A Student’s Guide

Economics

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FifthEdition

A Student’s Guide

Economics

JOHN BEARDSHAW

DAVID BREWSTER

PAUL CORMACK

ANDREW ROSS

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Dedicated to John Beardshaw 1943–1995

Pearson Education LimitedEdinburgh GateHarlowEssex CM20 2JEEngland

and Associated Companies throughout the world

Visit us on the World Wide Web at:www.pearsoned.co.uk

First published in Great Britain under the Pitman Publishing imprint in 1984Second edition published 1989Third edition published under the Longman imprint in 1992Fourth edition published 1998Fifth edition published 2001

© John Beardshaw 1984, 1989 and 1992© Denise Beardshaw and Pearson Education Limited 1998, 2001

The rights of John Beardshaw, David Brewster, Paul Cormack and Andrew Rossto be identified as the authors of this work have been asserted by them inaccordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, storedin a retrieval system, or transmitted in any form or by any means, electronic,mechanical, photocopying, recording, or otherwise without either the priorwritten permission of the publishers or a licence permitting restricted copyingin the United Kingdom issued by the Copyright Licensing Agency Ltd,90 Tottenham Court Road, London W1T 4LP.

ISBN-10: 0-273-65140-4ISBN-13: 978-0-273-65140-6

British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication DataEconomics : a student’s guide / John Beardshaw ... [et al.].-- 5th ed.

p. cm.Includes bibliographical references and index.ISBN 0-273-65140-4 (alk. paper)1. Economics. I. Beardshaw, John.

HB171.5 .E3346 2001330--dc21 2001023882

10 9 8 7 607 06 05

Typeset in 10/12pt Sabon by 30.Printed in Malaysia, KHL

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Preface xv

Syllabus map xviAbout the authors xviiiAcknowledgements xix

SECTION 1 The market system

1 Introduction: what is economics all about? 32 Mathematical techniques in economics 163 The economic problem: resources, scarcity and choice 294 The allocation of resources in competitive markets 475 Elasticities of demand and supply 646 Markets in movement 807 The business organisation, costs and profits 988 Market structures 112

SECTION II Market failure and government intervention

9 The mixed economy: market failure vs government failure 12510 Government intervention in the market 137

SECTION III Markets in operation

11 The market in practice: agriculture, housing and labour 15512 The leisure industry 17313 The economics of the environment 18214 Transport and the economy 196

SECTION IV The national economy

15 What is the macroeconomy? 21116 Measuring the macroeconomy 21617 Analysing the macroeconomy 22818 Managing the macroeconomy: problems and policies 238

SECTION V Business economics

19 The size and growth of firms 25920 Costs in the short run and the long run 270

Contents

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21 Competitive supply 27922 Price and output under imperfect competition 28623 Aspects of monopoly 30424 Public ownership, privatisation, regulation and deregulation 318

SECTION VI Labour markets and the distribution of income

25 The pricing of productive factors 33926 Labour and wages 35427 An introduction to welfare economics 37128 Inequality and public policy 392

SECTION VII Macroeconomic analysis

29 Keynesian macroeconomics 41330 Changes in aggregate demand: consumption, savings

and investment 42331 The Keynesian aggregate model 43932 The multiplier 44833 Aggregate demand and supply analysis 455

SECTION VIII Managing the economy: issues and policies

34 Growth and stability 46935 Money and prices 48036 Fiscal and monetary policies 51037 Monetary analysis and income analysis 52738 The control of inflation 55039 Unemployment and government policy 56640 Advanced policy issues 58541 The gains of international trade 60642 The balance of payments and exchange rates 62243 Conflicts between objectives 641

SECTION IX The EU and wider perspectives

44 International institutions 64945 The European Union 66246 The developing economies 69247 Schools of thought and future issues 705

Index 717

Contentsvi

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Preface xv

Syllabus map xviAbout the authors xviiiAcknowledgements xixPublishers’ acknowledgements xx

SECTION 1

The market system

1 Introduction: what is economics all about? 3

The subject matter of economics 3Positive and normative statements 5Scientific method 6Different answers to the same questions 8Conclusions 11Summary 12Questions 12Data response A 13Data response B 13

2 Mathematical techniques in economics 16How to use this chapter 16The use and abuse of statistics 16Indices 19Statistics 24Summary 26Questions 26Data response A 26Data response B 27Data response C 27

3 The economic problem: resources, scarcityand choice 29

Wants and needs 29The factors of production 30The division of labour 32Economies of scale 33New technology 36Increasing costs and diminishing returns 37The law of increasing costs 38International trade 42

Summary 45Questions 45Data response A 45Data response B 46

4 The allocation of resources in competitivemarkets 47

The price system 47Demand 48Supply 51Equilibrium prices 53Demand in detail 56The price system assessed 60Summary 61Questions 62Data response A 62Data response B 63

5 Elasticities of demand and supply 64Introduction 64Elasticity of demand 64Price elasticity of demand and the firm’s decision

making 66The calculation of price elasticity of demand 67Factors determining price elasticity of demand 69Arc elasticity 71Point elasticity 72Income elasticity of demand 73Cross elasticity of demand 74Price elasticity of supply 75Summary 78Questions 78Data response A 79Data response B 79

6 Markets in movement 80Some important ideas reviewed 80Changes in market price 81The effect of time on prices 84Government interference with equilibrium prices 84Taxes and subsidies 89

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Problems with demand and supply analysis 92Summary 95Questions 95Data response A 96Data response B 96

7 The business organisation, costs and profits 98

Types of business organisation 98Legal forms of firms 100Costs of production 103Profits 108Conclusion 110Summary 110Questions 111Data response A 111Data response B 111

8 Market structures 112Supply 112Profit maximisation 112Types of competition 113Alternative objectives 119Summary 120Questions 120Data response A 120Data response B 120

SECTION 1I

Market failure and government intervention

9 The mixed economy: market failure vsgovernment failure 125

What is a mixed economy? 125The origins of the mixed economy 127Criteria for government intervention in the

market 130The allocative role: provision of goods and

services 130The distributive role: transfer payments 132Criteria for the allocation of resources 133Conclusion 135Summary 135Questions 136Data response A 136

10 Government intervention in the market 137

Introduction 137

Case study 10.1 The growth of public expenditure 137Reasons for growth in public expenditure 138Strategies for the control of public expenditure 139Case study 10.2 Reform of the NHS: technical

efficiency and transactions costs 140How to pay for the service? 141Case study 10.3 Markets in education: allocative

efficiency 144Case study 10.4 Monopoly and privatised industries 146Case study 10.5 Regional problems 147Summary 151

SECTION III

Markets in operation

11 The market in practice: agriculture,housing and labour 155

Introduction 155Case study 11.1 Agricultural prices 155Features of the agriculture industry 157Recent developments in policy 158A comparison of three policies 159Case study 11.2 The housing market 161The public sector 163The voluntary sector 165The owner occupied sector 165Case study 11.3 Minimum wage legislation 170Summary 172

12 The leisure industry 173The meaning of leisure 173Travel and tourism 176Some economic aspects of the English Premier

League 177Conclusion 179Summary 179Questions 180Data response A 180

13 The economics of the environment 182An introduction to the environment 182Policies to deal with the environment 182Pollution characteristics 185Case study 13. 1 Global warming 187Policies 189Case study 13.2 Ozone depletion 192Case study 13.3 Rubbish and recycling 193Policy 194Summary 195Questions 195

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14 Transport and the economy 196Introduction 196Case study 14.1 Road congestion 196Case study 14.2 Privatising a loss-making monopoly

200Privatisation 202Accountability 203Alternative methods of privatisation 203Case study 14.3 Air transport 204Case study 14.4 The Channel crossing: intermodal

competition 207Summary 208

SECTION IV

The national economy

15 What is the macroeconomy? 211Pre-Keynesian attitudes 211Macroeconomics 212Conclusion 214Summary 214Questions 214Data response A 215

16 Measuring the macroeconomy 216The four macroeconomic policy targets 216The circular flow of national income 217The components of national income 218National income accounts 219Growth 222Conclusion 225Summary 226Questions 226Data response A 226

17 Analysing the macroeconomy 228The aggregate demand and supply curve

approach 228The derivation of the aggregate supply curve 231Conclusion 234Summary 235Questions 235Data response A 236

18 Managing the macroeconomy: problemsand policies 238

The major objectives of government policy 2381945 to the early 1970s 2391974–1982 2411982–1996 249

1997 onwards 251International interdependence and ‘globalisation’ 252Conclusion 254Summary 254Questions 254Data response A 255

SECTION V

Business economics

19 The size and growth of firms 259The size of firms 259The growth of firms 260Multinational firms 264The continuation of the small business 264Conclusion 265Summary 265Questions 265Data response A 266Data response B 266

