declines. Recessions are not uncommon; indeed, economies over time experience cyclical periods of recession followed by periods in which economic activity rises. Figure 1.1 shows the GDP growth rate for the US economy from 1980 to 2012. It shows that in the last 22 years there have been several periods in which the US economy faced a negative growth rate in terms of output; however, none to the extent of the recession that began in 2007. The situation started with a financial crisis in the US market for sub- prime mortgages. Sub-prime mortgages are those given to people who want to buy a house but have a poor credit record and a relatively high probability of eventually not being able to repay their loan. Why lend money to people who are such a high credit risk? The reason was the constantly increasing price of houses before 2007, as shown in Figure 1.2. With the price of houses increasing, the risk of losing on a sub-prime mortgage was limited. The increase in house prices created an incentive for banks to lend to sub-prime customers. In the case of default on a mortgage by a sub-prime borrower, the lender could repossess their house and sell it at a high price. To make those subprime mortgages more profitable, mortgage companies started to bundle them into bonds and sell them to other financial companies. By doing so, the mortgage companies were in effect borrowing to lend mortgages. Figure 1.1 The growth rate of US real GDP: quarterly data Source: Federal Reserve Bank of St. Louis.  Figure 1.2 The US house price index: monthly data At the same time, the interest rate on mortgages was relatively low in the US, creating an incentive for people to get a mortgage and buy a house. The sub-prime mortgage market in the US is relatively small, comprising around 10 per cent of the entire market. How can such a small market create such a huge effect? After 2002, bond issuance increased substantially, as shown in Figure 1.3. The problem started when more and more sub-prime borrowers started to default on their mortgages and repossessions increased. The wave of repossessions had a dramatic effect on house prices. More houses were available in the market, which caused the house price boom of the previous few years to reverse.  Figure 1.3 Global issuance of bonds backed by mortgages Source: Bank of England. © 2010 The World Bank Group. All rights reserved. With decreasing house prices, the sub-prime mortgages started losing value. Those financial investors who had bonds with sub-prime mortgages started experiencing big financial losses. At the end of 2007 many banks announced $60 billion worth of losses, as many of the bonds backed by sub-prime mortgages had fallen in value. The financial crisis started in the US. However, given the connectedness of financial institutions across countries, it rapidly spread globally. Governments in different countries started bailout programmes to avoid many big banks and financial companies collapsing and disappearing. Those companies were considered too big to fail. The losses made by the financial and banking sectors resulted in what is called a credit crunch. A credit crunch is a reduction in the availability of credit from the banking sector. Banks become more reluctant to lend to borrowers and, more importantly, to each other. Credit becomes a scarce resource. The contraction of credit affected economic activity in all sectors of various economies and this had the effect of worsening the crisis. Many firms rely on borrowing for running their usual business. The scarcity of credit available caused those firms to reduce their activity. Many closed down; others reduced their activity by cutting jobs. Unemployment started to rise. Consumers— confidence started to decrease. People started to save more and to spend less. For many economies the recession caused by the financial crisis started at the end of 2007/beginning of 2008. The first signs of a slight recovery appeared at the end of 2009. However, five years after the credit crunch started, most developed economies have still not fully recovered. The financial crisis has affected the way societies answer the questions of what, how and for whom to produce. Production decreased because of the recession. Some sectors were more affected than others. The building sector suffered big losses as a result of falling house prices and the number of new houses built fell substantially during the crisis. Expensive and non-essential goods also suffered. Demand for cars fell and in many cases governments intervened by providing incentives to buy new cars to sustain demand. However, investments in research and development (R&D) and software increased. Looking at how things are produced, the crisis created a reallocation of input resources used in production. This reallocation has affected labour input most dramatically. Reduction in economic activity implies a reduction in employment. The job market shrinks and so more people become unemployed. Moreover, finding jobs becomes even more difficult, causing unemployment to last longer. Finally, the ‘for whom’ question. As a result of the crisis the banking and financial sector suffered big losses. The same happened to many investors because of the fall in stock values in financial markets. The crisis has hurt middle- and low-income households more than the very rich ones. The fall in the price of houses made firsttime buyers better off. Discount supermarkets’ sales figures also rose. CASE 1.2 THE OIL PRICE SHOCKS Oil provides fuel for heating, transport and machinery and is an input for petrochemicals and household products ranging from plastic plates to polyester clothes. What happens if continuing uncertainty in the Middle East or the ravages of climate change lead to very high oil prices? A little history lesson is useful in thinking about the likely results. Up to 1973 the use of oil increased steadily. It was cheap and abundant. In 1973 OPEC – the Organization of Petroleum Exporting Countries (www.opec.org) – organized a production cutback by its members, making oil so scarce that its price tripled. Users could not quickly do without oil. Making oil scarce was very profitable for OPEC members. The figure below shows the real (inflation-adjusted) price of oil, measured in US dollars, from 1970 to 2009. The price tripled between 1973 and 1977, doubled between 1979 and 1980, but then fell steadily until the mid-1990s. Markets found ways to overcome the oil shortage that OPEC had created. High oil prices did not last indefinitely. Given time, the higher price induced consumers to use less oil and non-OPEC producers to sell more. These responses, guided by prices, are part of the way many societies determine what, how and for whom to produce. Consider first how things are produced. When the price of oil jumps, firms cut their use of oil-based products. Chemical firms develop artificial substitutes for petroleum inputs, airlines order more fuel-efficient aircraft, and electricity is produced from more wind farms. Higher oil prices make the economy produce in a way that uses less oil. How about what is being produced? Households install better insulation to economize on expensive central heating and they buy smaller cars. Commuters form car-pools or move to the city centre. High prices choke off the demand for oil-related commodities but also encourage consumers to purchase substitute commodities. Higher demand for these commodities bids up their price and encourages their production. Designers produce smaller cars, architects use solar energy and research laboratories develop alternatives to petroleum in chemical production. © Instinia | Dreamstime.com The for whom question in this example has a clear answer. The revenues of oil producers increased sharply. Much of their increased revenue was spent on goods produced in the industrialized Western nations. By contrast, oil-importing nations had to give up more of their own production in exchange for oil imports. In terms of goods as a whole, the rise in oil prices raised the buying power of OPEC and reduced the buying power of oil- importing countries such as Germany and Japan. The world economy was producing more for OPEC and less for Germany and Japan. After 1982, OPEC’s power diminished as other oil supplies came on stream and users developed adequate substitutes. However, OPEC got its act together again in 1999, cut supply, forced up oil prices and prompted another fuel crisis in 2000. Since 1999 the sharp rises in oil prices must also be attributed not merely to a restriction of oil supply but also to a surge in energy demand by emerging economies, particularly China and India.  