Ten Thoughts on Improving Your Economics Papers Eton Economics Revision May 2008

(1) The Importance of the Margin Textbook eco – many decisions are made at the margin –Marginal revenue = marginal cost (profit max) –Marginal social benefit = marginal social cost (social equilibrium) –Marginal utility of consumption compared to the price But few businesses / people have the capacity to reach such precise equilibrium points – or seek to find them But…… –Marginal changes in behaviour can have a big effect if enough people make them –Changing behaviour ‘at the margin’ can have important social effects – social norms can change + policies can impact –The fundamental value of something depends on the value of the marginal unit – important in lots of markets (e.g. oil, food)

2: The Law of Unintended Consequences A root cause of ‘government failure’ All government interventions have at least one and often many unintended consequences Easy to have the benefit of hindsight Reasons: –Economics is a social science about behaviour –Rational agents will look for ways to offset policies that cost them –Information failure among policy-makers –Dynamic nature of markets – governments cannot move on internet time –Disintermediation is inevitable in a globalized world

3: Stakeholders matter! ‘Any person or organization that has a legitimate interest in a specific project or policy decision.’ Check to see the sources of information in data response and the EU paper Identify and comment on value judgements – scores high for evaluation Risk of government failure: –Regulatory capture –Policy decisions – to please a vested interest

Stakeholders Employees of a business / organization Communities where a business is located or affected by a decision Suppliers Shareholders Creditors Government (and through them – taxpayers) Trade unions (and the workers they represent)

Stakeholders Employees of a business / organization Communities where a business is located or affected by a decision Suppliers Shareholders Creditors Government (and through them – taxpayers) Trade unions (and the workers they represent) NGOs and other advocacy groups (i.e. World Bank, IMF, Pressure Groups) Prospective employees Prospective customers Local communities National communities International community Competitors within a market Professional associations

4: Time Periods in Economics Be familiar with –Immediate (momentary) –Short run (at least one fixed factor) –Long run (all factor inputs are variable) Applications –Elasticity of supply (micro and macro supply curves) –Elasticity of demand (Ped, CPed, Yed) –‘Discounting’ the future value of costs and benefits –Long run macroeconomic policies e.g. supply-side –Long run micro policies – e.g. liberalising a market

5: (a) Demand and supply are often non-linear! P P Q D S

5(b): Upward sloping demand and downward-sloping supply! P P Q D S1 S2 LRS

6: Change the elasticity to build / develop the analysis! P D S S + tax Q1 Q2 P1 P2

6: Change the elasticity to build / develop the analysis! P Q D S S + tax Q1 Q2 P1 P2 P Q D1 S S + tax Q1 Q2 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 –Complements –Derived demand –Composite demand –Joint supply –Competitive supply Also important in macroeconomics –Factor markets and the economic cycle –Bond markets / currency markets / equity markets –Macroeconomic effects of external demand/supply shocks

8: Relative prices, preferences and incentives Markets are powerful – don’t underestimate them – especially the role that auctions can play! Policy interventions seek to change behaviour of agents People respond to incentives –Govt failure if the incentives turn out to be perverse –Govt failure if the incentives are not strong enough Behaviour change when relative costs and benefits alter –Leads to substitution effects (changes in demand for X and Y) This requires –Sufficient degree of changes in relative prices –Availability of alternative courses of action –Sufficient time for agents to respond

Examples of changes in relative prices London congestion charge / underground fares National minimum wage Relative prices of different crops Relative price of ethical-products Relative prices and demand for exports / imports Relative prices of legal versus illegal transactions (e.g. crime / organ sales)

9: Expectations matter! Expectations of the future drive current behaviour –Housing market –Capital investment –Food supply decisions –Currency demand and supply –Monetary policy / inflation –Fiscal policy / tax cuts / govt borrowing Formation of expectations: –Rational expectations –Adaptive expectations

10: Importance of 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 Individual rationality does not always lead to a socially optimum / desirable outcome Behavioural economics questions the core rationality embedded into conventional textbook economics

And finally…. Most policy problems require a combination of strategies Aim to understand (properly) the meaning of efficiency and equity in markets (allocative, productive, dynamic efficiency must be learnt) Have the courage to challenge the conventional wisdom Let your diagrams do the work for you – develop the analysis with higher quality diagrams Pick out bias in extracts – normative economics Use the data that is provided but be aware of its pitfalls / limitations What is rational for individual agents can often leading to outcomes that are very damaging for society Be cautious about government intervention – markets often find solutions to intractable problems in the long run – if the incentives are strong enough