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A when the PED is neither elastic nor inelastic but unit elastic. We saw earlier that unit elasticity arises when the percentage change in quantity demanded is the exact same as the percentage change in price so that there is no change in total revenue.

Price elasticity of demand: some special cases

It is possible to envisage situations where irrespective of what price is charged for a product, the quantity demanded would remain constant. Some necessities would fall into such categories where irrespective of price consumers have to bear any price change. Demand functions for goods to which consumers are addicted might also display such characteristics. Such a demand function would be a vertical line, shown in Figure 3.9. Since quantity demanded does not react at all to any change in price, it is described as a demand function with perfectly inelastic demand. At a relatively high price of P1 in panel A, the same quantity is demanded as at the lower price of P2. At the higher price, the firms’ revenue and consumers expenditure is higher.

At the opposite end of the spectrum it is also possible that demand exists for a product at only one price, also shown in Figure 3.9. This is possible if we consider the output of a single firm with many competitors which can only charge the market price for their product, i.e. the price determined by market demand and supply (this case is considered in more detail later in Chapter 6). Quantity demanded reacts perfectly to any change in price by completely disappearing! The firm can sell as much as it wishes to produce at P3 in Panel B of Figure 3.9. If the firm produces Q2 it will earn higher revenues than if it chooses to produce Q1.

A Perfectly inelastic demand				B Perfectly elastic demand
Price		D		Price
P1
				P3			D
P2
			Quantity						Quantity
	Q1					Q1	Q2

F I G U R E 3 . 9 P R I C E S E N S I T I V I T Y A N D D E M A N D

3.6.2APPLICATIONS OF ELASTICITY ANALYSIS

If a firm seeks to increase its revenue and wishes to change the price it charges for a product, it needs to know to what extent quantity demanded is responsive to the price change. The above analysis shows that there would be little point in a firm

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raising its price with the intention of boosting its revenues if quantity demanded was in the elastic part of the demand curve. In terms of a firm’s pricing strategy, therefore, it makes sense for the firm to have information on the price elasticity of demand for its product(s).

Information on elasticity is not just of interest to business but can be useful for policy-makers also.

If a government is thinking about increasing taxes on cigarettes with the intention of reducing the quantity demanded, it needs to have an estimate of the PED for cigarettes.

If the function of the tax is to reduce aggregate expenditure on cigarettes, a price increase (via the tax) would have to result in the price rising to the elastic portion of the demand curve. The result of the tax would be that the percentage increase in price would bring about a larger proportionally percentage fall in quantity demanded – consumers would buy fewer cigarettes, and the total revenue to cigarette firms would decline. Hence, the responsiveness of consumers to price provides useful information for decision-making.

3.6.3OTHER ELASTICITY EXAMPLES

Income elasticity of demand

In general if a consumer’s income increases, it is expected that their demand for goods and services would increase too, but not necessarily by the same proportion. The relationship between the quantity demanded of any goods and income is described by the income elasticity of demand.

Income elasticity of demand measures the responsiveness of the quantity demanded of a good to changes in consumers’ income (I ).

It is computed as % Qd/% Y

Goods are described as normal goods, if their income elasticities are greater than zero implying the quantity demanded changes in the same direction as a change in income. Most goods fall into this category – we buy more of them if our income rises. In the case of inferior goods their quantity demanded declines if income increases. Income elasticities for inferior goods are negative because a percentage increase (fall) in income leads to a decline (rise) in quantity demanded of the good.

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Goods for which the percentage change in quantity demanded is greater than the percentage change in income are described as income elastic (with income elasticity greater than one). This would be the case if income rose by 15% and the quantity demanded of package holidays, for example, increased by 20%. Other goods are called price inelastic when a change in income results in a less than proportionate change in quantity demanded: an example would be a 3% increase in quantity demanded of electricity following a 15% increase in income. Income elastic goods are also known as luxury goods whereas income inelastic goods are necessities.

Cross-price elasticity

The relationship between the quantity demanded of one good and the price of another good is described by the Cross-price elasticity.

Cross-price elasticity indicates the responsiveness of the quantity demanded of one good (good A) when the price of another good (good B) changes.