The oil price shocks show how society allocates scarce resources between competing uses. The higher oil price reflected its greater scarcity when OPEC reduced production levels. Source: adapted from The Economist, 21 July 2007. Income distribution You and your family have an annual income that lets you enjoy various goods and services and live in a particular place. Your standard of living includes the necessities of life – food, shelter, health, education – and something beyond, such as recreation. Your income is lower than some people’s but higher than that of others. Nations also have different levels of income. A nation’s income, or national income, is the sum of the incomes of all its citizens. World income is the sum of all countries’ incomes, hence also the sum of the incomes earned by all the people in the world. Income distribution is closely linked to the what, how and for whom trade-offs. Table 1.1 shows the percentage of the world population that lives in different groups of countries. Twenty-one per cent of the world’s population lives in poor countries, such as Bangladesh and Indonesia. Seventy per cent live in middle-income countries, a group including Thailand, Brazil, Mexico and China. The rich countries, including the US, Western Europe, Canada and Japan, account for 9 per cent of the world population. The income distribution (in a country or in the world) tells us how total income is divided between different groups or individuals. Table 1.1 World population and income Country group Poor Middle Rich Income per head (£) 300 3900 17700 % of world population 21 70 9 % of world income 3 19 78 Source: World Bank, World Development Indicator. © 2010 The World Bank Group. All rights reserved. Income per person indicates the average standard of living. Table 1.1 shows that in poor countries the average income per person is only £300 a year. In the rich industrial countries annual income is £17 700 per person, nearly 60 times larger. These are big differences. Table 1.1 also shows that poor countries account for one-fifth of the world’s population but only 3 per cent of world income. Rich countries have 9 per cent of the world’s population but 78 per cent of world income. For whom does the world economy produce? Mainly for the 9 per cent of its population living in the rich industrial countries. This also helps answer what is produced. World output is directed mainly to the goods and services consumed in the rich countries. The degree to which income is unequally distributed within a country affects also which goods are produced. In countries where income is very unequally distributed, the rich can employ low-income people as maids, cooks and chauffeurs. In countries where equality is much greater, few people can afford to hire servants. Why is inequality so great? This reflects mainly how goods are produced. Poor countries have little machinery and few people with professional and technical training. One American worker uses power driven earth-moving equipment to complete a task undertaken in Africa by many more workers equipped only with shovels. Workers in poor countries are less productive because they work under adverse conditions. Income is unequally distributed within each country as well as between countries. In Brazil, the richest 10 per cent of families get 48 per cent of national income, but in Denmark, only 20 per cent. These differences partly reflect things like state education, which increases access to education and training. However, in looking at income distribution within a country, we must include two extra things that are often less important when discussing differences in income per person between countries. First, individual incomes come not just from working but also from owning assets (land, buildings, corporate equity) that earn rent, interest and dividends. In Brazil, ownership of land and factories is concentrated in the hands of a small group; in Denmark, it is not. Second, societies may decide whether to change their distribution of income. A pure socialist economy aims to achieve considerable equality of income and wealth. In contrast, in an economy based on private ownership, wealth and power become concentrated in the hands of a few people. Between these extremes, the government may levy taxes to alter the income distribution that would otherwise emerge in a private ownership economy. Income inequality also affects individuals— incentives. Low-income people have little incentive to save and a higher incentive to borrow to increase their consumption. If governments decide to increase taxes to smooth income inequality, this affects the incentive of the high-income individuals. In 2012 France proposed introducing a 75 per cent income tax on the very rich. Introducing such a tax would create an incentive for the very wealthy French to move their business to countries where taxes are lower. CONCEPT 1.2 BEHAVIOURAL ECONOMICS Rationality is a fundamental assumption in standard economics. We can explain a great deal of individuals’ behaviour using that assumption. However, in some cases rationality seems to fail to accurately explain observed human behaviour. Why do people appear to dislike losing something roughly twice as much as they like gaining it? Why do we sometimes overspend on things we do not really need? Why in certain periods do investors tend to express excessive optimism about the value of stock prices? In those cases a different explanation that departs from rationality should be considered. This is the main subject of a relevant branch of economics called behavioural economics. Behavioural economics is the study of psychological and sociological influences on the individual’s behaviour. Behavioural economics has become very popular over the years, especially after the recent financial crisis when it appeared that some investors may have underestimated the risk of their investments. The assumption of rationality implies that people take full account of all information available to make their decisions. What are possible departures from this assumption? Here are some possibilities. Suppose there is a fixed cost of either acquiring information or of taking the time to make a decision. This leads to bounded rationality. It is no longer optimal to examine every possible decision in great detail – you would incur too many fixed costs – so instead you incur costs once, have a good think, and then come up with a simple decision rule that you implement automatically until it no longer fits the facts, at which point you incur some more thinking costs and try to improve your rule. Simple rules may explain why people extrapolate the recent past rather than conduct extensive research all the time. In 1979 Kahneman and Tversky, two psychologists, proposed prospect theory as a means to explain why individuals in some circumstances appeared to be loss averse: they are more sensitive to losses compared to gains of similar magnitude According to this theory, individuals have different preferences for losses compared to gains mainly for psychological reasons. In 2002 Daniel Kahneman was awarded the Nobel Prize in Economics. Richard Thaler, an economist at the University of Chicago, proposed nudge theory to show how psychological positive reinforcement can alter individuals’ decisions. Here is an example: in the US two letters were sent to non-payers of vehicle taxes. First, a generic letter was sent to non-payers reminding them that they would lose their car if they didn’t pay the tax. Second, a more personalized letter was sent with an attached picture of the car in question. The rewritten letter tripled the number of people paying the tax. One possible criticism of behavioural economics is that, while there is only one way to be rational, there are millions of ways in which to be irrational. Anyone can explain a particular event by invoking a particular kind of irrationality – it then takes a lot of data to establish whether there is anything systematic in this irrationality or whether it was just a coincidence invoked by someone trying to be wise after the event.  1.3 Scarcity and the competing use of resources In this section we consider a simple economic model to show how a society chooses to allocate scarce resources between competing uses. Consider an economy with workers who can make food or films. Table 1.2 shows how much of each good can be made. This depends on how workers are allocated between the two industries. In each industry, more workers means more output produced. The number of workers is the scarce resource. To keep things simple we abstract from monetary values, like the prices of goods and the wages of workers. Table 1.2 Production possibilities Food workers Output Film workers Output 4 25 0 0 3 22 1 9 2 17 2 17 1 10 3 24 0 0 4 30 The law of diminishing marginal returns applies when one input (such as labour) is varied but other inputs (such as equipment and land) remain fixed. Suppose workers in the film industry can use a fixed number of cameras and studios. The first worker has sole use of these facilities. With more workers, these facilities must be shared. Adding extra workers dilutes equipment per worker. Output per film worker falls as employment rises. A similar story applies in the food industry. Each industry faces diminishing returns to extra workers. The law of diminishing marginal returns says that each extra worker adds less to output than the previous extra worker added. Table 1.2 shows combinations of food and films made if all workers have jobs. By moving workers from one industry to the other, the economy can make more of one good but only by making less of the other good. There is a trade-off between food output and film output. The production possibility frontier (PPF) shows, for each output of one good, the maximum amount of the other good that can be produced. Figure 1.4 shows the maximum combinations of food and film output that the economy can produce. Point A plots the first row in Table 1.2, where food output is 25 and film output is 0. Points B, C, D and E correspond to the other rows of Table 1.2. The curve joining points A to E in Figure 1.4 is the production possibility frontier, or PPF. Figure 1.4 The US house price index: monthly data The frontier shows the maximum combinations of output that the economy can produce using all the available resources. The frontier displays a trade-off: more of one commodity implies less of the other. Points above the frontier need more inputs than the economy has available. Points inside the frontier are inefficient. By fully using available inputs the economy could expand output to the frontier. The frontier curves around the point given by zero output of both goods. This reflects the law of diminishing marginal returns. Movements from A to B to C each transfer a worker from the food industry to the film industry. Each transfer yields less additional film output and gives up increasing amounts of food output. At point A we start with 25 units of food but no films. Moving from A to B, we gain 9 films but lose 3 units of food. Adding an extra worker to the film sector, that is, moving from B to C, increases the production of films by 8 units but reduces the amount of food by 5 units. Therefore 3 units of food is the opportunity cost of producing the first 9 films and 5 extra units of food is the