Ten Thoughts on Improving Your Economics Papers

AS and A2 Economics Revision

April 2012

(1) The Importance of the Margin

• Textbook economics – decisions made at the margin– Marginal revenue = marginal cost (profit max output)– Marginal social benefit = marginal social cost (social equilibrium)

• Few businesses / people have the capacity to reach precise equilibrium points – or even seek to find them

• But……– Marginal changes in behaviour can have a big effect if enough

people make them (e.g. Energy consumption)– Economists increasingly interested in power of network effects– Changing behaviour ‘at the margin’ can have important social

effects – social norms can change + policies can have an impact– The fundamental value of something depends on the value of

the marginal unit – important in lots of markets (e.g. oil, food)

2: Unintended Consequences

• This is a root cause of ‘government failure’

• All govt interventions in a market have at least one and often several unintended consequences

• Easy to have the benefit of hindsight when seeing this!

• Reasons:– Economics is a social science about human behaviour

– Rational agents look for ways to offset policies that cost them

– Widespread information failure by state when setting policies

– Policies are static but markets are dynamic - markets and the agents that inhabit them move far more quickly than government

– Disintermediation is inevitable in a globalized world

3: Stakeholders matter!

• Stakeholders are ‘Any person or organization that has a legitimate interest in a specific project or policy decision.’

• Check to see the source of comment in data response questions – is there inbuilt bias?

• Identify and comment when value judgements are being made – always scores high for evaluation

• When evaluating – bring in the views of different stakeholders (see the WEESTEPS approach)

• Risk of government failure:– Regulatory capture / powerful lobbying for particular group– i.e. policy decisions made to please a vested interest– Inequitable impact between one group and another

Examples of Stakeholders

• Employees • Communities where a business is located or affected by

a decision• Supply chain businesses• Shareholders• Creditors • Government (and taxpayers)• Trade unions (and the workers they represent)

• NGOs and other advocacy groups (i.e. World Bank, IMF, Pressure Groups)

• Prospective employees • Prospective customers • National communities • International community• Competitors in a market

4: Time Periods – Always Consider Them!

• Be familiar with– Immediate (momentary) especially in primary sectors

– Short run (at least 1 fixed factor, diminishing returns)

– Long run (all factor inputs are variable, internal and external economies and diseconomies of scale can be exploited)

• Applications of time periods in your analysis– Elasticity of supply (micro and macro (AS) supply curves)

– Elasticity of demand (Ped, CPed, Income elasticity)

– ‘Discounting’ the future value of costs and benefits (CBA)

– Long run effects of macro policies e.g. supply-side / trade policy

– Long run effects of micro policies – e.g. liberalising a market, nationalisation, buffer stock schemes, indirect taxes

5: (a) Demand and supply curves are often non-linear!

P P

Q

Demand

S

Changing elasticity of supply as output increases

Q

No reason for demand curve to be drawn as straight line

5(b): Upward sloping demand and downward-sloping supply!

P P

Q

D

S1

S2

S2

Long run supply with economies of scale

Q

Upward sloping demand curve – e.g. Speculation or snob-value demand

6: Change the elasticity to build / develop / deepen your analysis!

P

D

S

S + tax

Q1Q2

P1

P2

6: Change the elasticity to build / develop / deepen your analysis!

P

Q

D

S

S + tax

Q1Q2

P1

P2

P

Q

D1

S

S + tax

Q1Q2

P1

P2

D2

More close substitutes – higher CPED

7: Most markets are inter-related

• Changes in relative prices / rewards in one market affect resource allocation in others

• Key related-market concepts to revise:– Substitutes – products in competitive demand– Complements – products in joint demand– Derived demand – especially in supply-chain / labour markets– Composite demand – factor input can be used in different ways– Joint supply – increased supply of one product by-products– Competitive supply – Q of X causes contraction in Q of Y

• Also important in macroeconomics– Factor markets and the economic cycle (labour demand)– Bond markets / currency markets / equity markets– Macroeconomic effects of external demand/supply shocks

8: Relative prices, preferences and incentives in our choices

• Markets are powerful – don’t underestimate them – especially the power of setting the right incentives

• Policy interventions seek to change behaviour of agents• People do respond to incentives

– Govt failure if the incentives turn out to be perverse– Govt failure if the incentives are not strong enough (ineffective)

• Behaviour changes when relative costs & benefits alter– Leads to substitution effects (changes in demand for X and Y)– Agents react to changes in measured costs and benefits of their

own actions• This requires

– A sufficient change in relative prices to make a difference– Availability of alternative courses of action– Enough time for agents to respond and react

Examples of changes in relative prices

• London congestion charge / underground fares

• National minimum wage / living wage

• Changes in relative prices of low and high carbon energy

• Relative prices (profits) of different crops in farming

• Relative price of ethical-products

• Relative prices and demand for exports / imports e.g. Following an exchange rate change

• Relative prices of legal versus illegal transactions (e.g. Incentives to engage in crime / trade in human organs)

• Relative labour costs in different countries (FDI decisions)

9: Expectations matter!

• Expectations are hugely important in micro and macro!• Expectations of the future drive current behaviour!

– Housing market / property development / decisions on land use– Investment decisions by businesses (expected profits)– Food supply decisions – expected returns from different crops– Currency demand and supply – speculative activity in FOREX– Monetary policy / inflation – inflation expectations and wages– Fiscal policy / tax cuts / govt borrowing – expectations of

changes in taxes

• Formation of expectations:– Rational expectations – growing doubts about rationality– Adaptive expectations – adapting to recent experiences

10: The cost-benefit principle

• The mother of all economic ideas is the cost-benefit principle. • It says that should take an action if, and only if, the extra benefit

from taking it is greater than the extra cost• The hard part is

– Identifying the relevant costs and benefits– Measuring and valuing them – many things that matter to us do not

have market prices or accurate valuations• Key point: Individual rationality does not always lead to a socially

optimum / desirable outcome• Behavioural economics questions the core rationality embedded into

conventional textbook economics• A cost benefit approach can be applied to most intervention issues• But be aware of the limitations of cost-benefit analysis!

And finally….to help your evaluation

• Most policy problems require a combination of strategies• Understanding network effects – they are important• Understand interdependence in markets - agents can be influenced

directly by what others do• Understand the meaning of efficiency and equity in markets

(allocative, productive, dynamic efficiency)• Have the courage to challenge the conventional wisdom• Let your diagrams do a lot of the hard work for you – develop your

analysis with high quality diagrams – it will make a difference• Use the data that is provided but be aware of limitations• Be cautious about the effectiveness of government intervention• Few policies are subject to a rigorous trial process – a weakness• Markets often find solutions to intractable problems in the long run –

if the incentives are strong enough

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