It is computed as % QdA /% PB

Cross-price elasticity is of interest for goods that display some economic relationship, such as complement or substitute goods.

If car insurance rises by 20%, this may have an impact on the quantity of new cars demanded, a complement good for car insurance, which might be expected to fall and so the cross-price elasticity would be negative. Since new cars are substantially more expensive than insurance, the effect on demand should not be close to 20% and so the cross-price elasticity would be less than one. Among young drivers and focusing on the first-time drivers’ secondhand car market, the cross-price elasticity might be considerably higher, when annual insurance costs may even be greater than the price many pay for their first car.

If Indian and Chinese takeaway food are substitute products, it would be expected that if the price of Chinese takeaways rises, the demand for Indian food would rise as consumers substitute away from the more expensive to the cheaper good, presuming the consumer is indifferent between the goods. This means that the cross-price elasticity would be positive since the price change (rise or fall) in one good leads to a change in quantity demanded of the substitute good in the same direction (rise or fall) as the price change.

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3 . 7 C O N S U M E R C H O I C E A N D P R O D U C T A T T R I B U T E S

Many purchasing decisions are made not between very different products such as call credit and nights out, but between different brands or types of similar products. Such decisions can be analysed using the attribute model of consumer demand. This model explains that consumer utility, and therefore demand, is the result of product characteristics, performance features or attributes, other than price. In selecting one brand of a good over another, consumers compare and subjectively rank their preferred attributes, which are those that generate highest utility for them.

The features or attributes that explain consumers’ decisions to buy one variety or brand instead of another are the basis for product differentiation.

3.7.1THE ATTRIBUTE MODEL: BREAKFAST CEREALS

An individual considering buying one of the variety of competing cereals has decided on the two most important non-price attributes for their subjective purchasing decision as wholegrain cereal and low sugar content. Having evaluated four possible products, the product information is as shown in Table 3.6.

This information is also presented in Figure 3.10 where each of the four products is drawn as a line against the two attributes and where the slope of each product line reflects the computed ratio of the attributes. The difference in the slopes of the product lines reflects the different trade-offs of the two attributes in the

T A B L E 3 . 6 P R I C E A N D A T T R I B U T E

I N F O R M A T I O N F O R B R E A K F A S T C E R E A L S

		Attribute rating
		(on scale of 1 – 10 where 1 is lowest)		Ratio of
Brand	Price	Wholegrain	Sugar content	attributes
A	£2.35	9	4	2.25
B	£2.59	7	5	1.40
C	£2.85	5	7	0.71
D	£2.99	3	9	0.33

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		Wholegrain	Brand A
			Brand B
			A ×
			× B	Brand C
			C
			×
			D	Brand D
			×
				Sugar
				content
	F I G U R E 3 . 1 0 T H E A T T R I B U T E M O D E L

eyes of the consumer (similar to the concept of marginal rate of substitution discussed earlier).

Points A, B, C and D in Figure 3.10 indicate the cost of acquiring each product (which can alternatively be called an attribute combination) as measured from 0 and the distance reflects the budget the consumer wishes to allot to buying cereal and the price of each brand. We can simplify having to guess the budget the consumer wants to spend on cereals by assuming our consumer here has sufficient income to buy any of the four products but their purchasing decision is about buying one pack only (for their weekly shopping). This assumption corresponds more closely to how purchases actually occur – in terms of one cereal brand versus others. Hence, points A, B, C and D are each one unit out from 0. Points A, B, C and D represent the buyer’s maximum satisfaction/utility frontier and, for example, reflect that at point A the attribute combination corresponding to one unit of Cereal A is 9 for wholegrain and 4 for sugar content.

In making the purchasing decision the consumer must evaluate their marginal rate of substitution between the attributes and these are shown by the addition of indifference curves as in Figure 3.11. The decision of which cereal to purchase is seen from selecting the brand that corresponds to the highest indifference curve, which is Brand B on IC4. The ‘next best’ option is Brand C on IC3, next Brand A on IC2 and finally Brand D on IC1.