opportunity cost of producing 8 extra films. The slope of the PPF tells us the opportunity cost of a good: how much of one good we have to sacrifice to make more of another. Since there are only films and food, the most valued alternative of films is food and vice versa. To see why the curve is a ‘frontier’, think about point G in Figure 1.4. Society makes 10 units of food and 17 films. This is feasible. From Table 1.2, it needs 1 worker in the food industry and 2 in the film industry. Society has spare resources. The fourth person is not employed. G is not a point on the PPF because we can make more of one good without sacrificing output of the other good. Employing the extra person in the food industry takes us to point C, with 7 extra units of food for the same film output. Employing the extra person to work in films takes us to point D, with 7 extra units of films but no less food output. The PPF shows the points at which society is producing efficiently. Points such as G inside the frontier are inefficient because society is wasting resources. More output of one good would not require less output of the other. There would be no opportunity cost of expanding output of one good a bit. Points outside the production possibility frontier, such as H in Figure 1.4, are unattainable. Given the inputs available, this output combination cannot be made. Scarce resources limit society to a choice of points inside or on the production possibility frontier. Since people like food and films, society wants to produce efficiently. Points inside the PPF sacrifice output unnecessarily. Society chooses between the different points on the production possibility frontier. In so doing, it decides not only what to produce but how to produce. Table 1.2 shows how many workers must be allocated to each industry to make a particular output combination. As yet, our example is too simple to show for whom society produces.  Production efficiency means more output of one good can be obtained only by sacrificing output of other goods. How does society decide where to produce on the production possibility frontier? The government may decide. However, in most Western economies, the most important process that determines what, how and for whom goods are produced is the operation of markets. Opportunity cost and absolute and comparative advantage The concept of opportunity cost plays a fundamental role in how people make economic decisions. Moreover, the idea of opportunity cost can explain why people trade with each other. Indeed when two individuals (or firms, or nations) have different opportunity costs of performing various tasks, they can always increase the total value of available goods and services by trading with one another. Therefore, the idea of opportunity cost can provide a reason why individuals trade and why trade can be mutually beneficial. To see how the idea of opportunity cost is related to gains from trade, we consider a simple example. Consider two individuals: Jennifer and John. Both can produce two different goods, cakes and T-shirts. Jennifer is very good at sewing and she can make 4 T-shirts in 1 hour. She is also a good cook and can bake 2 cakes in 1 hour. On the other hand, John can bake 1 cake in 1 hour and he can make a T-shirt in 2 hours. Suppose that both cannot work more than 10 hours a day. Here, time is the scarce resource. The problem is the following: should John and Jennifer produce their own cakes and T-shirts or should they trade with each other? We are going to look at two possible scenarios. First scenario: suppose that John and Jennifer produce their own T-shirts and cakes. First, assume that each splits the 10 hours equally in producing the two goods. John can make 2.5 T-shirts and 5 cakes in 10 hours. Jennifer can make 20 T-shirts and 10 cakes. In this scenario the total amount of cakes produced is 15 and the total amount of T-shirts is 22.5. Second scenario: suppose that John specializes more in producing cakes than T-shirts. For example, assume he spends 8 hours in preparing cakes and 2 hours in making T-shirts. On the other hand, Jennifer specializes more in making T-shirts than cakes. She spends 6 hours in making T- shirts and 4 hours in preparing cakes. In this case, John can make 8 cakes and 1 T-shirt while Jennifer can make 24 T-shirts and 8 cakes. Now the total amount of cakes produced is 16 and we have 25 T-shirts. Compared to the first scenario, the total amount of both goods has increased. Why? The reason is that, in our example, John and Jennifer have different opportunity costs in producing the two goods. John is more efficient than Jennifer in producing cakes in terms of T-shirts. On the other hand, Jennifer is more efficient in producing T-shirts in terms of cakes than John. What is John’s opportunity cost of cakes in terms of T-shirts? Suppose that John wants to bake more cakes. He needs to spend less time on making T-shirts. How many T-shirts should he forgo? Suppose that John increases the production of cakes by 1 unit. How much time does he need to do that? He needs 1 hour to bake a cake. In that hour he could have made half a T-shirt (½). So John’s opportunity cost of cakes in terms of T-shirts is half a T-shirt. What about Jennifer? If she wants to bake one more cake she needs an extra half hour. In that half hour she could have made 2 T-shirts. So Jennifer’s opportunity of cakes in terms of T-shirts is 2 T-shirts. Therefore, John has a lower opportunity cost of cakes in terms of T-shirts than Jennifer. In this case, we say that John has a comparative advantage in making cakes compared to Jennifer. You can check that Jennifer has a comparative advantage in producing T-shirts compared to John. Therefore, from our example we can say that if each individual specializes more in producing the good in which he or she has a comparative advantage, then it is possible to increase the total production of goods, and so trade can be beneficial. An individual has a comparative advantage compared to another in the production of a good if she has a lower opportunity cost in producing it. Compared to the first scenario, in the second scenario Jennifer can trade 2 T-shirts with John in exchange for 2 cakes. Jennifer ends up with 22 T- shirts and 10 cakes, while John has 3 T-shirts and 6 cakes. Both gain from this trading in goods compared to the first scenario. In contrast to the concept of comparative advantage is that of absolute advantage. An individual has an absolute advantage in producing a good if he or she is more efficient at producing that good compared to someone else. In our example, Jennifer has an absolute advantage in producing both goods compared to John. In the same period of time she can make more T-shirts and cakes compared to John. Nevertheless, in determining possible benefits from trade the concept of comparative advantage is what matters, not absolute advantage. 1.4 The role of the market Markets bring together buyers and sellers of goods and services. In some cases, such as a local fruit stall, buyers and sellers meet physically. In other cases, such as the stock market, business can be transacted by computer. We use a general definition of markets. In markets buyers and sellers trade goods and services. As a result of this trade process the prices of those goods and services and their quantities (produced and consumed) are determined. Market prices influence the decisions about what, how and for whom to produce. Prices of goods and of resources (which are also goods, such as labour, machinery, land, energy) adjust to ensure that scarce resources are used to make the goods and services that society wants. A market is a process by which households’ decisions about consumption of alternative goods, firms’ decisions about what and how to produce, and workers’ decisions about how much and for whom to work are all reconciled by adjustment of prices. The price of a hamburger is lower than the price of a steak. Nevertheless McDonald’s is in the business because, given the price of beefburger meat, the rent and the wages for staff, it can still sell beefburgers at a profit. If rents were higher, it might sell beefburgers in a cheaper area or switch to luxury lunches for rich executives. The student behind the counter works there because a part-time job helps meet his tuition fees. If the wages were lower, he might not work at all. Conversely, the job is unskilled and there are plenty of students looking for such work, so McDonald’s does not have to offer high wages. ACTIVITY 1.1 SCARCITY IN ACTION: THE RISE OF MARKETS IN A POW CAMP2 In 1945 R. A. Radford, a British economist, published an article about his experience as a prisoner of war during the Second World War. He explained how in a society like the prisoner of war camp economic institutions like markets rose naturally to deal with the problem of scarcity. The story takes place in an Oflag, a camp for officers only, where between 1200 and 2500 people were imprisoned between 1943 and 1945. There was no paid labour in the camp. The only goods available were the food parcels from the German Army and the Red Cross. At the beginning the goods rations, such as chocolate, jam and cigarettes, were divided equally among the prisoners. There was no income inequality in that society. However, very soon, prisoners realized that trading could help deal with scarcity. For example, at the beginning non-smokers started giving cigarettes to smokers in exchange for chocolate. Over time more complex exchanges started to take place. A formal shop was created where exchanges could take place. A market was created. Cigarettes became the currency used in exchanges. Each good had a price in terms of cigarettes and only sales in cigarettes were accepted. Prices changed over time according to demand and supply. Oatmeal, once rare, became more common after 1943 and so its price fell. During hot weather people wanted more soap and less chocolate, and so the price of soap increased while that for chocolate decreased. In 