20 Costs in the short run and the long run 270

Average costs in the short run 270Average costs in the long run 272The mathematics of marginal cost 275Changes in costs 276Conclusion 276Summary 277Questions 278Data response A 278Data response B 278

21 Competitive supply 279The best profit output 279The supply curve 281The optimality of perfect competition 282Summary 284Questions 284Data response A 284Data response B 285

22 Price and output under imperfect competition 286

Perfect and imperfect competition 286Profit-maximising techniques 287The equilibrium of the monopolist 292The equilibrium of the monopolistically competitive

firm 293Oligopolistic competition 295

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Managerial and behavioural theories revisited 298Contestable markets 299Limit pricing 300Conclusion 300Summary 300Questions 301Data response A 301Data response B 301

23 Aspects of monopoly 304Governments and monopoly 304Pricing problems 308Discriminating monopoly 308Monopoly assessed 311Conclusion 313Summary 313Questions 314Data response A 314Data response B 314

24 Public ownership, privatisation, regulationand deregulation 318

How to use this chapter 318Introduction 318Case study 24.1 The development of the nationalised

industries 319Reasons for nationalisation 319Case study 24.2 Problems of nationalised industry

control 321Case study 24.3 The privatisation process 325Methods of privatisation 325Case study 24.4 Privatisation and the introduction of

competition 326Vertical disintegration 326Local monopolies competing in the capital

markets 329Competition and new technology 329Case study 24.5 The regulation of privatised

industries 331Case study 24.6 Is privatisation a success? 333Summary 335

SECTION VI

Labour markets and the distribution of income

25 The pricing of productive factors 339Introduction 339Marginal distribution theory 339Resources and costs 345

Production in the long run 347Conclusion 350Summary 350Questions 351Data response A 351Data response B 352

26 Labour and wages 354The determination of the wage rate and level of

employment 354The supply of labour 355Trade unions and wages 358National minimum wage 362Monopsony in labour markets 362Differentials and disequilibriums 363Summary 366Questions 366Data response A 367Data response B 368

27 An introduction to welfare economics 371Introduction 371Partial and general equilibrium 371The Pareto criterion 373Allocative efficiency 374Welfare and utility 375Efficiency and the free market 375Pareto efficiency and perfect competition 376The welfare significance of equilibrium in a perfect

market 378Causes of market failure 381Imperfect competition 381Externalities 382Public goods 386Public goods, efficiency and valuation 387Conclusion 389Summary 389Questions 390Data response A 391

28 Inequality and public policy 392Structure of the chapter 392The distribution of income and wealth 392Understanding the tax-benefit system 395Understanding the benefit system 399Case study 28.1 What makes a good tax? 399Case study 28.2 The shift to expenditure taxation 400Case study 28.3 Direct taxes: a disincentive to work?

403Tax reform 406

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Case study 28.4 Local taxation and autonomy 408Summary 409

SECTION VII

Macroeconomic analysis

29 Keynesian macroeconomics 413The Keynesian revolution 413Macroeconomics 414The fundamental ideas of Keynes 416Keynesian recession and depression 417The revival of the neo-classical school 421Conclusion 421Summary 421Questions 421Data response A 422Data response B 422

30 Changes in aggregate demand:consumption, savings and investment 423

Income and consumption 423Determinants of consumption 427Savings 428Determinants of investment 430Conclusion 433Summary 435Questions 435Appendix: the accelerator 435Data response A 437Data response B 438

31 The Keynesian aggregate model 439Goods and money 439Withdrawals and injections 440The ‘hydraulic' Keynesian model – an overview 441The equilibrium of national income 443A model of the economy 443Conclusion 445Summary 445Questions 446Data response A 446

32 The multiplier 448The multiplier defined 449The operation of the multiplier 449The multiplier formula 450Equilibrium and the multiplier 451Conclusion 453Summary 453

Questions 453Data response A 454Data response B 454

33 Aggregate demand and supply analysis 455

The aggregate demand and supply curve approach 455

A neo-classical view 459Conclusion 461Summary 461Questions 462Data response A 462Data response B 463

SECTION VIII

Managing the economy: issues and policies

34 Growth and stability 469Economic growth 469Factors influencing growth 471People and growth 474The problems of the UK economy 477Summary 478Questions 479Data response A 479Data response B 479

35 Money and prices 480Introduction 480The development of money 480Credit creation 481The functions and attributes of money 483Measuring the money supply 486The quantity equation of money 489The concept of the general price level 491Alternative measures of inflation 495International comparisons 496Financial institutions 497Commercial banks 498Money markets 502The capital market 505Central banking 505Summary 506Questions 508Data response A 508

36 Fiscal and monetary policies 510Introduction 510Fiscal policy 510

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The development of monetary policy 514The stages of monetary policy 515The weapons of monetary policy 516Problems of monetary policy 519The independence of the Bank of England 521Summary 522Questions 522Data response A 523Data response B 523

37 Monetary analysis and income analysis 527Monetarists and Keynesians 527Money and national income 529Liquidity preference 532Monetarist theory of the demand for money 535The determination of aggregate real income 539Recession or the natural rate of unemployment? 542Conclusion 546Summary 546Questions 547Data response A 548Data response B 548

38 The control of inflation 550The costs of inflation 550The Phillips curve 551The causes of inflation 555The control of inflation 559Conclusion 563Summary 563Questions 563Data response A 564Data response B 564

39 Unemployment and government policy 566

Employment and unemployment 566The costs of unemployment 569Vacancies and unemployment 569Types of unemployment 570Regional unemployment 572The control of unemployment: the supply side

view 577The control of unemployment: neo-Keynesian

views 580Conclusion 581Summary 581Questions 582Data response A 582Data response B 582

40 Advanced policy issues 585About this chapter 585The philosophy behind neo-classical economics 585Demand and marginal utility 586Case studies 589Case study 40. 1 Acid rain 589Case study 40.2 Problems of decision making in the

public sector 592Cost-benefit analysis 592Case study 40.3 Pricing in practice on the railways

593Conclusions 597Summary 597Appendix: indifference curve analysis 597Applications of indifference curve analysis 600Revealed preference theory 603Appendix summary 604Appendix questions 604Data response A 604Data response B 605

41 The gains of international trade 606The theory of comparative advantage 606Comparative advantage: a model 607Comparative advantage and exchange rates 611Extending the theory 612Limitations of comparative advantage 614Protectionism considered 616Conclusion 618Summary 619Questions 619Data response A 620

42 The balance of payments and exchange rates 622

The pattern of the UK’s overseas trade 622The balance of payments 625The problems of a surplus 627Deficit problems 628Exchange rates 630The exchange rate debate 632Fixed exchange rates 633The equilibrium exchange rate 634The Asian crisis 635Recent UK developments 636Summary 638Questions 638Data response A 638Data response B 639

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43 Conflicts between objectives 641The lessons of history 641Conclusion 644Summary 644Questions 645

SECTION IX

The EU and wider perspectives

44 International institutions 649Introduction 649The International Monetary Fund 649The break-up of the Bretton Woods System 651Eurocurrencies 654The General Agreement on Tariffs and Trade (GATT)

and its successor, the World Trade Organisation(WTO) 655

Other international institutions 657Summary 659Questions 659Data response A 660Websites 661

45 The European Union 662Introduction 662The economics of integration 663Economic and Monetary Union 668Regional problems and policy in the EU 678Employment and social policy in the EU 681EU enlargement 683Summary 686Questions 687

Data response A 687References 691Websites 691

46 The developing economies 692Development economics 692Population and development 694Technological issues 696The problem of agriculture 697Trade issues 697The state and development 699The debt problem of developing countries 699What is necessary for development? 701Conclusion 702Summary 703Questions 703Data response A 703

47 Schools of thought and future issues 705Introduction 705Political economy 706The Austrian school 707Post-Keynesian economics 708Marxist economics 709Where are we now? 712Future issues 713Summary 715Questions 715Data response A 716Data reponse B 716

Index 717

Full contents xiii

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A Companion Web Site accompanies

ECONOMICS: A Student’s Guide

Visit the Companion Web Site at http://www.booksites.net/beardshawto find valuable teaching and learning material.

● Up-to-date web-links ● Questions for further discussion● Updates for the textbook● Glossary● A syllabus manager that will build and host your very own course website

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A fifth edition is an achievement for any textbookbut particularly so in a field where there is such awide range of excellent books to choose from. Webelieve this success is due to marrying long-estab-lished strengths with advances in learning methods,together with an up-to-date and comprehensivepresentation of economic theory and practice. Youmay ask – is this the best economics book to buy?Well, although this book has won number one slotin a review of such texts, John Beardshaw himselfstressed that economics tells us that league tablesare not necessarily a useful approach to individualchoice. Put simply, John saw that product differen-tiation in the market for economics texts hadbenefited the student and hence students shouldmake use of this diversity and use the texts whichbest suit their own needs and preferences. We hopethat we have again provided a textbook for thoselooking for a combination of the best of new and‘traditional’ approaches and a thorough but nottoo technical approach to economics.