The attribute model can also be used to consider the effect of price changes as this will impact how far on each product line the consumer can purchase and hence a change in price of one brand changes the utility frontier and the highest indifference curve that could be reached. If the price of Brand B increases, for

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Wholegrain	IC2
	IC1
	×
	A
	× B
		×	IC4
			IC3
	C	×
			D	Sugar
				content
F I G U R E 3 . 1 1 T H E A T T R I B U T E M O D E L W I T H
P R E F E R E N C E S

example, then with the same amount of money fewer attributes can be bought (or more must be paid for a given set of attributes). This would have the effect of moving the satisfaction frontier reflecting brand B from point B to a point on the same line but closer to 0. Following the price change, Brand B might no longer be the consumer’s preferred choice.

3 . 8 A G G R E G A T E C O N S U M E R B E H A V I O U R

Moving from individual microeconomic consumer behaviour to macroeconomic behaviour we now turn our focus to the general trend that emerges from analysing macroeconomic consumption behaviour. The higher people’s disposable income – gross income less direct taxes – the more they plan to spend on consumption goods. If Y denotes income and t denotes the income tax rate, then disposable income Yd can be defined as Y − tY = Yd. If Y is £30 000 and t is 25% then Yd is £30 000 less £7 500, which is £22 500. The relationship between planned consumption expenditure and disposable income for an economy is represented by the consumption function, as shown in Figure 3.12.

Total expenditure on consumption is made up of two components, autonomous consumption (a) and a fraction of disposable income (b), in other words:

C = a + bYd

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	Consumption	C = a + bYd
	£bn
		(e.g. C = 50 + 0.8 Yd)

50

a

Yd

F I G U R E 3 . 1 2 T H E C O N S U M P T I O N F U N C T I O N

From the consumption function in Figure 3.12, we see that even if disposable income is zero, some consumption still occurs. In the figure, this value of autonomous consumption is £50bn. This is the intercept value of the consumption function.

Consumption expenditure that is independent of the level of income is called autonomous consumption. It occurs if people borrow to buy consumption goods or if they spend their savings (or borrow) when they have no income to pay for consumption goods.

People also spend some of their disposable income. This portion of income is represented by b in Figure 3.12 and is the slope of the consumption function. The value of b is different in different countries, and varies over time in countries also. It is a fraction lying between 0 and 1. This means that if disposable income increases by £1, for example, planned consumption expenditure will rise but by less than £1. Any disposable income not spent on consumption is saved. The term b in Figure 3.12 is known as the marginal propensity to consume – MPC.

The MPC describes the relationship between a change in disposable income and the resulting change in aggregate consumption expenditure.

As with demand, the ceteris paribus assumption applies to the consumption function. Many factors help to explain the shape of a consumption function for a group of consumers. Changes in the factors lead to changes in the consumption function, in either the autonomous component or in the marginal propensity to consume or sometimes in both.

Disposable income is not the only factor that determines consumption behaviour. Other relevant factors include consumers’ wealth, and their expectations about future prices and income levels. The higher their wealth, whether measured as

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savings, inherited wealth, property or shares, the higher people tend to consume out of their current disposable income. The rationale is that those with higher wealth have less need to save than other less wealthy consumers. Expectations of higher future prices would induce rational consumers to purchase sooner rather than later as would the expectation of a higher future level of income.

Income distribution across a population also affects consumption behaviour since poorer consumers tend to have a higher MPC and tend not to have the luxury of being able to save out of their low incomes. Tastes and preferences regarding borrowing and buying on credit also affect consumption and this is true both for individuals and groups or nationalities.

A consumption function shifts with changes in:

•Wealth: greater wealth → increased consumption (reflected in either higher autonomous consumption or a higher MPC).

•Expectations of future prices and future income: expectations of higher prices or higher income → increased current relative to future consumption

(reflected in either higher autonomous consumption or a higher MPC). The specific effects depend on consumers’ opinions as to how long higher prices will prevail and the expected increase and size of the increase in income.

•Income distribution: the higher the share of rich people in the population the lower the marginal propensity to consume as rich consumers have more discretion in how to spend income. A rise in the proportion of rich people in the population would reduce the MPC and may change autonomous consumption also.

•Preferences regarding buying on credit: an increase in preferences to borrow for consumption purposes increases the MPC and may increase autonomous consumption also.