1944 the supply of food parcels was halved  and prices changed accordingly. Canadian butter and marmalade became scarce resources and their prices increased. Prisoners started to switch to German margarine and jam. Even in a simple society, with no production or labour, a market was created as a natural mechanism to allocate scarce resources. Questions a. How do you think that the creation of the market in the POW camp helped answer the what, how and for whom to produce questions? b. If cigarettes become a scarce resource, what do you think should happen to their market price? Prices guide the consumer’s decision to buy a beefburger, McDonald’s decision to sell beefburgers and the student’s decision to take the job. Society allocates resources – meat, buildings and labour – into beefburger production through the price system. If people hated beefburgers, McDonald’s sales revenue would not cover its cost. Society would devote no resources to beefburger production. People’s desire to eat beefburgers guides resources into beefburger production. However, when cattle contract BSE, consumers shun beefburgers in favour of bacon sandwiches, and the price of bacon rises. As the fast- food industry scrambles to get enough pork, the price of pigs rises but the price of beef falls. Adjustments in prices encourage society to reallocate land from beef to pig farming. At the height of the British beef crisis in the mid- 1990s, caused by fears about ‘mad cow’ disease, pork prices rose 2 per cent but beef prices fell. Quite an incentive to reallocate! In a command economy a government planning office decides what will be produced, how it will be produced and for whom it will be produced. Detailed instructions are then issued to households, firms and workers. The command economy How would resources be allocated if markets did not exist? Such planning is very complicated. There is no complete command economy where all allocation decisions are undertaken in this way. However, in many countries, for example China, Cuba and those formerly in the Soviet bloc, there was a large measure of central direction and planning. The state owned factories and land, and made the most important decisions about what people should consume, how goods should be produced and how people should work. This is a huge task. Imagine that you had to run by command the city or town in which you live. Think of the food, clothing and housing allocation decisions you would have to make. How would you decide who should get what and the process by which goods are made and services delivered? These decisions are being made every day, mainly by the allocative mechanism of markets and prices. CASE 1.3 POOR MARX FOR CENTRAL PLANNERS During the Cold War, economists used to argue about the relative merits of capitalism and communism. But the Soviet bloc, falling increasingly behind the living standards of the West, abandoned Marxist central planning after 1990 and began transition to a market economy. By 2003 fans of Chelsea Football Club were celebrating the arrival of their new owner, Roman Abramovich, who had made his fortune in the market economy, initially as an oil trader and then as chairman of one of Russia’s leading oil companies. The Berlin Wall fell because the Soviet bloc had fallen far behind market economies in the West. Key difficulties that had emerged were: Information overload Planners could not keep track of the details of economic activity. Machinery rusted because nobody came to install it after delivery; crops rotted because storage and distribution were not co-ordinated. Bad incentives Complete job security undermined work incentives. Factory managers ordered excess raw materials to ensure they got materials again the next year. Since planners  could monitor quantity more easily than quality, firms met output targets by skimping on quality. Without environmental standards, firms polluted at will. Central planning led to low-quality goods and an environmental disaster. Insufficient competition Planners believed big was beautiful. One tractor factory served the Soviets from Latvia in the west to Vladivostok in the east. But large scale deprived planners of information from competing firms, making it hard to assess efficiency. Managers got away with inefficiency. Similarly, without electoral competition, it was impossible to sack governments making economic mistakes. The ‘invisible hand’ Individuals in free markets pursue their own self-interest without government direction or interference. The idea that such a system could solve the what, how and for whom problems is one of the oldest themes in economics, dating back to the Scottish economist Adam Smith, whose book The Wealth of Nations (1776) remains a classic. Smith argued that individuals pursuing their self-interest would be led ‘as by an invisible hand’ to do things that are in the interests of society as a whole. Markets in which governments do not intervene are called free markets. Suppose you wish to become a billionaire. You play around with new ideas and invent something, perhaps a very fuel-efficient car. Although motivated by self-interest, you make society better off by creating new jobs and opportunities. You move societys production possibility frontier outwards – the same resources now make more or better goods – and become a billionaire in the process. Smith argued that the pursuit of self- interest, without any central direction, could produce a coherent society making sensible allocative decisions. This remarkable insight has been studied at length by modern economists. In later chapters, we explain when the invisible hand works well and when it works badly. Some government intervention may then be justified. The invisible hand is the assertion that the individual pursuit of self- interest within free markets may allocate resources efficiently from society’s viewpoint. The mixed economy The free market allows individuals to pursue their self-interest without government restrictions. The command economy allows little scope for individual economic freedom. Decisions are taken centrally by the government. Between these extremes lies the mixed economy. Most countries are mixed economies, though some are close to command economies and others are much nearer to free market economies. Figure 1.5 illustrates this point. Even Cuba allows consumers some choice over the goods they buy. Conversely, even countries such as the US, which espouse more enthusiastically the free market approach, still have substantial levels of government activity in the provision of public goods and services, the redistribution of income through taxes and transfer payments, and the regulation of markets. In a mixed economy the government and private sector jointly solve economic problems. The government influences decisions through taxation, subsidies and provision of free services such as defence and the police. It also regulates the extent to which individuals may pursue their own self-interest.  Figure 1.5 Market orientation The role of the market in allocating resources differs vastly between countries. In the command economy resources are allocated by central government planning. In the free market economy there is virtually no government regulation of the consumption, production and exchange of goods. In between lies the mixed economy, where market forces play a large role but the government intervenes extensively. 1.5 Positive and normative In studying economics it is important to distinguish between ‘positive’ and ‘normative’ economics. Positive economics studies objective or scientific explanations of how the economy works. The aim of positive economics is to analyse how society makes decisions about consumption, production and exchange of goods. It aims both to explain why the economy works as it does, and to allow predictions about how the economy will respond to changes. In positive economics, we aim to act as detached scientists. Whatever our political sympathy or our ethical code, we examine how the world actually works. At this stage, there is no scope for personal value judgements. We are concerned with propositions of the form: if this is changed, then that will happen. In this regard, positive economics is similar to the natural sciences such as physics, geology or astronomy. Economists of widely differing political persuasions would agree that, when the government imposes a tax on a good, the price of that good will rise. The normative question of whether this price rise is desirable is entirely distinct. As in any other science, there are unresolved questions where disagreement remains. These disagreements are at the frontier of positive economics. Research in progress will resolve some of these issues but new issues will arise, providing scope for further research.  Normative economics offers recommendations based on personal value judgements. Competent and comprehensive research can in principle resolve many of the outstanding issues in positive economics; no such claim can be made about the resolution of issues in normative economics. Normative economics is based on subjective value judgements, not on the search for any objective truth. The following statement combines positive and normative economics: ‘The elderly have very high medical expenses, and the government should subsidize their health bills.’ The first part of the proposition is a statement in positive economics. It is a statement about how the world works. We can imagine a research programme that could determine whether or not it is correct. (Broadly speaking, it is.) The second part of the proposition – the recommendation about what the government should do – could never be ‘proved’ true or false by any scientific research investigation. It is a subjective value judgement based on the opinion of the person making the statement. Many people might share this subjective judgement. Others might disagree. You might believe that it is more important to devote society’s scarce resources to improving the environment not the health of the aged. Economics cannot be used to show that one of these normative judgements is correct and the other is wrong. It all depends on the preferences or priorities of the individual who, or the society that, has to make this choice. But we can use positive economics to clarify the menu of options from which society must eventually make its normative choice. The professional economist is offering expert advice on positive economics. Scrupulous economists distinguish their role as an expert adviser on positive economics from their status as involved private citizens arguing for particular normative choices. 