While seeking to preserve the strengths ofEconomics: A Student’s Guide that have servedso well, there is much that is new in this edition.Most noticeable is the extensive restructuringthat will allow the AS-level student to master thebasics of economics in the first part of the bookwhile retaining the higher level of analysis neededat A-level and for first-year university or profes-sional courses later in the text.

On the macroeconomic side: to reflect changes insyllabuses this book no longer requires the reader tounderstand the ‘Keynesian-cross’ 45-degree dia-gram, but it is still there in self-contained chaptersfor those syllabuses and readers that require it. Thechapter on the fundamental insights of Keynes,introduced to praise in the last edition, is retained.This is because the insights of Keynes are still as rel-evant as ever to syllabuses and economics, even ifthe mechanics of representing his ideas have movedon. Accordingly, aggregate demand and supply isused more extensively, but not uncritically, together

with a more in-depth treatment of the micro-foun-dations for more advanced readers. The importanttopic of national income accounting has also beensimplified to reflect the reduced emphasis in impor-tance in many syllabuses. A new applied chaptertraces the course of UK macroeconomic policy-making since the Second World War, highlightingthe necessary theoretical underpinnings along theway. There is also much that is new on interna-tional aspects and a whole new chapter on Europeby a specialist in the field.

On the microeconomic side: there is a new sec-tion on the housing market and a new chapter onthe leisure industry to meet the needs of A-levelsyllabuses. New sections on regulation and dereg-ulation of industry plus a comprehensive reviewof changes to competition policy have been intro-duced. Changes in the introduction of importantmicroeconomic concepts have been made toreflect new syllabuses but the need for logicaldevelopment of theory has been retained.

Given recent changes in some syllabuses, notextbook can provide a ‘one size fits all’ solutionand hence there will be parts of the book thatyou can return to another day as they may not bedirectly relevant to your course. Where examina-tion boards have provided materials to helpstudents prepare for the board’s assessments, stu-dents would be foolish not to use these. Equally itwould be too narrow an approach not to haveaccess to a main textbook such as Economics: AStudent’s Guide or another of the excellent text-books that now exist (it would also herald a veryunhealthy reduction in competition in the text-book market!). The mapping below shows youhow to use this book if you are following themain UK syllabuses at AS/A-level but your tutorwill give guidance for other syllabuses such asprofessional or undergraduate courses. If you arefortunate enough to be able to read the book inits entirety then you will have gained a very sub-stantial introduction to the subject.

Preface

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Prefacexvi

Syllabus map for AS/A-level students

Course Where to find this in the book

AQA

Module 1 Markets and market failure Sections I and II (Chapters 1–10)

Module 2 The national economy Section IV (Chapters 15–18)

Module 3 Markets at work Section III (Chapters 11–14)

Module 4 Working as an economist Section IX (Chapters 44–45)

Module 5 Business economics and the Section V (Chapters 19–24) and Section VI (Chapters 25–28)distribution of income

Module 6 Government policy, the national Section VII (Chapters 29–30 and 33), Section VIII and international economy (Chapters 34–36, 38–39, 41-43) and Section IX (Chapter 46).

(Chapter 40 of Section VIII and Chapter 47 of Section IX can also be read for a more advanced analysis of certain issues)

Edexcel

Unit 1 Markets – how they work Section I (Chapters 1–8) and Section III (Chapter 11)

Unit 2 Markets – why they fail Section II (Chapters 9–10) and Section III (Chapters 13–14)

Unit 3 Managing the economy Section IV (Chapters 15–18)

Unit 4 Industrial economics Section V (Chapters 19–24)

Unit 5A Labour markets Section VI (Chapters 25–28)

Unit 5B Economic development Section VIII (Chapter 34), Section IX (Chapter 46) and Section III (Chapter 12)

Unit 6 The UK in the global economy Section VII (Chapters 29–30 and 33), Section VIII (Chapters 34–36, 38–39, 41–43) and Section IX (Chapters 44–45).(Chapter 40 of Section VIII and Chapter 47 of Section IX can also be read for a more advanced analysis of certain issues)

OCR

Module 2881 The market system Section I (Chapters 1–8), Section III (Chapter 11) and Section V (Chapters 19–24)

Module 2882 Market failure and government Section II (Chapters 9–10) and Section III (Chapter 13)intervention

Module 2883 The national and international economy Section IV (Chapters 15 and 17–18) and Section VIII(Chapters 38–39 and 41–42)

Module 2884 Economics of work and leisure Section III (Chapter 12) and Section VI (Chapters 25–26 and 28)

Module 2885 Transport economics Section III (Chapter 14) and Section VI (Chapter 27)

Module 2886 Economics of development Section VIII (Chapter 34) and Section IX (Chapter 46)

Module 2887 The UK economy Section IV (Chapter 16), Section VII (Chapter 29–30 and 33) andSection VIII (Chapters 35–36 and 43) (Chapter 40 of Section VIIIand Chapter 47 of Section IX can also be read for a more advanced analysis of certain issues)

Module 2888 Economics in a European context Section IX (Chapters 44–45)

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The new syllabuses have allowed the introduc-tion of an even greater number of appliedchapters dealing with recent economic events andalso more case studies. This has enhanced the‘real-life’ feel of the book, but we have also beencareful to trace through the logical developmentof the theory that underlies such applied analysis.Without proper attention to this it would beimpossible for you to achieve the deep learningnecessary for an understanding of the subjectmatter. thus this edition further embraces anddevelops an ‘active learning’ approach but avoidsthe mistake of confusing active learning withsimply providing a set of resources for activities.In short, modern learning methods are employedto make learning more enjoyable and effectivebut have not replaced the painstaking workrequired to present the student with a clear expo-sition of complex subject matter.

This book is packed with student activities,questions and data response exercises, but it isalso unashamedly a textbook that seeks to pro-vide the student with a structured and graduatedladder to understanding. Admittedly, written textis a limited medium for interactivity, but we havesought to steer the reader away from those mis-conceptions and confusions which so frequentlyblock understanding by pointing out commonstudent misunderstandings at the point at whichthese are most likely to occur. This draws on theextensive classroom experience of the authors inteaching economics, but we would be delightedto continue to receive further suggestions forwhere this powerful technique for avoiding thecommon misunderstandings taking hold thatmight block learning could be deployed.

Although exercises, questions, activities andguidance break-up the text, we have deliberatelyavoided the ‘magazine’ format favoured by somemodern authors. This is not a criticism of theirapproach but merely a preference that we know

accords with many teachers and students. Thereis room for different approaches and this canonly benefit students overall. Such an attitudereflects another difference of approach; withinthe necessary confines of the syllabus, this bookcontinues to be deliberately more pluralistic thanmost comparable texts. This is not in anyway anattack on mainstream economics, but simplyrecognition that other approaches are worthy ofat least a mention and indeed provide a contextu-alisation for mainstream economics. Also, from alearning methodology angle, because consideringproblems from new perspectives is an importanttechnique for deep learning.

We realise that teachers have a difficult job inrecommending the most appropriate learningresources for their students and their ownteaching style. For our part we have againattempted to present an informed, readable,uncluttered and well-structured text that morethan covers the syllabuses it will be used for. To theextent that it retains its well-established traditionalstrengths, it is more ‘scholarly’ than some recentapproaches. To the extent that it has utilised find-ings from recent research in teaching and learning,it is more worldly, digestible and interactive thanmore technical and didactic approaches. But wehave also been mindful that the book should con-tinue to do justice to the discipline of economicsitself. Economics profoundly affects all our livesand its principles can be applied in everyday life aswell as business. For these and many other reasonsyou should find it an interesting subject. This bookdoes require effort by the reader for no-one claimsthat economics is an easy subject. We hope thisnew edition continues to make studying economicsinteresting and successful for many more students.

David BrewsterPaul CormackAndrew Ross

Preface

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About the authors

John Beardshaw

John Beardshaw graduated from the LondonSchool of Economics and taught at colleges inand around London before becoming SeniorTutor in Banking Studies and Lecturer in chargeof Economics at Southgate College. John main-tained his regular teaching throughout a careerwhich included authorship, examining andawards moderation, consultancy for a major mer-chant bank and a highly successful series ofintensive revision courses for A-level students.

He began writing on economics with the inten-tion of producing a book for students which wasboth comprehensive and comprehensible. Sincehis first and very successful publication in the late1970s, he went on to write other well receivedtextbooks, workbooks and articles on economics.This work brought him international recognitionas a leading author in his field.

