A key economic principle is that rational decision making requires thinking at the margin. This involves a comparison of the additional (or marginal) benefits and costs of an activity.
An example of such rational behaviour would be deciding to drink one more beer or spending one more hour studying only if the additional benefits were greater than the additional costs. The optimum is where marginal benefit equals marginal cost.
And this applies to firms too. A firm maximises its profits by producing the output at which marginal revenue is equal to marginal cost.
However, a recent book by the American business guru Clayton Christensen argues that thinking in this way can be a problem. A recent article in the Guardian describes a story he tells of the time he refused to play for his university basketball team in a national final which took place on a Sunday and therefore conflicted with his religious beliefs. His decision involved sticking to his principles rather than thinking at the margin. For him, whilst the marginal cost of sacrificing these principles just once may well have been small compared to the resulting benefits, the eventual cost would be much higher.
Christensen also suggests that similar arguments can apply to firm decision making. The above article provides an example he uses of decisions made by executives at the Blockbuster video chain. When smaller rivals started offering movies by mail, Blockbuster instead continued to invest in its existing video store business model. This eventually proved disastrous for the company. The explanation given for this is that building on previous investments made more sense than setting up a mail-order arm which would cannibalise their existing business. On the other hand, an alternative explanation may be that executives at Blockbuster were irrationally allowing sunk costs to affect their decision making.
Articles
Clayton Christensen’s “How Will You Measure Your Life?” Harvard Business School, Clayton Christensen (9/5/12)
Clay Christensen’s life lessons BloombergBusinessweek, Bradford Wieners (3/5/12)
Bust Blockbuster goes on the block Guardian, Ben Child (4/4/11)
Questions
- Can you think of a situation where you have decided to stick to your principles rather than think at the margin?
- Why does a firm maximise profit by producing the output at which marginal revenue is equal to marginal cost?
- What do you think are the main costs of setting up a mail-order business?
- Are these costs mainly fixed or variable costs?
- Why is it irrational to take sunk costs into account when making a decision?
- Can you think of a situation where you have been influenced by sunk costs?
With tight incomes, the first things that families tend to cut back on are the more luxury items. Extensions to houses are delayed, interior refurbishments are put off and the old car that was going to be traded in becomes something you can live with for another few years.
Car sales have been adversely affected during the recession, but data for May 2012 show a positive turn. Manufacturers have said that car sales are up by 7.9% compared with May last year. According to the Society of Motor Manufacturers and Traders (SMTT), much of the increased demand has come from private sales, where the increase has been over 14%.
This data may not be the answer to the economic troubles, but it is perhaps an indication that confidence is beginning to return. However, should things go from bad to worse in the eurozone, it isn’t hard to see data for the coming months showing the opposite trend. One other key piece of information to take from this data is the growth in the sales of lower-emissions vehicles. Sales of these were up 31.8% in May 2012 compared to the same time last year. Jonathan Visscher from SMMT said:
‘The green sector is growing fast…Every car manufacturer is going to have a hybrid model on its lists by the end of this year, even Ferrari.’
The continuing upward trend in car sales is by no means guaranteed to continue, especially with things like the expected rise in fuel duty later this year and the ongoing crisis in the eurozone, with Spanish banks potentially looking for help via a bail-out in the not too distant future. The following articles consider the acceleration in car sales.
UK sees biggest annual rise in car sales for nearly 2 years Reuters (8/6/12)
New car sales accelerate ahead Press Association (8/6/12)
UK new car sales accelerated in May, say manufacturers BBC News (8/6/12)
New car sales accelerate ahead Independent, Peter Woodman (8/6/12)
Car registrations accelerate in May Financial Times, John Reed (8/6/12)
Questions
- How would you define a luxury good? What is the relationship with income?
- How could an increase in car sales benefit the economy? How could the multiplier effect have an impact?
- Which factors have contributed towards the growth in low-emissions cars?
- Sales of low-emissions cars have significantly increased. However, why is this increase
- What are some of the key things that can help to bring a recession to an end? Into which general category would you place this increase in car sales?
- Fuel duty is expected to rise later this year. How might this affect the number of new car registrations? What does your answer tell you about the cross elasticity of demand?