If the MPC is 0.8 this means that 80p out of every additional £1 is spent on consumption goods. Furthermore, it implies that the marginal propensity to save is equal to 0.2 and that 20p will be saved out of each £1. A savings function can be drawn to correspond to the consumption function above as shown in Figure 3.13.

The savings function describes the relationship between income and the desired level of savings. If consumers in Figure 3.13 consume £50bn with an income of 0, they must be borrowing or dis-saving. This is why the savings function in Figure 3.13 begins at −£50bn on the savings axis. Since whatever income is not used for consumption is saved, the slope of the savings function is (1 – b) which is 0.2 in this case.

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Savings

£bn

S = – a + (1 – b)Yd

(e.g. S = – 50 + (1 – 0.8) Yd)

Yd

–a

–50

F I G U R E 3 . 1 3 T H E S A V I N G S F U N C T I O N

The extent of borrowing or dis-saving in an economy is of interest since some economists have argued any growth in consumer credit can be beneficial or detrimental for an economy. The value of economic activity increases when consumers borrow whether it is to buy cars, pay for holidays or whatever the consumption goods purchased. However, if consumers take on too much debt relative to their income, it is argued that there may come a time when consumers can no longer spend on new goods and services and focus instead on paying off old debts. Potentially, that could slow down economic activity.

Consumers’ demand for credit also has a direct bearing on interest rates. Interest rates are the price of money determined in money markets by demand for money and the supply of money (both of which are considered in more detail in Chapter 7). As in any market, if the demand (for borrowed money) exceeds the supply (provided by lenders), prices (interest rates) rise. If demand for credit falls and lenders are trying to fight for customers, they may offer lower interest rates to attract business.

The paradox of thrift is an example of the fallacy of composition which holds that although a certain action might make sense for an individual it does not follow that the same activity makes sense for an economy overall. Increased saving by an individual consumer provides the consumer with increased opportunities for consumption in the future. It does not follow that an economy benefits from increased savings. Why?

An unexpected increase in savings implies decreased consumption expenditure. Firms will sell less than they planned and require fewer employees to produce output. Unemployment may rise with the result of lower incomes being earned at the level of the economy overall. Falling income has a knock-on effect

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of reducing consumption expenditure. If such a scenario unfolds, the paradox of thrift is observed. Further implications may follow with firms reducing their planned investments in line with lower expectations of consumer expenditure so the process continues on and on until the cycle is ended by changes in behaviour once again.

3 . 9 G O V E R N M E N T P O L I C I E S – C O N S U M E R F O C U S

Many government policies are microeconomic in focus and attempt to influence the demand for specific products – such as in the case of cigarettes. Annual government budgets often include increased taxes on alcohol and petrol as governments try to increase their tax revenues. Following the law of demand, with an increase in the price of a good, whether caused by an increase in taxes on the goods or any other factor, the expectation is that quantity demanded will fall. We saw earlier that the extent to which quantity demanded changes in response to a price change depends on the price elasticity of demand for the product, which is related to the initial price and quantity demanded of the good – it may be price elastic, unit elastic or inelastic.

Macroeconomic policies are also used to affect consumer spending at a broader level. Since consumption expenditure is such a substantial share of economic activity, governments sometimes try to focus policies on increasing consumer demand. This is particularly relevant before and during recessions when consumer demand slows down as people put off purchases that are not entirely necessary. During recessions consumer confidence is low and unemployment can be high as firms lay off workers when their output is not in demand.

One policy that governments use to affect macroeconomic consumption behaviour is through the tax system. During recessions governments often cut income taxes so that consumers have more disposable income that they can spend on consumer goods. This is one example of how government attempts to affect the consumption function. By cutting taxes, consumers have more disposable income, and hence their consumption expenditures would probably rise. Any change in the tax rate alters consumption behaviour via the consumption function, as explained in this worked example.

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T H E T A X R A T E A N D C O N S U M P T I O N

Consider the following consumption function: C = 50 + 0.8Yd

If the net tax rate is 20%, this means disposable income is 80% of national income or

Yd = 1 − 0.2Y = 0.8Y

A change in the net tax rate to 30% would affect consumption behaviour by changing the amount of disposable income to

Yd = 1 − 0.3Y = 0.7Y

This indicates that when the net tax rate changes consumption is affected.