David Brewster

David Brewster teaches economics at theWestminster Business School, part of theUniversity of Westminster. He studied at ReadingUniversity and at Brunel University. He taughteconomics at Thames Valley University for overtwenty years and then briefly at the University ofNorth London before moving to Westminster. Hehas also been a Visiting Professor at CaliforniaState University, Fullerton. He has written anumber of articles in the fields of business eco-nomics and industrial economics, and is theauthor of Business Economics: decision-makingand the firm (Thomson Learning Business Press).

Paul Cormack

Paul Cormack is a Senior Lecturer in the Schoolof Environment and Development at SheffieldHallam University. He is a graduate of HullUniversity and holds an MA from LeicesterUniversity and an MBA from Thames ValleyUniversity. He taught A-level economics inLondon schools for three years before movinginto higher education, where he has taught since1978. He has a special interest in transport andenvironmental economics, but his currentresearch is into costs in higher education.

Andy Ross

Andy Ross began working life as a telephoneengineer. After A-levels as a mature student, hestudied full-time at the LSE and then as a post-graduate at Birkbeck College London. He gaineda distinction for the teaching certificate atGarnett College and taught A-level economics forfive years before lecturing in higher education.Since then he has held the post of Head ofDepartment of Economics, Head of the School ofEuropean and International Studies, and Directorof the College of Undergraduate Studies atThames Valley University. Currently Head ofBranch at the Office for National Statistics, Andyhas recently become an Economic Advisor in theGovernment Economic Service.

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Thanks goes to Brian Ardy of South BankUniversity for updating the chapters on Europeand international institutions, adding much inter-esting new material. Acknowledgement must alsogo to Malcolm Cummings, Chris Faux, AndreasKyriacou and David Palfreman for their contribu-tions to previous editions. A particular thank youis given to Denise Beardshaw for her advice andcomments on previous editions.

Permission has been sought from the manynewspapers and statistical sources used and these

are noted as appropriate, but if any have beeninadvertently overlooked, the publishers will bepleased to make the necessary arrangement at thefirst opportunity.

Appreciation also for the support, guidanceand patience of the team at Pearson Education,especially Paula Harris, Laura Prime and LizTarrant.

As usual, the authors accept responsibility forany mistakes or shortcomings.

Acknowledgements

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We are grateful to the following for permission toreprint copyright material:

Ashgate Publishing Limited for Table 45.3 fromThe Economics of European Integration, 3rd edition,by W. Molle (1997); Atlantic Syndication Partners for‘The French put tax on hard work’ by Peter Shard inDaily Mail, 28 August 1997; BEQB for Figure 38.11;Figure 29.3 (a) and (b) used with permission of theConfederation of British Industry; The EconomistNewspaper Limited, London, for extracts from thearticles ‘Bashing the Unions’ in The Economist, 14September 1996, ‘A Good Start’ in The Economist, 10May 1997, ‘Labour stats aren’t working’ inThe Economist, 7 February 1998, ‘The Air War’in The Economist, 11 September 1999, ‘Snarl-up’ inThe Economist, 15 April 2000, ‘Loosening the Belt’in The Economist, 15 July 2000, and ‘Motoring down-hill – Tourism in Scotland’ in The Economist, 5 August2000; Tables 1.2 and 45.4 from Eurostat; Table 11.1adapted from General report on the activities of theEU, 1998, and Tables 20.2 and 45.9 from Pratten(1989) The Cost of Non-Europe, Vol. 2, Office for theOfficial Publications of the European Communities,Luxembourg; Table 40.4 adapted from EMEP data;Figure 45.5 and Tables 45.11 and 45.12 fromEuropean Commission (1999a and b), Tables 45.5 and45.6 from the European Commission website:http//www.europarl.eu reproduced by permission ofthe European Commission; Guardian Newspapers Ltdfor extracts from ‘Analysis’ by Larry Elliott in TheGuardian, 11 September 1977, ‘Rouble devalued bySoviet Union’ in The Guardian, 26 October 1989,‘Putting trade in its place’ in The Guardian, 27 May1996, ‘Dedicated followers of fashion’ in TheGuardian, 18 August 1997, ‘Whisper it . . . takeoversdon’t pay’ by Lisa Buckingham and Dan Atkinson inThe Guardian, 30 November 1999; the InternationalMonetary Fund for Figures 19.1 and Tables 44.1, 44.2,45.1 and 45.2; Figure 19.1 reproduced by permission

of KPMG, London; ‘Money, a telling law’ by DorothyRowe in The Observer, 31 August 1997, and‘Inwardly troubled’ by Simon Caulkin in TheObserver, 16 April 2000; the Office for NationalStatistics for permission to reprint the many tables andfigures which are shown credited to them in the text;the Office for the Official Publications of the EuropeanCommunities for Figures 1.2 and 45.5 and Tables 12.1,20.3, 45.3, 45.8, 45.11 and 45.12; the OECD forTables 30.3 and 34.1; Palgrave Publishers Ltd forextracts from ‘The General Theory Of Employment,Interest And Money’ in The Collected Writings of JohnMaynard Keynes by John Maynard Keynes (CUP,1936); Syndication International for the article‘Feelgood factor boost for firms’ by Kevin Relly in theDaily Mirror, 30 June 1997; The World Bank for anextract from World Development Report 1990, IBRD;the Financial Times for permission to reprint ‘Cuba’srevolution in a class of its own’, © Financial Times, 20March 2000; ‘Avoiding the trap of transition’ plusfigure, © Financial Times, 11 October 2000; Figure 7.6from ‘UK corporate profitability’, © Financial Times,28 September 2000; ‘Big oil, big bucks’, © FinancialTimes, 18 August 1998; ‘Service staff shortages promptinflation warning’ plus figure, © Financial Times, 6June 2000; from ‘UK glories in seventh heaven’ plusfigure, © Financial Times, 22 September 2000; ‘Indefence of domination’, © Financial Times, 8November 1999; ‘A once-toothless watchdog gets setto bite back’, © Financial Times, 1 March 2000;‘Central bankers upbeat despite euro slide’, ©Financial Times, 12 September 2000; and ‘A hole of itsown making’, © Financial Times, 7 August 1997; andthe United Nations for Table 1.1.

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I

The market system

‘It is not from the benevolence of the butcher, the brewer orthe baker that we expect our dinner, but from their regard totheir own self-interest.’

Adam Smith

SECTION

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The subject matter of economics

Students who can relate economics to the worldaround them will find it a fascinating subject.This should be easy for you to do, for examplesof economic forces at work are all around youand are constantly in the media. This book willhelp you to recognise and analyse these powerfulforces that affect us all.

There is something of interest in economics foralmost everyone. This is because it is a verywide-ranging subject. Economics looks at peopleand production; markets and institutions; enter-prise and exploitation; individual behaviour andsocial relations; scarcity and choice; prosperityand poverty; power and free trade; nationaleconomies and globalisation; efficiency andwaste; crisis and growth; inequality and welfare;rent and reward; the creation and destructionof resources; the environment and the prospectsfor the economic future of humankind. It is

a dynamic subject that studies changes in theeconomy and which itself changes as new ideas,and old ones, battle for influence.

Although there is much that economists agreeon there are also vast differences between differ-ent groups, or schools, of economists. Theydisagree as to what are the important areas ofstudy, the scope and nature of the subject itself,as well as over more technical matters such as theaccuracy and interpretation of economic data.This is also true of the natural sciences such asphysics at their frontiers of knowledge, but eco-nomics is made more involving for the student asits debates are so often the subject of intensemedia and political interest. Astrophysics, likeeconomics, is a fascinating subject but we are notoften called to make judgments on astrophysicswhen electing governments!

Defining economics

As you may have suspected by now, a single defi-nition of economics is unlikely to cover all itsaspects. And yet, economics is as old as thehuman race. When some cave-dweller went outto hunt while others remained to defend the fire,or when skins were traded for flint axes, we hadeconomics. But economics as an academic disci-pline is relatively new: the first major book oneconomics, Adam Smith’s The Wealth of Nations,was published in 1776. Since that time the sub-ject has developed rapidly and there are nowmany branches of economics as well as compet-ing schools of thought.

Economics can help explain many of thechanges we see around us. Some are dramaticworld events such as the collapse of the Soviet

Introduction: what is economics all about?1

Learning outcomesAt the end of this chapter you will be able to:◗ State what economists mean by the economic

problem and use this idea to give a definition ofeconomics.

◗ Explain the importance of economics for humanwelfare.

◗ Describe and criticise the scientific method inrelation to economics.

◗ Define the price mechanism.◗ Contrast market and planned economies.◗ Comment on the experience of Eastern

European transition economies.