1.6 Micro and macro Many economists specialize in a particular branch of the subject. Labour economics deals with jobs and wages. Urban economics deals with land use, transport, congestion and housing. However, we need not classify branches of economics by subject area. We can also classify branches of economics according to the approach used. In this regard we make a distinction between microeconomics and macroeconomics. For example, we can study why individuals prefer cars to bicycles and how producers decide whether to produce cars or bicycles. We can then aggregate the behaviour of all households and all firms to discuss total car purchases and total car production. We can examine the market for cars. Comparing this with the market for bicycles, we can explain the relative price of cars and bicycles and the relative output of these two goods. The sophisticated branch of microeconomics known as general equilibrium theory extends this approach to its logical conclusion. It studies simultaneously every market for every commodity. From this it is hoped to understand the complete pattern of consumption, production and exchange in the whole economy at a point in time. Microeconomics offers a detailed treatment of how individuals and firms make economic decisions. Macroeconomics emphasizes interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy. But this is very complicated. It is easy to lose track of the phenomena in which we were interested. The interesting task, which retains an element of art in economic science, is to devise judicious simplifications that keep the analysis manageable without distorting reality too much. Here, microeconomists and macroeconomists proceed down different avenues. Microeconomists tend to study one aspect of economic behaviour but ignore interactions with the rest of the economy in order to preserve the simplicity of the analysis. A microeconomic analysis of footballers’ wages would emphasize the characteristics of footballers and the ability of football clubs to pay. It would largely neglect the chain of indirect effects to which an increase in footballers’ wages might give rise (such as higher prices for luxury houses, leading to a boom in swimming pool manufacture). When microeconomic analysis ignores indirectly induced effects, it is ‘partial’ rather than ‘general’ analysis. In some instances, indirect effects may not be important and it will make sense for economists to examine particular industries or activities in great detail. When indirect effects are too important to ignore, an alternative simplification must be found. Macroeconomists rarely worry about the division of consumer goods into cars, bicycles and DVDs. Instead, they treat them as a single bundle called ‘consumer goods’ because they want to study the interaction between household purchases of consumer goods and firms’ decisions about purchases of machinery and buildings. Because macroeconomic concepts refer to the whole economy, they get more media coverage than microeconomic concepts, which are chiefly of interest to those in a specific group. Here are three macroeconomic concepts you have probably encountered. Gross domestic product (GDP) After the credit crunch in 2007 the global economy entered a recession. Figure 1.6 shows world real gross domestic product (GDP) (inflation adjusted). We can see that, after 2007, world real GDP started to decrease compared to previous years. During a recession, GDP is falling or is growing only very slowly. Gross domestic product (GDP) is the value of total output produced in an economy in a given period.  Figure 1.6 World real GDP, US$ (bn) Source: © The World Factbook 2013-14. Washington, DC: Central Intelligence Agency, 2013. Aggregate price level The prices of different goods may move differently. aggregate price level tells us what is happening to prices on average. When this price level is rising, we say there is inflation. The aggregate price level measures the average price of goods and services. Unemployment rate The labour force is people of working age who have a job or want one. Some of the rich, the sick and the lazy are of working age but not looking for work. They are not in the labour force and not counted within the unemployment rate. The unemployment rate is the fraction of the labour force unemployed but actively looking for a job. People dislike both inflation and unemployment. In the 1970s, oil price shocks and excessive money creation led to high inflation. Then, inflation fell but unemployment increased. By 2000 both inflation and unemployment had finally fallen back to low levels. Yet by 2007 inflation was beginning to increase again. However, after the credit crunch took place, in many economies inflation started to fall and unemployment started to rise. In some cases, inflation became negative – a situation known as deflation. Macroeconomists want to understand what generates these fluctuations. Getting the most out of each chapter There is a summary of the main points at the end of each chapter. Like learning to drive, the best way to check your progress is not to read more and more but to try to do it for yourself. Attempt the review questions that follow the summary (answers are provided on the Online Learning Centre website: www. mcgraw-hill-co.uk/textbooks/begg). Connect has many more problems, also with answers: a self-contained driving instructor. Summary Economics analyses what, how and for whom society produces. The key economic problem is to reconcile the conflict between people’s virtually unlimited demands and society’s limited ability to produce goods and services to fulfill these demands. Rational individuals, in making choices, must compare the benefits and the costs associated with those choices. A choice is made only if the benefit of doing it is larger than its cost. The production possibility frontier (PPF) shows the maximum amount of one good that can be produced given the output of another good. It depicts the trade-off or menu of choices for society in deciding what to produce. Resources are scarce and points outside the frontier are unattainable. It is inefficient to produce within the frontier. The opportunity cost of an activity is the value of the best alternative that we must sacrifice. It is the slope of the PPF. If individuals, firms or countries have different opportunity costs of producing a good compared to others, they have a comparative advantage. The fact that individuals have comparative advantages in producing different goods creates the possibility for gains from trading. Industrial countries rely extensively on markets to allocate resources. The market resolves production and consumption decisions by adjustments in prices.  In a command economy, decisions on what, how and for whom are made in a central planning office. No economy relies entirely on command. A free market economy has no government intervention. Resources are allocated entirely through markets in which individuals pursue their own self-interest. Adam Smith argued that an ‘invisible hand’ would nevertheless allocate resources efficiently. Modern economies are mixed, relying mainly on the market but with a large dose of government intervention. The optimal level of intervention is hotly debated. Positive economics studies how the economy actually behaves. Normative economics recommends what should be done. The two should be kept separate. Given sufficient research, economists could agree on issues in positive economics. Normative economics involves subjective value judgements. There is no reason why people should agree about normative statements. Microeconomics offers a detailed analysis of particular activities in the economy. For simplicity, it may neglect some interactions with the rest of the economy. Macroeconomics emphasizes these interactions at the cost of simplifying the individual building blocks. Review questions EASY 1 Suppose society abolishes higher education and as a result students have to find jobs immediately. If there are no jobs available, how do wages and prices adjust so that those who want jobs can find them? 2 Communist Russia used prices to allocate production among different consumers. Central planners set production targets but then put output in shops, fixed prices and gave workers money to spend. Why not plan the allocation of particular goods to particular people as well? 3 Which of the following statements are positive and which are normative? (a) Annual inflation is belowpercent. (b) Because inflation  is low, the government should cut taxes. (c) Income is higher in the UK than in Poland. (d) Brits are happier than Poles. 4 Common Fallacies Why are these statements wrong? (a) Since some economists are Conservative but others Labour, economics can justify anything. (b) Efficiency gains cannot increase the production of some commodities without sacrificing others, and therefore there is no such thing as a ‘free lunch’. Economics is about people, and thus cannot be a science. 5 Which of the following statements refer to microeconomics and which to macroeconomics? (a) Inflation is lower than in the 1980s. (b) The price of a tin of beans fell this month. (c) Good weather means a good harvest. (d) Unemployment in London is below the UK average. MEDIUM 6 OPEC made a fortune for its members by organizing production cutbacks and forcing up prices. (a) Why have coffee producers not managed to do the same? (b) Could UK textile firms force up textile prices by cutting back UK textile production? 