If the change in disposable income had no effect on autonomous consumption or the marginal propensity to consume then the function itself would remain at

C = 50 + 0.8Yd

However, the impact of having lower disposable income would imply lower planned consumption by consumers. If consumers reacted to higher taxes by saving less, the MPC could increase. The change in tax rate would probably have no impact on autonomous consumption.

Alternatively, governments trying to slow down activity in a booming economy might attempt to make savings a more attractive option.

Special savings accounts might be introduced such as in the case of the Irish Special Savings Investment Accounts (announced in the Finance Act 2001). In this case the Irish Government provided an additional 25% on each ¤1 saved in these special accounts (minimum monthly savings were ¤12.70: maximum were ¤254), which would be valid for a five-year period. To qualify for such attractive returns, savings could not be withdrawn before the five-year period or taxes equivalent to the government’s contribution would have to be paid. Approximately 40% of the adult population opened such accounts, which should mature for withdrawals around the time of the next General Election, should the government serve its full office.

Another government policy that focuses on trying to influence aggregate consumption is the expansion of public sector employment, which includes teachers, police,

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civil servants, nurses, doctors, etc. By increasing employment in this way fewer people are unemployed and the wages and salaries of the public sector workers can be spent on consumer goods, boosting demand. Unfortunately there are some examples of cases where governments created additional public sector jobs, which although resulting in generating extra consumer demand in the short term also created longterm problems of inefficiency in certain parts of the public sector and increased government expenditure via wages and salaries (see Johnson and Scholes, 2001).

Other less direct policies are also used by governments to stimulate consumer demand – as in the car industry example in the Philippines (outlined in Chapter 2). Because a price ceiling was set, consumer demand for a certain type of utility vehicle was boosted; however, since demand outstripped supply, many consumers willing and able to make their purchase were unable to do so due to the limited supply. This is interesting since it shows how government policies do not always have the desired effects.

Governments also try to affect consumer behaviour by policies such as banning smoking in the workplace, as in Norway, New York and Ireland. This means such governments have decided that the social costs of smoking outweigh the benefits to consumers who wish to smoke. Many debates rage regarding the right of government to affect consumption behaviour so drastically and point to the tension between protecting the public on the one hand and impinging on individual freedom from a ‘nanny’ state, on the other.

3 . 1 0 S U M M A R Y

•Expenditure on consumption goods is a substantial component of economic activity.

•Consumption activity can be analysed from a number of perspectives – how individual rational consumers make their consumption decisions, how this is reflected in the demand for a product in a specific market and how this relates to aggregate consumption.

•Concepts that allow us to understand the choices consumers make include total utility, marginal utility and consumer preferences. Price changes impact on planned consumption expenditure, i.e. on quantity demanded, which can be analysed using the marginal utility/price ratio or using budget line and indifference curve analysis.

•Consumer welfare can be analysed using the concept of consumer surplus.

•Economic decision-making regarding consumer behaviour can be supported by analysis of price elasticity.

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• The attribute model allows for analysis of demand for differentiated consumer products.

•Aggregate consumption behaviour is described by the consumption function.

•Government can influence aggregate consumption and/or demand for individual products.

R E V I E W P R O B L E M S A N D Q U E S T I O N S

1.Using the information provided, fill in column 3 by computing the marginal utility of car and motorbike consumption.

		Marginal			Marginal
No. of	Total utility	utility	No. of	Total utility	utility
cars (Q )	(TU)	( TU/ Q)	bikes (Q)	(TU)	( TU/ Q)
0	0	–	0	0	–
1	50		1		20
2	88		2		15
3	115		3		11
4	135		4		7
5	150		5		3
6	162		6		0

2. If the consumer in question 1 had £60 000 to spend and a car or bike cost £15 000:

a.Compute the marginal utility per pound for car and bike consumption.

b.Rank the consumer’s preferred consumption choices.

c.What difference does it make to your answers to (a) and (b) if the price of the bike is £10 000?

3.Given the following information on demand for roses in a small town:

Equilibrium price	£10.00
Quantity demanded when price is zero	480
Quantity demanded when price is £20.00	0

a.Estimate the consumer surplus.

b.If there is a change in the supply of roses that leads to an increase in the equilibrium price to £12.00, estimate the change in consumer surplus. Answer this question by drawing supply and demand curves. Can you think of any reasons that might cause supply to change?