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bloc, the problems experienced in transition fromplanned to market economies or recent instabilityin South East Asian economies. Other changesare more gradual but still profoundly affect thesocial and economic environments we live in suchas economic globalisation, the increase in paidfemale and part-time employment, increasedinequality, rising participation in education,increased road congestion, urban decay andhomelessness. Although most people are awarethat economic forces affect their lives few coulddefine economics.

Most definitions of economics focus onscarcity and choice. To the economist virtuallyeverything is scarce, not just diamonds or oil butalso bread and water. How can we say this? Theanswer is that one only has to look around theworld to see that there are not enough resourcesto give people all they want. This is not the samething as saying there are not enough resources tocloth and feed the world’s population, it israther to point out that it is not only the verypoor who feel deprived; even the relatively well-off seem to want more. Whether or not it isimmoral to want more affluence while othersstarve; when economists use the word scarcitythey mean that:

All resources are scarce in the sense that there arenot enough to satisfy fully everyone’s wants. For theindividual and for humankind it seems that wantsexceed means.

● Common misunderstanding

Scarce should not be confused with ‘rare’.

It is in this sense that resources are limited bothin rich countries and poor countries. The focusfor much of economics is to evaluate the choicesthat exist for the use of these resources. Youmake such choices everyday, you cannot buyeverything you want and so you must choosebetween the things you want or need. Thus wehave another characteristic of economics: it isconcerned with choice. Therefore we could defineeconomics as:

The human science which studies the relationshipbetween scarce resources and the various useswhich compete for these resources.

The central economic problem

There are many specific economic problems –poverty, inflation, unemployment, etc. However,if we use the term the economic problem we arereferring to the overall problem of the scarcity ofresources. Hence, because they cannot haveeverything, individuals and societies have tochoose carefully when trying to make the best useof scarce resources.

The American Nobel Prize winner PaulSamuelson noted that every economic society hasto answer three fundamental questions arisingfrom the economic problem: ‘What?’, ‘How?’and ‘For whom?’

● What? What goods are to be produced withthe scarce resources – clothes, food, cars, sub-marines, television sets, and so on?

● How? Given that we have basic resources oflabour, land, etc., how should we combinethem to produce the goods and services thatwe want?

● For whom? Once we have produced goods andservices we then have to decide how to distrib-ute them among the people in the economy.

These are economic questions that exist for allsocieties, regardless of geography or politics.

Economic goods and services

All the things that people want, goods and serv-ices, are lumped together by economists andcalled economic goods.

Economic goods are those which are scarce in rela-tion to the demand for them.

As scarce in this sense just means that more of itwould be wanted if it were free; clearly there areonly a few things that are not economic goods.About the only thing which fits happily into this

Section I · The market system4

Look through a newspaper to find an example ofany economic concern of the day. Explain why it ispart of the economic problem of scarcity andchoice and how it affects the questions of what,how and for whom.

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category is air. But even then clean air is notalways available and even things in natural abun-dance could be made scarce if someone were ableto establish property rights over it and hencerestrict its supply.

Wealth and welfare

An early definition of economics was that it is thestudy of wealth. By wealth the economist meansall the real physical assets which make up ourstandard of living – clothes, houses, food, roads,schools, hospitals, cars, oil tankers, etc. One ofthe primary concerns of economics is to increasethe wealth of a society, i.e. to increase the stockof economic goods. However, in addition towealth we must also consider welfare. The con-cept of welfare is concerned with the whole stateof well-being. Thus it is concerned not only withmore economic goods but also with publichealth, hours of work, law and order, and so on.It would be possible to increase the level ofwealth in a society while decreasing its level ofwelfare. For example, if everyone were to work50 per cent longer per day the country’s wealthwould be increased, but it is doubtful if its wel-fare would, because people would be overtired,have less time for leisure, their health couldsuffer, and so on.

Hence modern economics has tried to takeaccount not only of the output of economic goodsbut also of economic ‘bads’ such as pollution andloss of pleasure from the natural environment.

Wealth and money

Economics is not just about money as manypeople think. Indeed we could have an economywithout money. Also, if we consider economics tobe the study of wealth, it should be obvious that

we could print twice as much money withoutaltering the real wealth of the economy.

● Common misunderstanding

People often think money is wealth and has valueitself. In fact, it is merely paper or metal, or even bankdeposits with no physical form at all! Money is just aclaim to wealth. Nevertheless, changes in the quantityof money circulating in the economy could affectbehaviour and hence change the outcomes of thecentral questions of the economic problem.Thus,although economics is not directly concerned withmoney as wealth, economists do study its effects on theoutcomes of the central economic questions.

Positive and normative statements

Consider the following two statements:

(a) The death penalty reduces the number ofmurders.

(b) Murderers deserve to die.

Which statement attempts to state a fact andwhich is a value judgement? You may agree ornot agree with the first statement, but it asserts arelationship that could be investigated throughstatistical evidence. For example, the murder ratemay be compared under regimes that do and donot have capital punishment. If such evidencepoints clearly one way or the other, investigatorsmay come to agree on whether the relationshipexists or not even though they disagree over thesecond statement. By contrast, the second state-ment expresses a personal belief, or valuejudgement, about what ought to happen to mur-derers – it could not be disproved by any amountof statistical evidence.

Statement (a) is called a positive statement andstatement (b) is called a normative statement:

Positive statements concern what is, was, or will beand hence depend on facts. Normative statementsconcern what ought to be and hence depend onvalue judgements as to what is good or bad.

Unfortunately, it turns out that even positivestatements are usually difficult to prove or dis-prove as evidence is often incomplete, conflicting,or capable of being interpreted in different ways.

Chapter 1 · Introduction: what is economics all about? 5

Make a list of things which are currently free.Describe ways in which someone who owned all ofthe free good might restrict its supply and so set acharge. Could a price be set for all the things youhave listed? In the light of this explain why a pricecan be set for most things.

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For example, consider the statement: ‘Tradeunions are the cause of inflation because in push-ing up wage costs they also push up the priceof goods.’

This assertion has in fact been extensivelyinvestigated, but there is still no consensus ofopinion. Even when an apparent relationbetween trade union power and rising pricesseems to have been statistically established, thishas not settled the debate. One problem is thatunion power cannot be measured directly. Doesa high percentage membership or changes in thatpercentage indicate current strength? Is thenumber of strikes a good measure or is it thatpowerful unions seldom need to strike? How dowe know which of these measures is ‘correct’?Another problem is that of the direction of cau-sation: are unions pushing up prices or merelyattempting to keep pace with prices that arealready rising? Even if unions succeed in pushingup wages and prices in one market will this causeprices to fall in other markets thus off-settingany inflationary effects? Trade unions are justone part of an economic system that itself mightbe the cause of industrial conflict and wage/pricespiraling – so is it a value judgement to singleout unions for the blame?

You will not have to study economics for longbefore realising:

Debates over the truth of positive statements ineconomics are seldom settled by looking at the factsbecause the facts are rarely simple and rather than‘speaking for themselves’ have to be interpreted.

Does this mean that the investigation of issues byeconomists is pointless? No! The issues involvedare just too important to be left to politicians andthe ‘lay-person’. Even if disagreement cannot beeliminated, it can be reduced and the areas of dis-agreement clarified.

Scientific method

Some economists say they attempt to test eco-nomic ideas scientifically, but how is this done?Scientific method begins with trying to think ofpossible explanations for something we observe.For example, we may put forward the idea that

the demand for a good is determined by its price.On the basis of this we may reason that as theprice is increased, demand goes down, while ifthe price is decreased the demand will go up. Thisthen is a hypothesis that can be tested onobserved behaviour. This testing of ideas on theevidence is known as empiricism. Having madeour observations we may then:

(a) accept the hypothesis as our best attempt sofar to explain the facts;

(b) reject it; (c) amend it in the light of the evidence.

This process is shown in diagrammatic form inFigure 1.1.

Section I · The market system6

Figure 1.1 The scientific testing of theories

Process of logicaldeduction

Formation ofhypotheses

Theories abouthuman

behaviour

Hypotheseschecked byobservation

Theorydoes or does not

agree withfacts

Theorypasses the testof observation

Theory discardedFormulate new theory

Theory amendedin light of

observations

Yes

No

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Ceteris paribus

This is Latin for ‘all other things remaining con-stant’. In physics if we wished to test the effectsof heat on something we would not simultane-ously change the pressure, altitude, etc. It is thesame in economics; if, for example, we wish toexamine the effect of price on demand we wantto separate out simultaneous changes in incomes,tastes, etc. Therefore, when formulating eco-nomic principles, we are usually careful to statethat such and such will happen, ceteris paribus.This principle presents particular problems in thesocial sciences because, whereas in the naturalsciences we can undertake laboratory experi-ments to control the variables, this is not possiblewhere human society is concerned – in a realeconomy we cannot command all things exceptone to stand still! This is an important problemfor economics that is addressed by a specialisedbranch of mathematics and statistical theorycalled econometrics (see Chapter 2).

