Category: Essential Economics for Business: Ch 03

With university fees for home students in England of £9250 per year and with many students receiving maintenance loans of around £9000 per year, many students are graduating with debts in excess of £50 000. Loans are repaid at a marginal rate of 9% on incomes over £25 716.

Many students also study for a masters degree. The average fee for a taught, classroom-based masters (MA) is £7392 and for a laboratory-based masters (MSc) is £8167 but can be considerably higher at some prestigious universities where demand is high. Government loans of up to £10 906 are available to contribute towards fees and maintenance. These are paid back at a marginal rate of 6% for people earning over £21 000, giving a combined marginal rate of 15% for first and masters degrees.

For high earners on the 40% income tax rate, the combined marginal rate of payment out of income is 40% tax, plus 2% national insurance, plus 15% for those with undergraduate and masters loans. This gives a combined marginal rate of 57%.

Average student debt in England is higher even than in the USA, where the average is $37 000. US university courses are more expensive than in the UK, costing an average of $34 000 per year in tuition alone. But undergraduates can borrow less. They can borrow between $5500 and $12 500 per year in federal loans towards both fees and maintenance, and some private loans are also available. Most students do some paid work during their studies to make up the difference or rely on parents contributing. Parental contributions mean that students from poor families end up owing more. According to a Guardian article:

Race is a huge factor. Black students owe an average of $7400 more than white students when they graduate, the Brookings Institution found. After graduation, the debt gap continues to widen. Four years after graduation, black graduates owe an average of nearly $53 000 – nearly double that of white graduates.

Student debt looks to become one of the key issues in the 2020 US presidential election.

Pressure to cancel student fees and debt in the USA

Most of the Democratic candidates are promising to address student fees and debt. Student debt, they claim, places an unfair burden on the younger generation and makes it hard for people to buy a house, or car or other major consumer durables. This also has a dampening effect on aggregate demand.

The most radical proposal comes from Bernie Sanders. He has vowed, if elected, to abolish student fees and to cancel all undergraduate and graduate debt of all Americans. Other candidates are promising to cut fees and/or debt.

Although most politicians and commentators agree that the USA has a serious problem of student debt, there is little agreement on what, if anything, to do about it. There are already a number of ways in which student debt can be written off or reduced. For example, if you work in the public sector for more than 10 years, remaining debt will be cancelled. However, none of the existing schemes is as radical as that being proposed by many Democrats.

Criticisms of the Democrats’ plans are mainly of two types.

The first is the sheer cost. Overall debt is around $1.6tn. What is more, making student tuition free would place a huge ongoing burden on government finances. Bernie Sanders proposes introducing a financial transactions tax on stock trading. This would be similar to a Tobin tax (sometimes dubbed a ‘Robin Hood tax’) and would include a 0.5% tax on stock transactions, a 0.1% tax on bond trades and a 0.005% tax on transactions in derivatives. He argues that the public bailed out the financial sector in 2008 and that it is now the turn of the financial sector to come to the aid of students and graduates.

The other type of criticism concerns the incentive effects of the proposal. The core of the criticism is that loan forgiveness involves moral hazard.

The moral hazard of loan forgiveness

The argument is that cancelling debt, or the promise to do so, encourages people to take on more debt. Generally, moral hazard occurs when people are protected from the consequences of their actions and are thus encouraged to make riskier decisions. For example, if you are ensured against theft, you may be less careful with your belongings. As the Orange County Register article linked below states:

If the taxpayers pay the debts of everyone with outstanding student loans, how will that affect the decisions made by current students thinking about their choices for financing higher education? What’s the message? Borrow as much as you can and wait for the debt to be canceled during the next presidential primary campaign?

Not only would more students be encouraged to go to college, but they would be encouraged to apply for more costly courses if they were free.

Universities would be encouraged to exaggerate their costs to warrant higher fees charged to the government. The government (federal, state or local) would have to be very careful in auditing courses to ensure costs were genuine. Universities could end up being squeezed for finance as government may try to cut payments by claiming that courses were overpriced.

Even if fees were not abolished, cancelling debts would encourage students to take on larger debt, if that was to be cleared at some point in the future. What is more, students (or their parents) who could afford to pay, would choose to borrow the money instead.

But many countries do have free or highly subsidised higher education. Universities are given grants which are designed to reflect fair costs.

Articles

Videos

Questions

  1. Assess the arguments for abolishing or substantially reducing student fees.
  2. Assess the arguments against abolishing or substantially reducing student fees.
  3. Assess the arguments for writing off or substantially reducing student debt.
  4. Assess the arguments against writing off or substantially reducing student debt.
  5. If it were decided to cancel student debt, would it be fair to pay students back for any debt they had already paid off?
  6. Does tackling the problem of student debt necessarily lead to a redistribution of wealth/income?
  7. Give some other examples of moral hazard.
  8. If student fees were abolished, would there be any problem of adverse selection? If so, how could this be overcome?
  9. Find out what the main UK parties are advocating about student fees and debt in the nations of the UK for home and non-home students. Provide a critique of each of their policies.

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?

One of the key developments in economics in recent years has been the growing influence of behavioural economics. We considered some of the insights of behavioural economics in a blog in 2016 (A nudge in the right direction?). As the post stated, ‘Behavioural economists study how people’s buying, selling and other behaviour responds to various incentives and social situations. They don’t accept the simplistic notion that people are always rational maximisers.’ The post quoted from a Livemint article (see first linked article below):

According to behavioural economists, the human brain neither has the time nor the ability to process all the information involved in decision making, as assumed by the rational model.

