Category: Economics 10e: Ch 11

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?

The linked article below, by Evan Davis, assesses the state of economics. He argues that economics has had some major successes over the years in providing a framework for understanding how economies function and how to increase incomes and well-being more generally.

Over the last few decades, economists have …had an influence over every aspect of our lives. …And during this era in which economists have reigned, the world has notched up some marked successes. The reduction in the proportion of human beings living in abject poverty over the last thirty years has been extraordinary.

With the development of concepts such as opportunity cost, the prisoners’ dilemma, comparative advantage and the paradox of thrift, economics has helped to shape the way policymakers perceive economic issues and policies.

These concepts are ‘threshold concepts’. Understanding and being able to relate and apply these core economic concepts helps you to ‘think like an economist’ and to relate the different parts of the subject to each other. Both Economics (10th edition) and Essentials of Economics (8th edition) examine 15 of these threshold concepts. Each time a threshold concept is used in the text, a ‘TC’ icon appears in the margin with the appropriate number. By locating them in this way, you can see their use in a variety of contexts.

But despite the insights provided by traditional economics into the various problems that society faces, the discipline of economics has faced criticism, especially since the financial crisis, which most economists did not foresee.

Even Davis identifies two major shortcomings of the discipline – both beginning with ‘C’. ‘One is complexity, the other is community.’

In terms of complexity, the criticism is that economic models are often based on simplistic assumptions, such as ‘rational maximising behaviour’. This might make it easier to express the models mathematically, but mathematical elegance does not necessarily translate into predictive accuracy. Such models do not capture the ‘messiness’ of the real world.

These models have a certain theoretical elegance but there is now an increasing sense that economies do not evolve along a well-defined mathematical path, but in a far more messy way. The individual players within the economy face radical uncertainty; they adapt and learn as they go; they watch what everybody else does. The economy stumbles along in a process of slow discovery, full of feedback loops.

As far as ‘community’ is concerned, people do not just act as self-interested individuals. Their actions are often governed by how other people behave and also by how their own actions will affect other people, such as family, friends, colleagues or society more generally.

And the same applies to firms. They will be influenced by various other firms, such as competitors, trend setters and suppliers and also by a range of stakeholders – not just shareholders, but also workers, customers, local communities, etc. A firm’s aim is thus unlikely to be simple short-term profit maximisation.

And this broader set of interests translates into policy. The neoliberal free-market, laissez-faire approach to policy is challenged by the desire to take account of broader questions of equity, community and social justice. However privately efficient a free market is, it does not take account of the full social and environmental costs and benefits of firms’ and consumers’ actions or a fair distribution of income and wealth.

It would be wrong, however, to say that economics has not responded to these complexities and concerns. The analysis of externalities, income distribution, incentives, herd behaviour, uncertainty, speculation, cumulative causation and institutional values and biases are increasingly embedded in the economics curriculum and in economic research. What is more, behavioural economics is becoming increasingly mainstream in examining the behaviour of consumers, workers, firms and government. We have tried to reflect these developments in successive editions of our four textbooks.

Article

Questions

  1. Write a brief defence of traditional economic analysis (i.e. that based on the assumption of ‘rational economic behaviour’).
  2. What are the shortcomings of traditional economic analysis?
  3. What is meant by ‘behavioural economics’ and how does it address the concerns raised in Evan Davis’ article?
  4. How is herd behaviour relevant to explaining macroeconomic fluctuations?
  5. Identify various stakeholder groups of an energy company. What influence are they likely to have on the company’s behaviour?
  6. In an era of social media, web-based information and e-commerce, why might it be necessary to rethink the concept of GDP and its measurement?
  7. What is meant by an efficient stock market? Why may the stock market not be efficient?