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4.List five products that you consume and explain why you are/are not pricesensitive in the case of each one. Which products do you think have the steepest and flattest demand curves? Why?

5.Using the given information, consider if Fair Furniture Ltd should or should not increase its price of tables (hint: compute the total revenue).

Current price	£275
Quantity sold	500
Proposed price	£325
Expected sales at price = £325	480

In increasing price from £275 to £325, does this correspond to the elastic or inelastic portion of the demand for tables? Explain your answer.

6.For an economy with a consumption function of C = 50 + 0.8Y and a tax rate of 0.2 (or 20%)

a.Rewrite the consumption function in terms of disposable income rather than national income.

b.Sketch both consumption functions to consider the effect of taking account of taxation.

c.If the tax rate rises to 0.4, what effect does this have on the consumption function?

7.What other products, apart from breakfast cereal, could be analysed using the attribute model? For one of the products you selected, ask two friends to indicate the most important attributes they consider in purchasing the product. Ask each of them to rank their preferences for each attribute (on a scale of 1–10) for four alternative products. Construct a table like Table 3.6 and draw a figure like Figure 3.10 showing the relative performance of the products in terms of their attribute ratings.

8.Read the following brief case study and answer the questions that follow.

The European car industry: consumers being taken for a ride?

The price of cars across the EU varies considerably for some makes and models. Many consumer groups have voiced concern over this issue and campaign for reform in this market that will result in greater standardization of prices. Despite the introduction of the euro, price divergences were still widespread in 2002, although recent information points to some convergence of prices within the euro zone.

An examination of manufacturers’ recommended retail (pre-tax) prices showed considerable diversity between the cheapest and most expensive countries in the euro zone with the average difference being approximately 10%

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in November 2002, down slightly on the previous estimate of May 2002. The euro zone countries where cars are cheapest are Denmark, Greece and the Netherlands while the most expensive are Germany and Austria. The most expensive EU country is still the UK.

For individual cases, some very wide price differences have been recorded, the greatest being for the Fiat Seicento, which costs 59.5% more in the UK than in its cheapest source, Spain.

In theory, at least, it should be possible for a European consumer to source a car from a cheaper location. However, in practice the process is not straightforward. For reports on car price differentials across the EU visit: http://europa.eu.int/comm/competition/car sector/price diffs/

a.Would you expect that manufacturers’ recommended retail (pre-tax) prices would differ for consumers in different countries? Why or why not?

b.Why might the introduction of the euro have been expected to reduce any price discrepancies across the euro zone?

c.What obstacles might stand in the way of a consumer wishing to purchase a car from another country?

F U R T H E R R E A D I N G A N D R E S E A R C H

•For more on Simon’s concept of bounded rationality see Simon, 1957.

•Interesting recent research on the implications for economics of research into human behaviour was published in Kopcke, Sneddon Little and Tootell, 2004.

•For related reading see Jensen and Meckling, 1994.

R E F E R E N C E S

Heston, A., R. Summers and B. Aten (2002) Penn World Table Version 6.1. Centre for International Comparisons at the University of Pennsylvania (CICUP), October.

Jensen, M. and W. Meckling (1994) ‘The nature of man’, Journal of Applied Corporate Finance, Summer, 4–19.

Johnson, G. and K. Scholes (2001) Exploring Public Sector Strategy. Prentice Hall. Kopcke, R., J. Sneddon Little and G. Tootell (2004) ‘How humans behave: impli-

cations for economics and economic policy’, New England Economic Review, First Quarter, 1–35.

Simon, H. (1957) ‘A behavioral model of rational choice’, in Models of Man. John Wiley & Sons, Inc., New York.

C H A P T E R 4

B E Y O N D S U P P L Y : F I R M S

I N T H E E C O N O M I C S Y S T E M

L E A R N I N G O U T C O M E S

By the end of this chapter you should be able to:

Describe the main activities of firms in the economic system.

Clarify why firms are necessary within the economic system.

Compare and contrast accounting and economic definitions of profit.