Human behaviour

It can be argued that since economics is concernedwith human behaviour, it is impossible to reachany firm conclusions. However, while individualsare often unpredictable, people in large numbersare less so. If, for example, we increase everyone’sincome it is possible that any particular individualmay or may not spend more. However, if weexamine what happens to a million people astheir income increases it is possible to conclude

that overall their expenditure will increase. Thus,examining a large number of people’s behaviourallows us to take advantage of the law of largenumbers. This law predicts that the randombehaviour of one person in a large group will beoffset by the random behaviour of another, sothat we are able to make predictions about thebehaviour of the group as a whole.

Dissenting schools of thought

So far this chapter has tended to outline the main-stream or orthodox view of economics whichgained almost total dominance after the SecondWorld War and which still dominates economicsyllabuses. This approach has emphasised a modelof ‘scientific economics’ with its emphasis on thetesting of positive statements by reference to, sup-posedly, value-free empirical data. But many of thecentury’s most influential economists, such asKeynes and Hayek, have rejected this methodology.There are deep philosophical considerations here,but the student of economics soon comes to realisethat the subject is inherently controversial. Manyeconomists have come to accept that it is mislead-ing to present economics as merely a debatebetween experts over purely technical matters.Increasingly there is recognition that economics is avalue-laden subject (see Chapter 47).

Such is the level of controversy in economicsthat there is a case for introducing the subjectas competing schools of thought rather than asingle discipline. Indeed, a more rounded viewof a problem can often be gained by consideringarguments from various schools of thought,and examiners do give credit to some extent forthis. Those who reject the notion that main-stream economics is scientific and value free oftenprefer the original term of ‘political economy’ to‘economics’. Political economists take the viewthat an economist necessarily interprets theoriesand empirical data through a political perspec-tive. It must be realised here that there is adistinction between bias and dishonesty. In anhonest and tolerant world bias should be con-fessed without shame or loss of argument;dishonesty will be hidden as it would destroy allcredibility if discovered.

The syllabuses to which this book is directed donot demand a detailed knowledge of alternatives to

Chapter 1 · Introduction: what is economics all about? 7

Think of the things you bought this week.Whatfactors do you think affected your decisions to buythose particular things? The price of the items maybe one of the variables that affected your decisionbut list two other things that can be measured.Obviously there may be exceptions to the rule andthings that you have left out, but think about howyour own behaviour matches up to this theory.Does your behaviour or that of others evercontradict your theory? Later in this book you willread about how economists measure consumerdemand. Make a note to compare your theory withthe theory of demand in economics.

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the mainstream approach and this book does notpretend to give a proper airing to them.Nevertheless, wider arguments are included whereappropriate. The major alternatives to the main-stream approach mentioned in this book are theNew-classical, Austrian, post-Keynesian andMarxian schools of thought. After completing thisbook you should return to this chapter, and theexercises at its end, when these terms will meansomething to you. In the meantime you will findthat there is much to learn from the mainstreamapproach. All economists study mainstream eco-nomics, not just because it is the dominant schoolof thought but also because it provides manyinsights into the economic forces at work in theworld. Also, it is a route to understanding the writ-ings of modern political economists from the‘right’ and the ‘left’ of the political spectrum.

Different answers to thesame questions

We stated earlier in this chapter that each societyhas to answer three fundamental economic ques-tions: ‘What?’, ‘How?’ and ‘For whom?’ Whilethere are a million variations on answers to thesequestions, when we look around the world wefind that there are only a limited number of waysin which societies have set about answering them.We will now examine these briefly.

Tradition and hierarchy

For most of human history the ‘What?’, ‘How?’and ‘For whom?’ have been solved by traditionand rulers. The decisions that were not fixed bytradition were taken by command. For example,in feudal society the king or the lord of the manorsimply ordered people what to do. We shouldnote that this system lasted for hundreds of yearswhilst our own has existed for only a relativelyshort period.

Free enterprise and the price mechanism

The feudal society we have described was largelya non-monetary society; people did not work forwages but merely to produce their food. They didnot pay rent for their land but worked for somany days in the lord’s fields. Money was used

only for the relatively small percentage of thingswhich the local economy could not produce.However, over a period of several hundred yearsthis changed and there was a monetisation of theeconomy: people grew food not to eat but to sell;labourers worked for wages; rent was paid forland; taxes were paid to the king. Thus wasdeveloped the price mechanism.

Thus, everything – houses, labour, food, land,etc. – came to have its market price, and it wasthrough the workings of market prices that the‘What?’, ‘How?’ and ‘For whom?’ decisions weretaken. Despite there being no central committeesorganising shoe production or regulating wages,this resulted not in chaos but order. People, bybeing willing to spend money, signalled to pro-ducers what it was they wished to be produced.The ‘How?’ question was answered because oneproducer had to compete with others to supplythe market; if that producer could not produce ascheaply as possible then custom would be lost tocompetitors. The ‘For whom?’ question wasanswered by the fact that anyone who had themoney and was willing to spend it could receivethe goods produced.

A price mechanism is a system where the economicdecisions in the economy are reached through theworkings of the market: changes in the relativescarcity of goods and services are reflected in changesin prices and these price changes produce incentivesfor producers to reallocate available resourcestowards reducing market shortages and surpluses.

The study of the price system forms much of thesubject matter of economics and, hence, of thisbook. It should be said, however, that the freemarket, or free enterprise system composed ofmany competing firms, as envisaged by earliereconomists such as Adam Smith and AlfredMarshall, has been much modified by the growthof large monopolistic businesses and unions.Today huge multinational companies withturnovers bigger than the national income of manycountries and globalisation (explained in moredetail at the end of this chapter) have created eco-nomic forces and power beyond that described byearlier economists. Hence many observers preferthe term capitalism rather than free market.

Capitalism refers to the private ownership of themeans of production.

Section I · The market system8

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Collectivism, command and planning

In the twentieth century in many countries theregrew up, or was imposed, an alternative to capi-talism known as collectivism.

Collectivism is the system whereby economicdecisions are taken collectively by planning commit-tees and implemented through the direction ofcollectively owned resources, either centrally or atlocal level.

Under this system planning committees areappointed and they provide the answers to ourthree central questions. Thus committees take thedecision on whether, for example, more cars ormore tractors should be produced. They solve the‘How?’ problem by directing labour and otherresources into certain areas of production andthey decide the ‘For whom?’ problem not by pric-ing but by allotting goods and services on thegrounds of social and political priorities.

For example, in 1917 a bloody revolution inRussia led to an attempt to set up a state runsystem of collectivisation run according tocommunist principles. But the first effects ofabolishing the market economy were disastrous,so to boost the economy elements of the freemarket for smaller businesses and farms were re-introduced. However, in 1924 Stalin came topower determined to make the Soviet Union ofcommunist countries a major world power. Hesucceeded but his regime was brutal.

Under Stalin a central planing committeecalled ‘Gosplan’ had the responsibility for prepar-ing five-year plans and then laying down annualproduction targets to achieve these plans.Managers who met the targets could expectbonuses and productive workers were honoured,but there was no price mechanism or provisionfor making profits. Despite this the Soviet system,particularly in its early years, achieved some veryhigh rates of economic growth and the systemlasted until the end of the 1980s.

From 1989 the former Soviet bloc countriesmade dramatic shifts from centrally plannedsystems towards a market-based price mechanism.By the early 1990s the central planning systemhad gone. This shift involved rapid large-scaleprivatisation, i.e. the transfer of state-ownedindustries to private ownership (see also Chapter24). A large part of the reason for the collapse ofthe Soviet system was the failure of the planned

system to cope effectively with the problems of‘What?’, ‘How?’ and ‘For whom?’

● What? Unlike the workings of a smoothly oper-ating price mechanism that we will examine inChapter 6, in a planned economy resources donot automatically move to eliminate shortagesand surpluses. The amount of information thatplanners would need to collect as to wants andresources is immense – it often took months oreven years to respond to shortages and sur-pluses because of bureaucracy and lack ofinformation. Thus there were many farcicalexamples of tractors being produced eventhough there were no tyres for them, shortagesof toilet paper, surpluses of black and whiteTVs, while, sometimes tragically, harvests rottedfor want of transport and storage facilities.International media crossed borders and thefalling behind the West in terms of consumergoods was thus all the more obvious.

● How? Factory managers were concerned solelywith meeting the output targets that had beenset by the central planners. The waste ofresources in production and the quality of thefinished products were of secondary impor-tance to them. The result was wasted resources,severe pollution and poor quality products.

