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in an industry (or a country) requires the summing up of the demand for labour across each firm in the industry (or the country).

2.9.2LABOUR SUPPLY: INDIVIDUAL SUPPLY DECISION

Whether to supply labour to firms is a subjective decision made by individuals who vary with regard to their incentives to supply their labour and the amount of time they are willing to supply. One factor that individuals usually take into account in this decision is the price that they expect to receive for their labour, the wage rate. Generally speaking, the higher the wage rate, the more attractive it is to work because the reward is higher. This can be restated in terms of opportunity costs.

People wish to work or not, and those that do seek employment. There is an opportunity cost of working, which is the leisure time given up. Or, there is an opportunity cost of not working, which is the income foregone.

In choosing between alternative employment possibilities, people also take the wage rate into account and will usually try to secure the highest wage possible, ceteris paribus.

In the case of labour supply for individuals, supply does not keep rising indefinitely as wages increase, simply because there is a limit to the hours any individual can and is willing to work. Someone who works 35 hours a week for £10 per hour might be enticed to work additional hours at a higher wage rate – this would happen if the person placed a higher value on the extra income they could earn rather than the extra leisure time given up. Someone else working 55 hours a week might actually cut down on their labour supply if they could earn a higher wage because they consider 55 hours to be the limit of the time they are willing to devote to work. A higher wage rate would cause the person to cut back on their labour supply if they place a higher value on their leisure time compared to the income they forego. Hence, the labour supply decision is different for different individuals and opportunity cost of work (or leisure) is a subjective and personal value. The supply of labour for one worker is shown in Figure 2.12.

A reservation wage indicates the lowest wage a worker will accept to take a job.

No labour is supplied if wages are below £4 per hour, the reservation wage, as the worker does not consider it worthwhile to work for less than this wage. If the wage rate rises to £16, the worker is willing to work 55 hours (income = £880). At any

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Price	24			Labour supply
£/hour
	20
	16
	12
	8
	4
	0				Quantity (labour
		0	25	50 55	hours per week)

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higher wage than £16, the worker prefers to cut back on hours worked and labour supply declines to 50 hours if the wage rises to £24 (income = £1200).

Moving from the individual to industry labour supply, we can think of labour supply as consisting of a mix of different skills. High skills command higher wages, ceteris paribus. So too do more ‘dangerous’ jobs, and some unpleasant jobs also attract a premium wage unrelated to skill levels but as recompense for the perceived unpleasantness. The supply curve for an occupation is likely to display a positive slope implying that to increase the quantity of labour supplied to one occupation the wage rate must rise.

2.9.3EQUILIBRIUM IN THE LABOUR MARKET

By considering labour demand and supply together, as shown in Figure 2.13, we can see how equilibrium wages and hours worked are determined. The demand and supply curves shown are those for the European Steering Lock industry, for manufacturing workers. The equilibrium wage in the industry is £10 per hour in equilibrium, and 10 000 workers are employed in the industry. Safelock is one average firm in this industry, and it pays the equilibrium wage rate.

As long as there are no changes in the factors determining either demand or supply, the equilibrium situation will prevail. Since information on the output of workers, the revenue they generate for the firm and the costs of employing them enter into the labour demand decision, a change in any one of these factors will impact on the demand curve. Going back to Tables 2.4 and 2.5, for instance any

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	Price
	£/hour			Labour supply
	20
	15
	10			Labour demand
	5
	0			Quantity (workers)
	0	5000	10 000
				15 000

F I G U R E 2 . 1 3 E Q U I L I B R I U M I N T H E L A B O U R M A R K E T

factor that changes element in these tables will give rise to a new demand curve. Any factors that change supply (such as a change in the rate of income tax) would generate a new supply curve, with implications for equilibrium workers and wages. Government policies too might have an impact if, for example, a minimum wage was imposed. The effects of all such changes can be analysed using the demand and supply model outlined in this chapter.

2 . 1 0 S U M M A R Y

•The demand and supply model is the framework that allows us to examine how markets function. We can consider the most relevant features that need to be taken into account for any market we wish to consider.

•Both buyers and sellers benefit from exchange.