The IFS has launched a major five-year review into all aspects of inequality. The review is led by Sir Angus Deaton, the Scottish-born Professor of Economics and International Affairs at Princeton University. In 2015, he was awarded the Nobel Prize in Economic Sciences for his analysis of consumption, poverty, and welfare. The review will cover all aspects of inequality, including inequality of income, wealth, health, life-span, education, social mobility, housing, opportunity and political access, and by gender, age, ethnicity, family and geography. It will look at trends in and causes of inequality, the impacts of globalisation and political change, barriers to tackling inequality and poverty, and at various policy measures.

Although the published Gini coefficient in England and Wales has not changed much over the past 15 years, largely because of support given to the poor by tax credits, it did rise from 31.7 to 33.2 from 2015/16 to 2017/18 (the latest year for which figures are available). Other measures of inequality, however, have changed more dramatically. There is huge geographical inequality in income in the UK, reflected in inequality in health. Average weekly earnings in London are 66% higher than in the north east of England. And, according to the IFS, ‘Men in the most affluent areas can expect to live nearly 10 years longer than those in the most deprived areas, and this gap is widening’.

The UK has the greatest inequality of income of developed countries, with the exception of the USA. The IFS warns that the UK could follow the USA:

…where wages for non-college-educated men have not risen for five decades, and where rising mortality for less-educated white men and women in middle age has caused average life expectancy in America to fall for the last three years – something that has not happened for a century. We have not experienced anything similar in the UK but we have now had a decade of stagnant wages and there is recent evidence that ‘deaths of despair’ – deaths from suicide and drug and alcohol abuse – are now rising among middle-aged Britons. Sir Angus will go on to say:
 
‘I think that people getting rich is a good thing, especially when it brings prosperity to others. But the other kind of getting rich, “taking” rather than “making”, rent-seeking rather than creating, enriching the few at the expense of the many, taking the free out of free markets, is making a mockery of democracy. In that world, inequality and misery are intimate companions.’

The initial report, which introduces the IFS Deaton Review, points to some possible causes of growing inequality, including the dramatic decline in union membership, which now stands at just 13% of private-sector employees, with more flexible labour markets with growing numbers of workers on temporary or zero-hour contracts. Other causes include growing globalisation, rapid technological change making some skills redundant, the power of large companies and their shareholders, large pay rises given to senior executives, growing inequality of access to education and changing family environments with more single parents.

About one in six children in the UK are born to single parents – a phenomenon that is heavily concentrated in low-income and low-educated families, and is significantly less prevalent in continental Europe.

Then there is the huge growth in housing inequality as house prices and rents have risen faster than incomes. Home ownership has increasingly become beyond the reach of many young people, while many older people live in relative housing wealth. Generational inequality is another major factor that the Deaton Review will consider.

Inequalities in different dimensions – income, work, mental and physical health, families and relationships – are likely to reinforce one another. They may result in, and stem from, other inequalities in wealth, cultural capital, social networks and political voice. Inequality cannot be reduced to any one dimension: it is the culmination of myriad forms of privilege and disadvantage.

The review will consider policy alternatives to tackle the various aspects of inequality, from changes to the tax and benefit system, to legislation on corporate behaviour, to investment in various structural resources, such as health and education. As the summary to the initial report states:

The Deaton Review will identify policy responses to the inequalities we face today. It will assess the relative merits of available policy options – taxes and benefits, labour market policies, education, competition policy, ownership structures and regulations – and consider how policies in different spheres can be designed to complement each other and minimise adverse effects. We aim not just to further our understanding of inequalities in the twenty-first century, but to equip policymakers with the knowledge and tools to tackle those inequalities.

Articles

IFS Deaton Review

Questions

  1. Identify different aspects of inequality. Choose two or three aspects and examine how they are related.
  2. Why has inequality widened in most developed countries over the past 20 years?
  3. What is meant by ‘rent seeking’? Why may it be seen as undesirable? Can it be justified and, if so, on what grounds?
  4. What policies could be adopted to tackle poverty?
  5. What trade-offs might there be between greater equality and faster economic growth?
  6. What policies could be adopted that would both reduce inequality and boost long-term economic growth?