Centrica, owners of British Gas, has warned that electricity and gas prices in the UK are set to rise in the autumn. Centrica blames this on the expected rise in the costs of wholesale gas and other non-energy inputs.
One of the other ‘big six’ energy suppliers, E.On, has responded by saying that it will not raise energy prices this year. Whether it will raise prices after 1 Jan next year remains to be seen.
Last autumn, household energy prices rose substantially: between 15.4% and 18% for gas and between 4.5% and 16% for electricity. This spring, in response to lower wholesale energy prices, suppliers cut prices for either electricity or gas (but not both) by around 5%.
The government and various pressure groups are encouraging consumers to use price comparison sites to switch to a cheaper supplier. The problem with this is that supplier A may be cheaper than supplier B one month, but B cheaper than A the next. Nevertheless, switching does impose some degree of additional competitive pressure on suppliers.
More powerful pressure could be applied by ‘collective switching’. This is where a lot of people switch via an intermediary company, which sources a deal from an energy supplier. This collective buying is a form of countervailing power to offset the oligopoly power of the suppliers. Such schemes are being encouraged by the Energy Minister, Ed Davey.
The other approach, apart from doing nothing, is for Ofgem, the energy regulator, to impose tough conditions on pricing. But at present, Ofgem’s approach has been to try to make the market more competitive (see also), rather than regulating prices.
British Gas owner Centrica warns of higher energy bills BBC News (11/5/12)
E.ON to keep residential energy prices unchanged in 2012 Reuters, Adveith Nair (14/5/12)
E.ON promises to hold energy prices for 5million customers in 2012 This is Money, Tara Evans (14/5/12)
British Gas owner Centrica feels cold blast from critics ShareCast, John Harrington (11/5/12)
Gas and electricity price battle lines drawn BBC News (14/5/12)
Taking on the energy giants: The co-operative insurgency gains ground Left Foot Forward, Daniel Elton (11/5/12)
Group Energy Buying hits the UK Headlines Spend Matters UK/Europe, Peter Smith (11/5/12)
Think tank calls for competition to break Big Six rip-off Energy Live News, Tom Gibson (30/4/12)
Collective switching will not fix the UK’s broken energy market Guardian, Reg Platt (27/4/12)
Make your own small switch for cheaper energy The Telegraph, Rosie Murray-West (14/5/12)
Questions
- What are the barriers to entry in the electricity supply market?
- How competitive is the retail energy market at present?
- To what extent do price comparison sites put pressure on energy companies to reeduce prices or limit price increases?
- What scope is there for collective buying of gas and electricity from the six energy suppliers by (a) households; (b) firms?
- Assess Ofgem’s package of proposals for a simpler and more competitive energy market.
Weather has already been partly blamed for poor economic growth, in particular in December 2010 and January 2011. April 2012 is no different – the wettest April on record is said to have caused the worst performance in sales since March 2011.
Like-for-like sales fell by 3.3%, mainly through lower demand for clothes and shoes. Supermarkets saw an increased demand for warmer food items with the colder weather and demand for home products also increased, with analysts suggesting that people decided to re-decorate their houses rather than venture outside! This was further supported by sales of gardening equipment, which also fell. However, the weather is not always bad – in March, sales were higher than expected, with the unusually warm weather, but unfortunately for growth statistics, the boost in sales in March has been more than offset by the decline in sales in April. Furthermore, there are concerns that the March ‘heat-wave’ may have encouraged consumers to do their summer shopping already and hence summer sales may suffer.
The retail data for April 2012 must be considered carefully, as comparing this month’s sales with the same period last year will be very misleading. Last April, the UK was hit with the Royal Wedding, which did boost sales of many products – underlying sales growth was recorded at 5.2% for the month. However, whilst April sales for 2012 could hardly hope to compete with April sales for 2011, the downward trend is undoubtedly going to cause concern for the government. Helen Dickinson, Head of Retail at KPMG said:
“While May will certainly be brighter than April, the health of the retail sector continues on a downward trajectory.”
Whether or not sales do continue their downward trend depends on many factors, including government policy measures to boost growth and cut unemployment. However, one other variable that may influence the trend is the weather. Here’s hoping that the sun shines and people begin to spend!