7 Suppose it becomes possible in 5 years’ time to make as much energy as we want from biofuels provided the price is the equivalent of at least $50/barrel for oil. (a) What does this imply about the eventual price of oil in, say, 10 years’ time? (b) Is it possible for oil prices to be substantially above $50/barrel for the next few years? (c) Do higher oil prices in the short run increase or reduce the incentive to look for alternative energy technologies? 8 An economy has 5 workers. Each worker can make 4 cakes or 3 shirts. (a) Draw the production possibility frontier. (b) How many cakes can society get if it does without shirts? (c) What points in your diagram are inefficient? (d) Can the economy produce an output combination which lies above the production possibility frontier? (e) What is the opportunity cost of making a shirt and making a cake? (f) Does the law of diminishing returns hold in this economy? 9 Suppose that a country can produce two goods: food and clothing. To produce one unit of food, it requires one worker. To produce one unit of clothing, it requires two workers. The total amount of workers available in the economy is fixed and equal to 100. Denoting with L the total amount of workers, with F the units of food produced and with C the units of clothing produced, the resource constraint for this economy can be written as: L = aF F + aC C, where aF is the amount of workers  needed to produce one unit of food and aC the amount of workers needed to produce one unit of clothing. Show how to construct the production possibility frontier from that resource constraint. In a graph with C on the vertical axis and F on the horizontal axis, plot the PPF of this economy. What is the slope of the PPF? HARD 10 Suppose a farmer is planning to grow cabbages on his land. The cost of growing cabbages is £50 per acre and he earns £100 from the produce in the market. There is another option for him, to grow pumpkins, which could yield him £110 if he spent £70 on it. (a) What is the opportunity cost of growing cabbages? Is it rational for the farmer to grow cabbages instead of pumpkins? (c) Suppose the only other option for him to earn from his farmland is to rent it to another farmer. How will the farmer arrive at a rational decision? 11 Essay question Two similar countries take the decision to try to increase the health of their poorest people. One country raises taxes on the rich and gives more money to the poor. The other country raises taxes on the rich and provides more health care, free to patients, through its national health service. Which country do you think is more likely to meet its objective? Why? 1 Some economists define the opportunity cost as the total cost of an activity, meaning they include the explicit costs in the definition of opportunity cost. We keep them separated to emphasize the fact that the cost of any activity includes both explicit and implicit costs. 2 Based on R. A. Radford, ‘The economic organisation of a P.O.W. camp’, Economica 12, no. 48 (1945): 189–201. CHAPTER 2 Tools of economic analysis Learning Outcomes By the end of this chapter, you should be able to: 11 recognize why theories deliberately simplify reality 12 understand time-series, cross-section and panel data 13 construct index numbers 14 differentiate between nominal and real variables 15 build a simple theoretical model 16 understand how to plot data and interpret scatter diagrams 17 use ‘other things equal’ to ignore, but not forget, important influences It is more fun to play tennis if you know how to serve, and cutting trees is much easier with a chainsaw. Every activity or academic discipline has a basic set of tools. Tools may be tangible, like the dentist’s drill, or intangible, like the ability to serve in tennis. This chapter is about the tools economists use. To analyse economic issues we use both models and data. Models or theories - we use these terms interchangeably – are frameworks to organize how we think about a problem. They simplify by omitting some details of the real world to concentrate on the essentials. From this manageable picture of reality we develop an analysis of how the economy works. A model or theory makes assumptions from which it deduces how people will behave. It is a deliberate simplifi cation of reality. An economist uses a model as a tourist uses a map. A map of Glasgow misses out many features of the real world – traffic lights, roundabouts, speed bumps – but with careful study you get a good idea of how the traffic flows and the best route to take. The simplified picture is easy to follow, but helps you understand actual behaviour when you must drive through the city in the rush hour. The data or facts interact with models in two ways. First, the data help us quantify the relationships to which our theoretical models draw attention. It is not enough to know that all bridges across the Clyde are likely to be congested. To choose the best route we need to know how long we have to queue at each bridge. We need some facts. The model is useful because it tells us which facts are likely to be the most important. Second, the data help us to test our models. Like all careful scientists, economists must check that their theories square with the relevant facts. For example, for a while the number of Scottish dysentery deaths was closely related to UK infl ation. Is this a factual coincidence or the key to a theory of infl ation ? The facts alert us to the need to ponder this question, but we can decide only by logical reasoning. Data are pieces of evidence about economic behaviour and can be used to test economic models. In this instance, we can find no theoretical connection. Hence, we view the close factual relationship between Scottish dysentery deaths and UK inflation as a coincidence that should be ignored. Without a logical underpinning, the empirical connection will break down sooner or later. Paying attention to a freak relationship in the data increases neither our understanding of the economy nor our confidence in predicting the future. The blend of models and data is subtle. The data alert us to logical relationships we had overlooked. And whatever theory we wish to maintain should certainly be checked against the facts. But only theoretical reasoning can guide an intelligent assessment of what evidence has reasonable relevance. When a theory that makes sense has for a long time survived exposure to the relevant economic data, we sometimes accord it the status of a behavioural law, such as the law of diminishing returns. A behavioural law is a sensible theoretical relationship not rejected by evidence over a long period. Next, we turn to the representation of economic data. Then we show how an economist might develop a theoretical model of an economic relationship. Finally, we discuss how actual data might be used to test the theory that has been developed. 2.1 Economic data How might we present data to help us think about an economic problem ? There are different ways in which real-world data can be presented. We distinguish between time-series data, cross-section data and panel data. Time-series data Th firest two columns of Table 2.1 report a time series of monthly copper prices. It shows how the price changes over time. This information may be presented in tables or charts. A time series is a sequence of measurements of the same variable at different points in time. Figure 2.1 plots, or graphs, these data. Each point in the fi gure corresponds to an entry in the table. Point A shows that in January 2010 the price of copper was $7385 per tonne. The series of points or dots in Figure 2.1, in whichever colour, contains the same information as the fi rst two columns of Table 2.1. Table 2.1 The price of copper, 2010 (US$/tonne) Monthly $/tonne Quarterly $/tonne Jan 7385 IV 6696 Jan 7385 IV 6696 Feb 6847 Mar 7462 Apr 7744 I 7231 Source: London Metal Exchange (www.lme.co.uk). Charts or diagrams must be interpreted with care. The eye is easily misled by simple changes in presentation of the data. In Figure 2.1 the green line corresponds to the left-hand scale and the purple line corresponds to the enlarged scale on the right. Both graphs plot the same data but the blue graph seems to move more. Diagrams can be manipulated in suggestive ways, a point well understood in advertising and politics. Daily data usually contain too much detail. Imagine studying daily prices over 10 or 20 years!1 Averages over a month, a quarter (three months) or a year may be the best way to present data. The last two columns of Table 2.1 show quarterly averages for copper prices. The four quarters of the year are the periods January-March, April-June, July-September and October-December. For the fourth quarter of 2009 the quarterly average is $6696. In the first quarter of 2010 the price of copper was on average $7231. It can be seen as one-third of the sum of the monthly numbers for January, February and March. The green line plots Table 2.1 using the left-hand-side scale. The purple line uses the right-hand-side scale. Prices seem now to move less. Figure 2.1 The monthly price of copper, 2010 Source: London Metal Exchange (www.lme.co.uk) Cross-section data Time-series data record how a particular variable changes over time. Economists also use cross-section data. Table 2.2 shows a cross-section of unemployment rates in August 2012 for different countries. Cross-section data record at a point in time the way an economic variable differs across different individuals or groups of individuals. Table 2.2 Unemployment by country, August 2012 (% of labour force) US Japan Germany France UK 8.1 4.2 5.5 10.6 8.0 Source: OECD; ONS. Panel data Panel data, also called longitudinal data, are a mix between time-series and cross-section data. Panel data record observations over multiple time periods for the same individuals or