Workers in the UK and USA work much longer hours per year than those in France and Germany. This has partly to do with the number of days paid holiday per year, partly with the number of hours worked per day and partly with the number of days worked per week.

According to the latest OECD figures, in 2017 average hours worked per year ranged from 2257 in Mexico (the OECD’s highest) to 1780 in the USA, 1710 in Japan, 1681 in the UK, 1514 in France, 1408 in Denmark and 1356 in Germany (the OECD’s lowest). Annual working hours have been falling in most countries across the decades, as the chart shows. However, in most countries the process has slowed in recent years and in the UK, the USA and France working hours have begun to rise. (Click here for a PowerPoint of the chart.)

But why do working hours differ so much from country to country? How do they relate to productivity? How do they relate to human happiness and welfare more generally?

Causes of the differences

There are various reasons for the differences in hours worked between countries.

In a situation where individual workers can choose how many hours to work, they have to decide the best trade off for them between income and leisure. As wages rise over time, there will be substitution and income effects of these extra hourly wages. Higher wages make work more valuable in terms of what people can buy from an extra hour’s work. There is thus an incentive to substitute work for leisure and hence work longer. This is the substitution effect. On the other hand, higher wages allow people to work fewer hours for a given income. This is the income effect.

As incomes rise, generally the substitution effect will tend to decline relative to the income effect. This is because of the diminishing marginal utility of income. Richer people will tend to value a given rise in income less than poorer people and therefore will value the income from extra work less than poorer people. Richer people will prefer to work fewer hours than poorer people. Generally workers in richer OECD countries work fewer hours than those in poorer OECD countries.

But this does not explain why people in the USA, Canada, Japan and the UK work longer hours than people in Germany, Denmark, Norway, The Netherlands and France.

One possible explanation for these differences is the role of trade unions. These tend to be stronger in countries with lower working hours. Reducing the working week or obtaining longer holidays is one of the key objectives of unions.

Another is income distribution. The USA, despite its high average (mean) income, has a relatively unequal distribution of income compared with Germany or France. The post-tax-and-benefits Gini coefficient in the USA is around 0.39, whereas in Germany it is 0.29, meaning that Germany has a more equal distribution of disposable income than the USA. In fact, rises in real incomes in the USA over the past 10 years have gone almost exclusively to the top 10 per cent of earners, leaving the median income little changed. In fact median household income only rose above its 2007 (pre-recession) level in 2016.

Social and cultural explanations may also be important. People in countries with higher working hours relative to hourly wages may put a greater store on consumption relative to leisure. The desire to shop may be very strong. The ‘Anglo-Saxon’ economic model pursued by right-of-centre governments in English-speaking countries, such as the USA, Canada, Australia and the UK puts emphasis on low taxes, low regulation, low public expenditure and self-advancement. Such a model encourages a more individualistic approach to work, with more emphasis on earning money.

Then there is the attitude to hours worked generally. There is a saying that in the UK the last one to leave the office is seen as the hardest working, whereas in Germany the last one to leave is seen as the least efficient. Social pressures, from colleagues, family, friends and society more generally can have a major effect on people’s choices between work and leisure.

Productivity

Productivity, in terms of output per hour worked, tends to decline as workers work longer hours. People get tired and possibly bored and demotivated towards the end of a long day or week. If workers are paid by the output they produce and if productivity declines towards the end of the day, then the hourly wage would fall as the day progresses. This would act as a disincentive to work long hours. In practice, most workers are normally paid a constant rate per hour for normal-time working. For overtime, they may even be paid a higher rate, despite their likely lower productivity. This encourages them to work longer hours than if they were paid according to their marginal productivity.