● For whom? The distribution of products and ofincomes was largely set centrally. In the SovietUnion basic foodstuffs and housing were avail-able to all, but the cost of this high basicsecurity was a lack of consumer goods and lux-uries. The material standard of living was belowthat of the richer market economies. The con-trol of incomes and overproduction of basics ledto bread being so cheap it was fed to cattle eventhough consumers had no meat. Workers hadlittle incentive to move to new jobs or attemptto improve their income; the result was often alack of incentive and a drab way of life.Corruption was rife among the bureaucrats whowere paid relatively small salaries in comparisonto the large amounts of resources they con-trolled and hence found it easy to collect bribes.

Has transition worked?

As more market elements were introduced somepeople were bound to suffer at first as the protec-tion of basic living standards under communismwas removed. But the people of the former Soviet

Chapter 1 · Introduction: what is economics all about? 9

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bloc countries hoped that capitalism would endyears of inefficiency and rapidly boost the econ-omy leading to a general increase in economicwell-being. In the West there was also excitedexpectation and even textbooks based on ‘scien-tific’ economics were jubilant:

At the end of a century of experimentation, themuch critised, free-market, capitalist system hasproved itself superior to centrally planned, or highlygovernment-regulated, systems.

(Positive Economics by Lipsey and Chrystal,8th edition, OUP, 1995)

However, Table 1.1 shows that the transition hasnot been as successful as expected and that the newtransition economies have had mixed fortunes. Infact, all the former communist countries initiallysaw huge declines in output, by as much as 30 percent. Thus there were massive increases in unem-ployment, poverty and inflation. Nevertheless, forsome such countries, particularly in Central Europesuch as Poland and Hungary, transition seemsclearly to have led to improved economic perform-ance. For other countries, such as Moldova, Russiaand Ukraine there have been disastrous falls inoutput and it is not possible to say yet that capital-ism has proved ‘superior’ in economic terms. Weare ignoring here the benefits of a reformed politi-cal system, but this has to be balanced against a

truly massive rise in poverty, hardship and crime.The consequences for the rest of the world of theslide of tens of millions of Eastern Europeans intothird world poverty may yet be felt.

It may be significant to note that, in sharp con-trast to the Soviet transition, China stimulatedconsumer spending to allow a consumer-led freemarket capitalism to grow up around, rather thanreplace, the massive state owned enterprises(SOEs). As private enterprise began to flourish theSOEs were gradually reduced. The combined effectof this took SOE production from 75 per cent ofthe Chinese economy in the 1970s to 28 per cent by2000. Again, ignoring important political aspectsand noting that China is still not a rich country interms of income per head, we see that in the 1990swhen so many former communist countries suf-fered massive falls in output, recessions hit Westerneconomies and the ‘Asian Crisis’ had severe conse-quences for many other far eastern countries, Chinamaintained an enviable record of growth (see Table1.1). Ironically perhaps, this growth was propelledby the rapid spread of the price mechanism and pri-vate ownership.

Perhaps the mistake in the Soviet transitionwas to so rapidly privatise the state owned indus-tries and to expect free markets to grow quicklyeven though consumer demand was weak.

Section I · The market system10

Table 1.1 World output growth and income per head

Average growth of output Income per head(annual percentage change) (1993 US dollars)

1981–1990 1991–1998 1980 1998

World 3.1 3.0 4078 4789

Developed economies 2.8 2.1 18 184 25 649Of whichUnited States 2.9 2.6 20551 28313European Union 2.3 1.7 15041 20838Japan 4.0 1.3 23483 35873

Economies in transition 1.9 –3.4 2261 1206

Developing economiesBy regionLatin America 1.3 3.2 3262 3395Africa 2.0 2.3 786 663Western Asia –0.6 2.8 6224 3 502East Asia 6.5 5.1 1150 2506South Asia 5.2 4.8 213 358China 9.1 10.8 181 777

Source:World Economic and Social Survey, United Nations

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Moreover, the rapid privatisation turned the hugecentralised industries into privately ownedmonopolies. Monopolists are often more likely toraise prices and reduce investment rather than theopposite (see Chapter 8). This is because they dohave to worry about competition and it can bemore profitable to simply raise prices rather thanincrease costs through investing in more capacity.

The mixed economy

By a mixed economy we mean one in which someeconomic decisions are taken by the market mech-anism and some collectively. In fact all realeconomies have a mixture of such collective orstate ownership and private ownership. (Although,more recently, many nations have increasingly usedthe state to direct rather than own resources; seeChapter 10.)

All economies are mixed to some extent; evenin Stalinist Russia some free markets remainedwhile, at the same time, predominantly capitalistnations such as the United States took some eco-nomic decisions collectively, e.g. the provision ofnational defence.

When we use the term mixed economy it is usuallyapplied to economies where there is a significantcomponent of both collectivism and free enterprise.

Despite the wave of privatisation in the UnitedKingdom and elsewhere, significant economic deci-sions are still taken collectively. Education, healthcare, defence and social security remain in the collec-tivist section of the economy. In the UKapproximately 40 per cent of all expenditure isundertaken by the state. Indeed, Table 1.2 shows thatas we enter the new millennium no country in theEuropean Union has state expenditure of less thanone-third of the value of national output. Thirteenhave state expenditure above 40 per cent, and fiveabove 50 per cent of the country’s national output.

Conclusions

The end of history?

Friedrich von Hayek (1899–1992), perhaps thecentury’s greatest champion of capitalism, diedwith the satisfaction of believing he had lived justlong enough to see his prophecy of the collapse of

communist collectivism come true. Some philoso-phers have even called it the ‘end of history’ withthe final victory going to capitalism.

As we noted above, facts are seldom so straight-forward. We should note, for example, that theSoviet Union was an oppressive and corrupt regime.There was little freedom to express discontent withthe performance of the planners or the economy,bribery was rife and there was little scope forreform from within the system. Its leaders also useda high percentage of resources to build up arms andthe military during the arms race; this added to theeffects of inefficiency and corruption in leaving lessresources to provide consumer goods.

We also saw that the transition from commu-nism to capitalism was immediately followed byenormous falls in output from which many of theformer Soviet countries have not yet recovered.This has caused some disillusionment, particu-larly among the older people who remember thecomparative stability and basic security of theformer system. In contrast, China, despite onlylimited political changes and a more gradualtransition, has been one of the world’s fastestgrowing economies for more than a decade,albeit from a very low base. Perhaps it was therapid transition of Soviet economies that was amistake and, had the political situation allowedit, a more gradual transition would have beenbetter for those Eastern European countries with-out the prerequisites for competitive markets.

Chapter 1 · Introduction: what is economics all about? 11

Table 1.2 General government expenditure as apercentage of total output in EU countries inyear 2000

Belgium 50.0Denmark 54.2Germany 47.2Greece 42.8Spain 40.7France 51.1Ireland 35.4Italy 47.8Luxembourg 43.6The Netherlands 45.0Austria 50.3Portugal 48.3Finland 47.7Sweden 56.0United Kingdom 39.1

Source: Eurostat

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The question that the vast majority of econo-mists today are concerned with, however, is lessabout the extremes and far more to do with howto get the best from a mixed economy:

Accepting the efficiency of market systems and theobvious long-term wealth creation of capitalism,the collapse of the Soviet Union does not prove thesuperiority of completely free market capitalism overthe mixed economy.

Why study economics?

In closing this first chapter we make a plea toavoid the OBE, the One Big Explanation for theeconomy. You just have to glance through thepages of this book to see that economics is a vastand often complex subject and many of the prob-lems are, as yet, imperfectly understood. Thisshould only encourage our wish to study and soto understand.

We study economics in the belief that throughunderstanding we will be able to increase the wel-fare of society, and with the conviction thatknowledge is better than opinion, analysis betterthan supposition. What we understand abouteconomics is very important; it influences us all.Perhaps it is as John Maynard Keynes wrote in1936 in one of the most influential economicsbooks of the century, The General Theory ofEmployment, Interest and Money:

The ideas of economists and political philosophers,both when they are right and when they are wrong,are more powerful than is commonly understood.Indeed the world is ruled by little else. Practicalmen, who believe themselves to be quite exemptfrom any intellectual influences, are usually theslaves of some defunct economist.

1 Comment upon the economic aspects of sport,leisure, religion, transport, television and education.

2 List five economic goods whose production alsoinvolves economic ‘bads’.

3 Why do economists disagree? 4 Make positive and normative statements about:

(a) the distribution of income;(b) inflation;(c) industrial relations;(d) health care.

5 Give two examples of goods or services providedby the state owned public sector.

6 What criteria would you use for assessing theeffectiveness of an economic society? Are they allpositive or are some normative?