groups of individuals. Table 2.3 shows a panel data example in which the same variable (unemployment rate) is recorded over time for the same group of countries. Table 2.3 Unemployment by country, 2008–11 (% of labour force) US Japan Germany France UK 2008 5.7 3.9 7.5 7.2 5.3 2009 9.2 5.0 7.7 9.0 7.7 2010 9.6 5.0 7.0 9.2 7.8  US Japan Germany France UK 2011 8.9 4.5 5.9 9.0 7.8 Source: OECD; IMF. 2.2 Index numbers To compare numbers without emphasizing units of measurement, we use index numbers. An index number expresses data relative to a given base value. Table 2.4 shows annual averages for aluminium and copper prices. We could choose 2004 as the base year and assign the value 100 to both the aluminium and the copper price index in this base year. Table 2.4 Prices of aluminium and copper (US$/tonne) 2004 2007 2010 Aluminium price 1758 2644 2232 Copper price 9.2 6710 7234 Aluminium Index (2004 5 100) 100 150 127 Copper Index (2004 5 100) 100 242 261 Metals Index (2004 5 100) 100 224 234 Source:London Metal Exchange (www.lme.co.uk). By 2007 the aluminium price of $2644 per tonne was around 1.5 times its price in 2004. If the aluminium prices had been 100 in 2004, this index must be 150 by 2007. To get the 2010 value, we divide the 2010 aluminium price of $2232 by the 2004 price of $1758 to get 1.27. Multiplying this by the starting value of 100 for the index in 2004 yields 127 for the aluminium index in 2010, as in Table 2.4. Using the index number for aluminium we can say that the price of aluminium in 2010 was 27 per cent higher than in 2004, the base year. The price index for copper is calculated in the same way, dividing each price by the 2004 price, then multiplying by 100. According to the copper index, the price of copper in 2010 was 161 per cent higher than in 2004. Now check that you understand this procedure. In 2001 average aluminium prices were $1482 per tonne and average copper prices were $1660. What were the values of the aluminium and copper price indices ? (Answer: 84 and 60.) Index numbers as averages Now think about the price of metals as a whole. The prices of different metals change differently. To derive a single measure of metal prices we average different metal prices. Suppose aluminium and copper are the only metals. An index of metal prices in the fifth row of Table 2.4 makes a single time series by combining the time series in the third and fourth rows. In the metal index, each metal has a weight or share that reflects the purpose for which the index is constructed. If it summarizes what firms pay for metal inputs, the weights should reflect the relative use of aluminium and copper as industrial inputs. Copper is much more widely used than aluminium. We might choose a weight of 0.8 for copper and 0.2 for aluminium. The weights always add up to 1. The last row of Table 2.4 shows changes over time in the metal price index, the weighted average of the indices for aluminium and copper. In the base year 2004, the metals index is 100, being (0.2 × 100) + (0.8 × 100). By 2007 the index is around 224, which is (0.2 × 150) + (0.8 × 242). In 2010 the index was 234. The metals index, a weighted average of aluminium and copper prices, must lie between the indices for the two separate metals. The weights determine whether the metals index more closely resembles the behaviour of copper prices or aluminium prices. The CPI and other indices To keep track of the prices faced by consumers, countries construct a consumer price index (CPI). The CPI is used to measure changes in the cost of living; that is, the money that must be spent to purchase the typical bundle of goods consumed by a representative household. In the UK the CPI forms the basis for the government’s inflation target which the Bank of England’s Monetary Policy Committee is required to achieve. The CPI is constructed in two stages. First, index numbers are calculated for each category of commodity purchased by households. Second, the CPI is constructed by taking a weighted average of the different commodity groupings. Table 2.5 shows the weights used and the main commodity groupings. The weights sum up to 1. The ‘shopping basket’ described in Table 2.5 is reviewed every year to make sure that it is up to date and representative of consumers’ spending. The consumer price index (CPI) measures changes in the cost of living by looking at the cost of a standard ‘shopping basket’ of goods. Table 2.5 Prices of aluminium and copper (US$/tonne) Item Weights Food and non-alcoholic beverages 0.106 Alcoholic beverages and tobacco 0.044 Clothing and footwear 0.068 Housing and household services 0.137 Furniture and household goods 0.059 Health 0.025 Transport 0.148 Communication 0.31 Recreation and culture 0.141 Education 0.021 Restaurants and hotels 0.117 Miscellaneous goods and services 0.103 Source: ONS (2013) Consumer Prices Index and Retail Prices Index: The 2013 Basket of Goods and Services. A 10 per cent rise in food prices will change the CPI more than a 10 per cent rise in the price of alcoholic beverages and tobacco. This is because food has a much larger weight than alcohol and tobacco in consumers’ expenditure. Another price index that is particularly important is the retail price index (RPI), which is also used to measure changes in the cost of living. The RPI is similar to the CPI, the main differences being in terms of the items included in one index and not in the other. For example, the RPI includes mortgage interest payments by household while the CPI does not. In the past, the RPI used to be the index used to calculate inflation in the UK. More recently, the CPI has been adopted as the main measure for UK inflation, as it is in other European countries. Price indices like the CPI and RPI may overstate the cost of living because they do not measure accurately changes in the quality of the goods over time. In Figure 2.2 we plot the inflation rate in the UK for the period 1989-2012 as measured by CPI and RPI indices. While there are differences between the two inflation measures, the behaviour of inflation over time looks pretty similar in both indices. The inflation rate is the annual rate of change of the consumer price index. Other examples of indices include the index of wages in manufacturing, a weighted average of wages in different manufacturing industries. The FTSE, or ‘footsie’, is the Financial Times-Stock Exchange index of share prices quoted on the London Stock Exchange. The index of industrial production is a weighted average of the quantity of goods produced by industry. The process by which index numbers are calculated is always the same. We choose a base date at which to set the index equal to 100, then calculate other values relative to this baseline. Where the index refers to more than one commodity, we have to choose weights by which to average across the different commodities that the index describes. Figure 2.2 UK inflation rate Source: Offi ce for National Statistics. CONCEPT 2.1 HYPERINFLATION In developed countries over the last few decades inflation has been moderate. However, there are cases in which inflation explodes over time. When prices start to increase very rapidly over time and inflation becomes particularly large, we have a case of hyperinflation. A typical example is what happened in Germany after the First World War. In 1918 the Allied victors demanded that Germany make reparations for the damage done and pay the pensions of Allied armed forces engaged in the war. By 1922, in economic ruin, Germany suspended reparations. In January 1923 French and Belgian troops occupied the Ruhr coalfields. German workers began a general strike and the government rolled the presses to print money to pay the 2 million workers involved. This was the last straw for the German economy. Prices spiralled out of control. Monthly inflation reached the equivalent of 1 million per cent a year. Paper money became almost worthless. Hyperinflation is not particularly rare. In the 1980s it occurred in several Latin American countries (Bolivia, Argentina, Brazil). More recently, Zimbabwe experienced extreme hyperinflation. To give an idea of the magnitude of price level increases, in 2008 the inflation rate in Zimbabwe was 231 150 888.87 per cent. This means that if a good had a price of 1 Zimbabwean dollar in 2007, the same good would have a price of 231 150 888.87 Zimbabwean dollars in 2008! During hyperinflation, national currency becomes worthless and people simply do not want to use it. In 2009 Zimbabwe abandoned printing of the Zimbabwean dollar, and the South African rand and US dollar became the standard currencies for exchange. 