•The equilibrium situation in a market is an outcome that is the intention of no single buyer or seller. It is the result of all buyers’ and sellers’ decisions in that market, and includes all available information used when making those decisions.

•Prices act as a signal that create incentives for exchange and help to explain the behaviour of both buyers and sellers in markets.

•If a market is in disequilibrium, that information creates incentives for the behaviour of buyers and sellers to change and move the market towards equilibrium.

•Where governments are unhappy with the prices determined in markets, they may intervene to change the market-determined outcome.

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•One of the most interesting markets to analyse is that for labour because of the need to understand the underlying principles governing firms’ decisions to hire or demand labour and people’s decisions to supply labour. Once these principles are understood, however, equilibrium in the market is found just as in any other and it is possible to consider the effects of changes on demand, or supply on equilibrium.

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.Explain how differences in (1) preferences and (2) opportunity costs of production can give rise to gains from exchange.

2.Using examples, illustrate that you understand the concepts of absolute and comparative advantage.

3.Arguments are sometimes put forward that countries should reduce their imports from other countries – reducing the amount of exchange that takes place. Does this argument make sense, given what you know about absolute and comparative advantage?

4.Use a diagram to explain what would happen to the quantity demanded of personal stereos if their price doubled, ceteris paribus. Add in supply curves to your diagram to indicate how the doubling of equilibrium price would be caused by a movement in supply. What possible effects on supply might be responsible for a doubling of the price?

5.Use a diagram to explain what would happen to demand for personal stereos if MP3s become a preferred substitute by a substantial portion of the population. Add in a supply curve for personal stereos and explain what happens to equilibrium price and quantity.

6.Explain how the principle of opportunity cost underlies the supply curve.

7.Use Table 2.4 to examine the equilibrium implications of a fall in workers’ output on the demand for labour. Update the table if output per worker falls by 5 units for each worker. What are the implications for MPPL, and MRPL (if price is £30)? What are the effects on the demand for labour? Would you expect any changes in the supply of labour? Can you think of any factors that might cause the average worker’s output to fall?

8.Read the following case study on the ELV initiative and answer the questions that follow.

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The end of life vehicle case

Each year across the EU somewhere between 8 and 10 million cars are scrapped (out of a car ‘population’ of around 170 million). Before the 1990s the imperative to recycle had not been taken on board by car manufacturers and the issue was only beginning to be considered by consumers and governments. In May 2002, an EU directive came into force which means that from 2006 onwards end- of-life-vehicles (ELVs) will be categorized as hazardous waste requiring careful disposal. The directive will force the final owner of a vehicle to return their ELV to an authorized collection point to deregister the vehicle. Furthermore, the directive indicates that delivery of the vehicle to this point should not involve any cost for the vehicle owner. Essentially this means that car manufacturers must have networks in place to support the collection and treatment cost.

Treatment of vehicles that reach their end of life between 2006 and 2014 must ensure that 85% of materials (based on the weight) must be reused/recovered. From 2015, this percentage rises to 95%. Currently, about 75% of materials are recovered.

Support from car manufacturers for the directive has been generally positive except in relation to the decision to force them, from 2007, to bear recollection cost for all cars they produced (not just those produced from 2002).

a.What do you see as the potential implications of the ELV initiative for each of the following: car manufacturers, dismantlers and recyclers?

b.What arguments do you see for/against the initiative?

c.Can you think of any obstacles to reaching high recycling targets?

d.Do you expect any effects on either demand or supply of cars by the imposition of this law?

e.Look up the websites of car companies or car associations (such as the ACEA) across Europe to consider their views on this directive and how they are currently dealing with meeting this directive.

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

•An interesting example of market analysis can be found in Lindsey, 2003. Using this and other publicly available information, such as

•Coffee Research Institute: www.coffeeresearch.org

•International Coffee Organization: www.ico.org/ed/edmark.htm

you could apply the demand and supply framework to explain: a. what has been happening to equilibrium price in this market;

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b.what has been happening to equilibrium quantity in this market;

c.why equilibrium has changed.

You should be able to identify demand-related issues of relevance, supply-related issues of relevance and any other relevant issues to a, b and c.