Linking pay more closely to productivity could encourage people to opt for fewer hours (if they had the choice). Indeed some companies are now encouraging workers to choose their hours – which may mean fewer hours as people seek a better work–life balance. (See the BBC article below about PwC’s employment strategy.) Alternatively, some other employers adopt the system of giving workers a set amount of work to do and then they can leave work when it is finished. This acts as an incentive to work more efficiently.

It is interesting that countries where workers work more hours per year tend to have a lower output per hour worked relative to output per worker than countries where workers work fewer hours. This is illustrated in the chart opposite. The USA, with its longer working hours, has higher output per person employed than France and Germany but very similar output per hour worked.

Hours and happiness

So are people who choose to work longer hours and take home more money likely to be happier than those who choose to work fewer hours and take home less money? If people were rational and had perfect knowledge, then they would choose the balance between work and leisure that best suited them.

In practice, labour markets are highly imperfect. People often do not have choices about the amount they work; they work the hours they are told. Even if they do have a choice, they are unlikely to have perfect knowledge about the impact of long hours on their health and happiness over their lifetime. They may not even be good judges of the shorter-term effects of more work and more pay. They may believe that more money will buy them more happiness only to find soon afterwards that they are wrong.

Articles

Data

Questions

  1. What factors are likely to encourage workers to work longer hours?
  2. Give some examples of jobs where workers have flexibility in the amount of hours they work per week and jobs where the working week is of a fixed length.
  3. For what reasons are annual working hours longer in the USA than in Germany?
  4. Would it be in employers’ interests if the government legislated so as to reduce the maximum permitted working week? Explain.
  5. What is meant by ‘efficiency wages’? How relevant is the concept to the issue of the average number of hours worked per year from country to country?
  6. Explain why people in poorer countries tend to work more hours per year than people in richer countries.
  7. If workers’ wages equalled their marginal revenue product, why might some workers choose to work more and others choose to work less (assuming they had a choice)?
  8. Are jobs in the gig economy and zero-hour contract jobs in the interests of workers?
  9. Is South Korea wise to cut its work limit from 68 hours a week to 52?

The UK’s Low Pay Commission has just published its annual report. This shows that the lowest-paid 20% of workers aged 25 and over benefited from last April’s 4.4% rise in the ‘National Living Wage (NLW)’, the name the government gives to the statutory minimum wage for people in this age group. Although only around 6.5% of such workers are paid at the NLW, when it rises this tends to push up wage rates which are just above the NLW as employers seek to maintain the differential.

If the new NLW is above the equilibrium rate for those receiving it, it would be expected that firms would respond by employing fewer workers. However, the Low Pay Commission found no evidence that rises in the NLW caused unemployment. Instead, employers responded by combinations of increasing prices, accepting lower profit margins, restructuring their workforce and reducing the gaps between pay bands.

Over the longer term, employers often seek to increase labour productivity to offset the higher cost per worker of paying increased minimum wage rates. This, however, could lead to a reduction in employment if it involves substituting capital for labour or if greater labour efficiency does not result in a sufficient increase in total output to compensate for an increase in output per worker.

Articles

Report and data

Questions

  1. Demonstrate on a supply and demand diagram for a perfectly competitive labour market the impact of a rise in the minimum wage on employment and unemployment in that market. Assume that the market is initially in equilibrium at the previous minimum wage rate.
  2. For what reasons in such markets may a rise in the minimum wage not lead to a rise in unemployment?
  3. Now demonstrate the effect of a rise in the minimum wage in a monopsonistic market. Assume that the previous minimum wage was previously being paid by the employer.
  4. For what reasons may the employer in the previous question choose to retain employment at the current level?
  5. For what reasons may the effect of a rise in the minimum wage be different in the long run from the short run?
  6. How can employers avoid paying the minimum wage (a) when workers work in the ‘gig’ economy; (b) when workers have to travel as part of their job: e.g. care workers moving from house to house; (c) workers working from home producing items for an employer, such as clothing or jewelry, or providing a service such as telesales?