Use marginal analysis to consider efficient production for a firm taking its costs and revenues into account.

Explain how producer surplus is a measure of producer welfare.

Apply the concept of price elasticity of supply and explain how it is useful for economic decision-making.

Outline the reasons why firms invest and how investment contributes to economic growth.

Apply the demand/supply model to discuss how government tries to influence producers with specific reference to:

•

•

production subsidies;

environmental taxes.

4 . 1 I N T R O D U C T I O N

Just as the economic system relies on consumers for its existence, suppliers play an equally important role in the organization and functioning of an economy. Suppliers facilitate the exchange of goods and services, which is a cornerstone of the economic process. But to see their function as simple intermediaries between people and goods and services would miss the variety of contributions made by firms to the continuation, growth and expansion of the economic system. In section 4.2, these contributions are discussed. The reasons why firms exist at all are presented in section 4.3 and the basic building blocks for microeconomic analysis of firms are presented in detail throughout this section, i.e. output, revenue and costs. This

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analysis is developed further to examine the concept of efficient production from a single firm’s perspective in section 4.4 in the context of a profit-maximizing firm. Efficient production in the face of a lower cost competitor is also considered here and the extent to which the production decision differs for firms in the short run or long run is examined.

Producers’ welfare is analysed in section 4.5 by estimating producer surplus and this is followed by consideration of how producers react to changes in prices in section 4.6. The discussion turns to focus on aggregate macroeconomic investment behaviour by firms in section 4.7, since the investment function fulfilled by businesses is a vital contribution by firms to the economic system. The role played by government in attempting to influence production is dealt with in section 4.8 where the examples of using subsidies and environmental taxes are analysed.

4 . 2 F I R M S I N E C O N O M I C A C T I O N

Producers make and supply products and/or services to consumers. Most firms operate in the private sector which means those companies are owned and operated by private individuals. Firms owned and/or operated by governments make up the public sector. Firms contribute to economic life in many ways through:

•the goods and/or services they provide;

•the employment they offer;

•the wages and salaries they pay employees;

•the money they spend on buying goods and services from other firms;

•the money they spend on improvements to their businesses (to buy new premises or new machinery and equipment, for example);

•the taxes they pay for their employees and on their profits;

•their expenditure on innovation to advance and increase the quantity or quality of products/services they provide.

As we saw in Chapter 3 the consumption behaviour of consumers provides firms with revenue so in terms of attempting to approximate the contribution of firms to economic life, this provides some information. If we consider the overall amount of economic activity conducted in an economy (whether measured as income or output) we note that firms also contribute to each of the other components of activity by:

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•providing some of the goods and services that are provided to government and which appear under government expenditure;

•supplying goods and services for exports and by importing such goods also, appearing under net exports;

•their attempts to maintain and improve the level of capital stock of their companies, and thereby the economy, classified as investment.

The monetary value of firms’ involvement in economic activity in no way exhausts all the ways in which firms contribute to economic life. Indeed it would be difficult, if not impossible, to put a value on the utility that individual entrepreneurs derive from setting up and running their own businesses rather than working for other employers.

4 . 3 W H Y O R G A N I Z E A N E C O N O M I C

S Y S T E M A R O U N D F I R M S ?

As outlined in Chapter 2, hypothetically speaking, economic life does not need to include firms. However, it does make better sense for firms to organize some economic activities because it is a more efficient way to use economic resources than if individuals instead engaged in those same activities. Hence, one reason why firms are needed is to save on unnecessary transactions costs that would arise if economic activity were conducted by individuals, instead of by firms.

If you were to ask those people actually running firms, the chief executive officers or managing directors, why their firms exist, they probably would not explain that it is to help society save on transactions costs. Similarly, although society benefits from firms’ advances to create new and innovative products, most firms would probably not rate society’s benefit as their reason for existing. Firms exist rather to generate income for their owners or shareholders and such income is generated as long as the firm’s total costs (in the economic sense) are less than its total revenues. This excess of revenue over costs amounts to a firm’s economic profits. Economists generally assume that firms exist to generate the maximum possible economic profit they can. This is the principle of profit maximization. This means firms make their decisions about how much to produce and what price they should charge with the aim of making the largest economic profit possible.