7 List the possible strengths and weaknesses of themarket economy when compared to the criteriayou have produced for question 7.

8 Has economic transition in former Sovietcountries been worthwhile?

9 Read the following statements.

The great object of the political economy of everycountry, is to increase the riches and power of thatcountry.

Adam Smith The Wealth of Nations

Section I · The market system12

Summary1 Economics is the human science which studies

the relationship between scarce resources and thevarious uses which compete for these resources.

2 All economic societies have to answer threefundamental questions: ‘What shall beproduced?’, ‘How shall it be produced?’ and‘For whom shall it be produced?’

QUESTIONS?

3 Wealth is the stock of physical assets whilewelfare is the general state of well-being.

4 It is difficult to arrive at ‘pure’ economic decisionssince the economic problems are closely boundup with political, moral, sociological and otherproblems.

5 Mainstream economics lays great emphasis onseparating positive from normative problems.

6 There are four main categories of economicsociety: those run by:(a) tradition and hierarchy;(b) the market mechanism;(c) collectivism and planning; and (d) a mixture of the other methods, i.e. the

mixed economy.7 The collapse of the Soviet Union highlights the

strengths of the price mechanism but does notprove the superiority of pure capitalism over amixed economy.

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The history of all hitherto existing society is thehistory of class struggles. Freeman and slave, patricianand plebian, lord and serf, guild master and journeyman,in a word, oppressor and oppressed, stood in constantopposition to each other, carried on an uninterrupted,now hidden, now open fight, a fight that each timeended, either in a revolutionary reconstitution ofsociety at large, or in the common ruin of thecontending classes.

Karl Marx and Friedrich EngelsThe Communist Manifesto

Economics is a study of mankind in the ordinarybusiness of life.

Alfred Marshall Principles of Economics

Economics is a science which studies human behaviouras a relationship between ends and scarce means whichhave alternative uses.

Lionel Robbins An Essay on the Nature andSignificance of Economic Science

The economist’s value judgements doubtless influencethe subjects he works on and perhaps also at times theconclusions he reaches. . . .Yet this does not alter thefundamental point that, in principle there are no valuejudgements in economics.

Milton Friedman Value Judgements in Economics

Debates between economists are not just technicalarguments among practitioners but often reflectphilosophical and ideological positions which are notalways made explicit.

Sam Aaronovitch Radical Economics

‘Do you have anything on economics?’ asked a colleaguein his local bookshop. ‘Over there’, replied the assistant,‘beyond fiction.’

Anonymous. Quoted in Financial Times

Having studied these statements, say which of thestatements you consider is the best description ofeconomic society and the study of economics?

Data response ACUBA AND THE ECONOMIC PROBLEM

Read the following abridged extract from the FinancialTimes of 20 March 2000 and then answer thequestions that follow.

1 What three questions have to be answered by anyeconomic system and why is it impossible to avoidthese questions?

2 Contrast the ways in which a centralised stateplanning system and a free market system addressthese questions?

3 Why have even the most committed communistcountries allowed elements of the free market?

4 Why should an economist not be surprised to findthat good business management is valued in allsocieties?

5 Evaluate the claim that a state run company can bemore efficient than the best capitalist one. (Chapter24 looks at this in detail).

6 Would it be impossible to have a price mechanismif all industries are state owned and what problemsmight arise in attempting to combine stateownership and the price mechanism?

7 Why is there a booming illegal private sector in Cuba?

Data response BTRANSITION FROM PLANNED TOMARKET ECONOMY

Read the following abridged extract from the FinancialTimes of 11 October 2000 and then answer thequestions which follow:

1 By ‘insider privatisation’ the author means that thehuge previously state owned industries were sold offto individuals whose sole interest was to make profitsfor themselves.As these industries were highlylocalised and had been run as a single entity they weremonopolies.Why is it unlikely that such a monopolywould begin by investing to raise output and maysimply raise prices instead? Would this behaviour beany different from a capitalist monopolist?

2 Why might it not be as easy for some countries tomove very quickly from a centrally plannedeconomy to a competitive free market as theauthor suggests?

3 The author points out that the transition countriesthat are closest to the output levels of a decadeago are the ones that have either reformed least ormost.Why do you think this is the case and does itprove that all such countries could or would benefitfrom a faster transition?

Chapter 1 · Introduction: what is economics all about? 13

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Trying to teach capitalist man-agement techniques in one ofthe world’s few remaining diehardCommunist states, whose presi-dent regularly reviles neo-liberaleconomics and demonises institu-tions such as the InternationalMonetary Fund, may appear atfirst sight as useful as trying toplough the sea.

But the challenge has not dis-couraged a group of Europeanbusiness school professors who areteaching a business managementcourse in Cuba. Far from experi-encing suspicion and resistance,the teachers have encounteredenthusiastic pupils and appar-ently willing cooperation from theCuban authorities.

‘The hunger for knowledge isincredible, it is amazing,’ saysFrancisco Lamolla, the Europeandirector of the programme and aprofessor from Esade in Barcelona,which is among several leadingEuropean business schools takingpart in the Cuba programme.Prof. Lamolla makes no secret ofthe fact that Europe’s intention inbacking the programme is to sup-port and encourage economicreform in Cuba, whose Communistleadership has pledged to remainfaithful to socialist economics,including the concept of centralplanning and pre-dominant stateownership. For this reason, the

courses, which include economics,accounting, business strategies andmarketing are aimed at career pro-fessionals. The course representsan intriguing opening to western-style capitalist managementconcepts and techniques in a coun-try where neo-liberal economicpolicies and capitalist financialinstitutions are regularly pilloriedby government leaders fromMr Castro downwards.

The veteran 73-year-old Cubanpresident, who has completed fourdecades in power since his 1959Revolution, opened up the island’sstate-run economy to foreign busi-nesses and tourism only in the lastdecade, to counter the effects of eco-nomic recession triggered by thecollapse of the Soviet bloc. He hasmade it clear several times sincethen that he introduced these andother cautious, liberalising reformsout of necessity, not conviction.

It may seem surprising that theprogramme, which Prof. Lamollasays is unashamedly capitalist inits criteria, has not been construedas ‘counter-revolutionary’ by theCuban authorities. But he notesthat some of the modern manage-ment objectives being taught in thecourse appear to dovetail with acurrent government campaignfor business improvement, to mod-ernise and reform Cuban statecompanies to make them more effi-

cient. Government officials say thisreform programme is a priority.

‘For socialism to be successful,it is essential for socialist statecompanies to be efficient,’ Cubanvice-president Carlos Lage wrotein a letter to Cuban companydirectors in January. ‘Today morethan ever, I am convinced that asocialist state company can bemore efficient than the best capi-talist one,’ he added.

Prof. Lamolla says he has noticedthat his students have appearedparticularly interested in applyingwhat they have learnt to the gov-ernment’s efficiency drive in thestate economic sector. However,Mr Castro, Mr Lage and othergovernment leaders take everyopportunity to stress that Cuba’slimited economic liberalisation andcautious reforms are not intendedto return the island to capitalism.Privatisation remains a dirty wordand Cubans are not allowed to ownor run full-blown businesses, apartfrom limited private economic activ-ities such as running a homerestaurant or renting one’s house.These, and tightly regulated self-employed trades and services,constitute Cuba’s tiny legal privatesector at present, although there isa booming illegal private sector.Source: Financial Times, 20 March 2000.Reprinted with permission.

Section I · The market system14

Cuba’s revolution in a class of its ownDie hard socialist it may be, but the island is nevertheless hosting a business managementcourse, says Pascal Fletcher

FT

ECON_C01.QXD 14/12/04 10:44 am Page 14

Chapter 1 · Introduction: what is economics all about? 15

Asuccessful transition is morethan worthwhile. It can beachieved. In its assessment of theexperience, published in the latestWorld Economic Outlook, theInternational Monetary Fund arguesthat ‘where reasonable fiscal disci-pline was maintained and meaningfulstructural reforms were pursued,inflation typically remained well con-tained and output recovered morerapidly than in countries where sta-bilisation and reform efforts wereless consistent and vigorous’. Equally,‘the recorded increases in povertywere sharpest in those countrieswhere the reform process had stalled,stultifying entrepreneurship and newgrowth opportunities, and where pri-vatisation favouring insiders andpoor targeting of social safety netshave permitted a lopsided accumula-tion of wealth’.

Reform works. But countries withthe longest experience of commu-nism and economies most distortedby its mania for large-scale heavyindustry, have also found it hardesteither to manage reform or achievea healthy recovery. Communism hasleft a deep footprint – so deep thatmany countries are finding it almostimpossible to climb out of it.

. . . Intriguingly, the transition coun-tries that are closest to the outputlevels