Weaker retail sales, job surveys raise risk of longer slump Reuters, Olesya Dmitracova (9/5/12)
Wettest April ‘hits retail sales’ BBC News (9/5/12)
Retail sales slide in wettest April on record Telegraph (9/5/12)
April showers wash out retail sales Financial Times, Sarah O’Connor (9/5/12)
Retail sales slip back 1 per cent as fashion stores weather April showers Independent, James Thompson (9/5/12)
Questions
- Use a demand and supply diagram to illustrate the effects of the weather on equilibrium price and output.
- What other factors besides the weather affect retail sales?
- What government policy measures could be implemented to try to boost the retail sector?
- From the information you are told are there any sectors that surprise you in terms of whether sales have risen or fallen? Explain your answer in each case.
- With sales in April falling, what is the implication for a firm’s profits? What steps might a firm take in a bid to boost sales?
46p – that buys you a First Class stamp. However, the price will now rise to 60p and the price of a Second Class stamp will increase to 50p from 36p, as Ofcom lifts some price caps. These significant price rises have seen shortages of stamps emerging across the country. As people anticipate the price rise, individuals and businesses are buying up stamps while they remain relatively cheap.
The problem is that this has started to result in a stamp shortage, so much so that the Royal Mail has now begun rationing retailers’ supply of stamps, capping each retailers’ supply this month to 20% of its annual allocation. A Royal Mail spokesman said:
“We are more than happy for retailers to receive the normal commercial return they obtain on stamps and no more than that … That is why we have put in place a prudent allocation policy to safeguard Royal Mail’s revenues and ensure there are more than enough stamps for people to buy both now and in the future.”
With postage volumes falling, as individuals turn to other methods of communication, Royal Mail says that this price rise is essential to keep this universal service going. Revenues have been low and the Royal Mail has been loss-making for some time.
However, while the price rise may help the Royal Mail, many businesses may suffer in its place. One optician, who sends out approximately 5,000 reminders to patients each year intends to bulk-buy 10,000 stamps in the hopes of saving some £1,400 when prices of stamps rise. An IT worker bought 20 books of 12 first-class stamps and said ‘If I could afford it, I would buy a lot more’. Many are unhappy at the ‘shameless profiteering at the public’s expense’, but whatever your opinion about the price rise, it does make for an interesting case of demand and supply. The following articles consider this stamp shortage.
Man’s 10,000 stamp panic: stampede for stamps leaves a 1st class mess as Royal Mail introduces rationing ahead of 30% price rise Mail Online, Colin Fernandez and John Stevens (15/4/12)
Stamps rationed by Royal Mail in run up to price rise (including video) BBC News (13/4/12)
Stamp rationing could hit pensioners Telegraph, James Hall (14/3/12)
Stamp sales limited ahead of price hike Sky News (13/4/12)
How stamp collecting came unstuck Guardian, Hunter Davies (13/4/12)
Royal Mail limits supply of stamps ahead of price rise Telegraph, James Hall and Andrew Hough (12/4/12)
’Profiteering’ Royal Mail limits supply of stamps before price rise Guardian, David Batty (13/4/12)
Royal Mail’s stamp price rises come into force BBC News (30/4/12)
How businesses will be affected by Royal Mail’s changing prices BBC News, Catherine Burns (28/4/12)
Questions
- If people expect prices to rise, what will happen to the demand curve? Illustrate this idea on a demand and supply diagram?
- If suppliers anticipate a price rise, what would their best strategy be?
- On a demand and supply diagram, illustrate the shortage of stamps that has emerged. If left to the free market, what should happen to the price of stamps?
- Why could pensioners and those in rural areas be the most adversely affected by this shortage and price rise?
- Why could ‘children and new collectors’ be priced out of the market?
- Why will small businesses be affected by this price hike? How could their customers be affected?
A key economic principle is that rational decision making requires thinking at the margin. This involves a comparison of the additional (or marginal) benefits and costs of an activity.
However, a recent book by the American business guru Clayton Christensen argues that thinking in this way can be a problem. A recent article in the Guardian describes a story he tells of the time he refused to play for his university basketball team in a national final which took place on a Sunday and therefore conflicted with his religious beliefs. His decision involved sticking to his principles rather than thinking at the margin. For him, whilst the marginal cost of sacrificing these principles just once may well have been small compared to the resulting benefits, the eventual cost would be much higher.