•Writings by Friedrich August von Hayek (1899–1992) are insightful and thought provoking for market analysis. Hayek was awarded the Nobel Prize in Economic Sciences in 1974 (jointly with Gunnar Myrdal). See Hayek, 1948, 1984.

•For statistical and other information on labour markets in terms of the proportion of the employed population, unemployment rates, check out the World Bank’s annual World Development Report, Eurostat’s Basic Statistics of the EU and Statistical Review and various OECD labour and employment-related publications.

R E F E R E N C E S

Hayek, F. (1945) ‘The use of knowledge in society’, American Economic Review, 35, 1–18.

Hayek, F. (1948) ‘The meaning of competition’, in Individualism and Economic Order . University of Chicago Press, Chicago, 92–106.

Hayek, F. (1984) ‘Competition as a discovery procedure’, in Nishiyama, C. and Leube, K. (eds) The Essence of Hayek. Hoover Institution Press, Stanford, 254–265.

Lindsey, B. (2003) Grounds for Complaint? Understanding the ‘Coffee Crisis’ , Trade Briefing Paper No. 16, CATO Institute, May.

Smith, A. (1970) An Inquiry into the Nature and Causes of the Wealth of Nations. Penguin, Harmondsworth [original publication 1776].

Stewart, A. (1997) Intellectual Capital: The New Wealth of Organizations. Currency.

C H A P T E R 3

B E Y O N D D E M A N D :

C O N S U M E R 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:

Identify how demand is related to consumers’ choices at a microeconomic level and to macroeconomic consumption behaviour.

Highlight the importance of consumers’ spending across international economies.

Explain consumers’ choices in terms of consumer satisfaction.

Relate the law of demand to consumer satisfaction.

Consider how price changes impact on consumer choices and demand.

Illustrate how consumers’ welfare can be estimated using the demand curve.

Show how consumers’ responsiveness to price changes can be measured and explain why it is useful for economic decision-making.

Analyse how consumers choose between different varieties of similar products.

Describe macroeconomic consumption behaviour using the consumption function.

Discuss how governments try to influence consumers at macroand micro-

economic levels.

3 . 1 I N T R O D U C T I O N

Understanding the ‘demand side’ of the economy is important in appreciating how an economy works and this chapter delves into an important component of demand – the consumer. Much of the economic system is organized to meet the demands of consumers. Consumers’ demands and moreover their willingness to pay for products and services provide incentives for entrepreneurs that attempt to meet their requirements and produce what consumers wish to buy. Purchases of ‘consumption’ goods represent a substantial component of economic activity, as

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shown in section 3.2. The choices that consumers make are based on their expected benefit or utility, which is discussed in section 3.3.

As rational people, consumers take all available information into account in making their consumption decisions. As explained in section 3.4, information about prices is relevant to consumers’ decisions and, taken with consumers’ subjective views of their expected utility, serves to help us understand why consumers make the choices they do. Using demand analysis it is possible to examine the benefit or utility that consumers earn when they consume and this is shown in section 3.5. How consumers’ decisions about what to buy are affected when prices change is examined, again using demand analysis, in section 3.6. Many consumer decisions are between different brands of quite similar products and section 3.7 focuses on how such choices are made. The focus of the chapter moves to macroeconomics when the behaviour of all consumers together is considered in section 3.7 through analysis of the consumption function. This allows for consideration of how consumption spending relates to a country’s national income. The final section in this chapter considers some examples of how and why governments try to affect consumption decisions.

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

Governments buy goods and services both for current (everyday) use and to make capital expenditures that are expected to meet more long-term requirements (e.g. road building or providing funds for future pensions). Firms also make purchases for current and longer-term purposes. But consumers buy the vast majority of goods and services produced.

The value of all economic activity is the sum of the output or income of that economy over a specific period of time – this is discussed in more detail in Chapter 5. For now, note that national output or national income is conventionally denoted as Y .

National output or income, denoted Y , is calculated as the value of

•all the goods bought for consumption purposes; C plus

•all the investment expenditures by firms; I plus

•all government expenditures; G plus

•the net value of all goods traded by the economy, exports minus imports:

X − M.