2.3 Nominal and real variables The first row of Table 2.6 shows the average price of a house, which rose from £2800 in 1963 to £166 000 in 2012.2 Are houses really 53 times as expensive as in 1963 ? Not when we allow for inflation, which also raised incomes and the ability to buy houses. Table 2.6 Average UK house prices 1963 1983 2012 House price (£000s) 2.8 27.6 166 RPI (2012 = 100) 4.5 34.3 100 Real price of houses (2012 £000s) 62.2 80.4 166 Source: Nationwide. The second row of Table 2.6 shows the retail price index, using 2012 as the base year.3 Inflation led to substantial increases in the RPI during 1963-2009. The third row of Table 2.6 calculates an index of real house prices, expressed in 2012 prices. The value of house prices is the same in 2012 in the top and bottom rows. To calculate the real price of houses in 1963, by expressing them at 2012 prices, we take the nominal price of £2800 and multiply by [(100)/(4.5)] to allow for subsequent inflation, yielding £62 200. Real prices have roughly increased by a factor of 2.5 since 1963 (from £62 200 to £166 000). Most of the 53-fold increase in nominal house prices in the top row of Table 2.5 was due to inflation. Real or relative prices The distinction between nominal and real values applies to all variables measured in money values. It does not apply to units of output, such as 4000 carpets per annum, which relate to physical quantities. Whatever the inflation rate, 4000 carpets is 4000 carpets. However, we do not know whether £100 is a large or a small amount until we know the measurement. general price level for goods. Nominal values are measured in the prices ruling at the time of measurement. Real values adjust nominal values for changes in the price level. The argument carries over to prices themselves. The nominal price of silver has risen a lot since 1970. To calculate an index of the real price of silver, divide an index of nominal silver prices by the RPI or the CPI and multiply by 100. Real prices indicate economic scarcity. They show whether the price of a commodity rose faster than prices in general. Hence, real prices are sometimes called relative prices. Consider the price of televisions over the past 20 years. TV prices, measured in pounds, have hardly changed. The RPI and the CPI have risen. The real price of TVs has fallen. Advances in technology have increased the quality of televisions but have also reduced the cost of producing them. Because the real price has fallen, many households now have several TVs. It is misleading to base our analysis on nominal values of variables. The purchasing power of money When the price of goods rises, the purchasing power of money falls because £1 buys fewer goods. To distinguish between real and nominal variables, we say that real variables measure nominal variables as if the purchasing power of money had been constant. Another way to express this idea is to distinguish nominal variables in current pounds and real variables in constant pounds. The purchasing power of money is an index of the quantity of goods that can be bought for £1. Table 2.6 described real prices of houses measured in 2012 pounds. We could of course have used 1960 pounds instead. Although the level of the real price index for houses would have been different, it would have grown at exactly the same rate as in the final row of Table 2.6.  CONCEPT 2.2 MONEY ILLUSION The distinction between nominal and real variables is a key concept in economics. Money illusion refers to a tendency to think in terms of nominal rather than real monetary values. This means that the nominal value of money can be mistaken for its purchasing power. Suppose you work and you get a wage of £1000. With that wage you buy only bread and the price of bread is £1 per kg. This means your wage in real terms has a value of 1000 kg of bread (meaning that the purchasing power of your wage is 1000 kg of bread). Now suppose you are asked to choose between the following two cases: You can get an increase to £1600 in your wage while the price of bread is £2. You can get a reduction in your wage to £800 while the price of bread is £1. Which one should you choose ? The two situations are equivalent in ‘real terms’. Therefore if you are rational you should not prefer one to the other. In both cases you buy the same amount of bread (800 kg). People who perceive these situations differently are said to be prone to money illusion. Do people suffer from money illusion ? Some evidence suggests that they do. Indeed, if we asked many individuals the same question as above, we would probably see some individuals choosing case (1). The reason is that some individuals will think that an increase in the nominal wage is better than a decrease in the nominal wage, even if in real terms nothing has changed. Source: E. Shafir et al., ‘On money Illusion’, Quarterly Journal of Economics 112, no. 2 (1997): 341-374. 2.4 Measuring changes in economic variables During the BSE crisis in 1996, UK beef production fell from 90 000 tonnes in January to 50 000 tonnes in April. The absolute change was −40 000. The minus sign tells us it fell. The percentage change in UK beef output was (100) × (−40 000)/(90 000) = −44%. Absolute changes specify units (e.g. tonnes), but percentage changes are unit-free. Data are often shown this way. The percentage change is the absolute change divided by the original number, then multiplied by 100. The growth rate is the percentage change per period (usually a year). When we study time-series data over long periods such as a decade, we do not want to know just the percentage or absolute change between the initial date and the fi nal date. We want to know the percentage or absolute change between every period. Negative growth rates show percentage falls. Economists usually take economic growth to mean the percentage annual change in the national income (that is, the real gross domestic product). 2.5 Economic models Now for an example of economics in action. The London Underground, known locally as the tube, usually loses money and needs government subsidies. Might different policies help ? You have to set the tube fare that will raise most revenue. How do you analyse the problem ? To organize our thinking, or build a model, we need to simplify reality, picking out the key elements of the problem. Economic models are usually built using mathematical equations linking the variables of interest. We begin with the simple equation Revenue = [fare] × [number of passengers] (1) London Underground sets the fare and influences the number of passengers only through the fare that is set. (Cleaner stations and better service may help. We neglect these for the moment.) The number of passengers may reflect habit, convenience and tradition, and be completely unresponsive to changes in fares. This is not the view an economist would adopt. It is possible to travel by car, bus, taxi or tube. Decisions about how to travel will depend on the relative costs of different modes of transport. Equation (1) requires a ‘theory’ or ‘model’ of what determines the number of passengers. We must model the demand for tube journeys. First, the tube fare matters. Other things equal, higher tube fares reduce the number of tube journeys demanded. Second, if there are price rises for the competing modes of taxis and buses, more people will use the tube at any given tube fare. Third, if passengers have higher income, they can afford more tube journeys at any given fare. We now have a bare-bones model of the number of tube passengers: Number of passengers = f (tube fare, taxi fare, petrol price, bus fare, passenger incomes … ) (2) The number of passengers ‘depends on’ or ‘is a function of’ the tube fare, the taxi fare, petrol prices, bus fares, incomes and some other things. The notation f ( … ) is shorthand for ‘depends on all the things listed inside the brackets’; or, in mathematical terms, it reads that the number of passengers is a function of all the variables in the brackets. The row of dots reminds us that we have omitted some possible determinants of demand to simplify our analysis. Tube demand probably depends on the weather. It is uncomfortable in the tube when it is hot. If the purpose of our model is to study annual changes in the number of tube passengers, we can neglect the weather provided weather conditions are broadly the same every year. Writing down a model forces us to look for all the relevant effects, to worry about which effects must be taken into account and which can be ignored in answering the question we have set ourselves. Combining equations (1) and (2), Tube revenue = tube fare × number of passengers = tube fare × f (tube fare, taxi fare, petrol price, bus fare, incomes … ) (3) Why all the fuss ? You would have organized your approach along similar lines. That is the right reaction. Models are simply devices to ensure we think clearly about a problem. Clear thinking requires simplification. The real world is too complicated for us to think about everything at once. Learning to use models is more an art than a science. Too much simplicity will omit a crucial factor from the analysis. Too much complexity and we lose any feeling for why the answer turns out as it does. Sometimes data guide us about which factors are crucial and which are not. At other times, as with tube fares, it is not enough to understand the forces at work. We need to quantify them. For both reasons, we turn now to the interaction of economic models and economic data. 2.6 Models and data Equation (3) is our model of determinants of tube revenue. Higher fares give more revenue per passenger, but reduce the number of passengers. Theory cannot tell us which effect dominates. This is an empirical or factual issue: how many passengers are put off by higher fares ? Empirical evidence We need some empirical research to establish the facts. Experimental sciences, including many branches of physics and chemistry, conduct controlled experiments in a laboratory, varying one factor at a time while holding constant all the other relevant factors. Like astronomy, economics is primarily a non-experimental science. Astronomers cannot suspend planetary motion to examine the relation between the earth and the sun in isolation; economists cannot suspend the laws of economic activity to conduct controlled experiments. Most empirical research in economics must deal with data collected over periods in which many of the relevant factors were simultaneously changing. The problem is how to disentangle the separate influences on observed behaviour. We approach this in two stages. First, we proceed by examining the relationship of interest - the dependence of revenue on fares - neglecting the possibility that other relevant factors were changing. Then we indicate how economists deal with the harder problem in which variations in other factors are also included in the analysis. Table 2.7 shows data on tube fares and passengers. When annual data are measured over overlapping calendar years - say, from April 1999 to March 2000 - we show the year as 1999/00. Column (1) shows the real tube fare per passenger kilometre, column (2) shows tube demand, in billions of passenger kilometres a year, and column (3) shows real revenue. Table 2.7 The tube, 1999/00–2008/09 (1) Real fare (08/09 pence) (2) No. of trips (bn pass. km) (3) Real revenue (08/09 £m) 1999/00 18.4 7171