Instead, people use heuristics. A heuristic technique is any approach to problem-solving, such as deciding what to buy, which is practical and sufficient for the purpose, but not necessarily optimal. For example, people may resort to making the best guess, or to drawing on past experiences of similar choices that turned out to be good or bad. On other accasions, when people are likely to face similar choices in the future, they resort to trial and error. They try a product. If they like it, they buy it again; if not, they don’t.

On other occasions, they may use various rules of thumb: buying what their friends do, or buying products on offer or buying trusted brands. These rules of thumb can lead to estimates that are reasonably close to the utility people will actually get and can save on time and effort. However, they sometimes lead to systematic and predictable misjudgements about the likelihood of certain events occurring.

In traditional models of consumer choice, individuals aim to maximise their utility when choosing between goods, or bundles of goods. The context in which the choices are offered is not considered.

Yet, in real life, we see that context is important; people will often make different choices when they are presented, or framed, in different ways. For example, people will buy more of a good when it is flagged up as a special offer than they would if there is no mention of an offer, even though the price is the same.

The recognition that framing is important to choices has led to the development of nudge theory. Indeed, it underpins many marketing techniques. These seek to persuade people to make a particular choice by framing it in an optimistic way or presenting it in a way that makes it easy to decide.

Governments too use nudge theory. In the UK, the Coalition government (2010–15) established the Behavioural Insights Team (BIT) (also unofficially known as the Nudge Unit) in the Cabinet Office in 2010. A major objective of this team is to use ideas from behavioural economics to design policies that enable people to make better choices for themselves.

The podcast linked below, looks at the use of nudge theory. The presenter, Mary Ann Sieghart looks at how we are being encouraged to change our behaviour. She also looks at the work of UCL’s Love Lab which researches the way we make decisions. As the programme notes state:

Mary Ann is grilled in UCL’s Love Lab to find out how she makes decisions; she finds taking the pound signs off the menu in a restaurant encourages her spend more and adding adjectives to the food really makes it taste better.

Walking through the Nudge Unit, she hears how powerful a tiny tweak on a form or text can get be, from getting people back to work to creating a more diverse police force. Popular with the political left and right, it has been embraced around the world; from Guatemala to Rwanda, Singapore to India it is used to reduce energy consumption, encourage organ donation, combat corruption and even stop civil wars.

But the podcast also looks at some of the darker sides of nudging. Just as we can be nudged into doing things in our interests, so too we can be nudged to do things that are not so. Politicians and businesses may seek to manipulate people to get them to behave in ways that suit the government or the business, rather than the electorate or the consumer. The dark arts of persuasion are also something that behavioural economists study.

The articles below explore some of the areas where nudge theory is used to devise policy to influence our behaviour – for good or bad.

Podcast

Video

Articles

Questions

  1. Explain what are meant by ‘bounded rationality’ and ‘heuristics’.
  2. How may populist politicians use nudge theory in their campaigning?
  3. Give some examples from your own behaviour of decisions made using rules of thumb.
  4. Should we abandon models based on the assumption of rational maximising behaviour (e.g. attempts to maximise consumer surplus or to maximise profit)?
  5. Find out some other examples of how people might be nudged to behave in ways that are in their own interest or that of society.
  6. How might we be nudged into using less plastic?
  7. How might people be nudged to eat more healthily or to give up smoking?
  8. To what extent can financial incentives, such as taxes, fines, grants or subsidies be regarded as nudging? Explain.
  9. Would you advise all GP surgeries and hospital outpatient departments to text reminders to people about appointments? What should such reminders say? Explain.

When did you last think about buying a new car? If not recently, then you may be in for a surprise next time you shop around for car deals. First, you will realise that the range of hybrid cars (i.e. cars that combine conventional combustion and electric engines) has widened significantly. The days when you only had a choice of Toyota Prius and another two or three hybrids are long gone! A quick search on the web returned 10 different models (although five of them belong to the Toyota Prius family), including Chevrolet Malibu, VW Jetta and Ford Fusion. And these are only the cars that are currently available in the UK market.

But the biggest surprise of all may be the number of purely (plug-) electric cars that are available to UK buyers these days. The table below provides a summary of total registrations of light-duty plug-electric cars by model in the UK, between 2010 and June 2016.

Registration of light-duty highway legal plug-electric cars by model in the UK between 2010 and June 2016

Model

Total registered at the end of(1)

Registrations by year between 2010 and December 2013

2Q 2016

2015

2014

2013

2012

2011

2010

Mitsubishi Outlander P-HEV

21 708

16 100

5 273

 

 

 

 

Nissan Leaf

12 837

11 219

6 838

1 812

699

635

 

BMW i3

4 457

3 574

1 534

NA

 

 

 

Renault Zoe

4 339

3 327

1 356

378

 

 

 

Mercedes-Benz C350 e

3 337

628

0

 

 

 

 

Tesla Model S

3 312

2 087

698

 

 

 

 

Volkswagen Golf GTE

2 657

1 359

0

 

 

 

 

Toyota Prius PHV

1 655

1 580

1 324

509

470

 

 

Audi A3 e-tron

1 634

1 218

66

 

 

 

 

Nissan e-NV200

1 487

1 047

399

 

 

 

 

BMW 330e iPerformance

1 479

 

 

 

 

 

 

BMW i8

1 307

1 022

279

 

 

 

 

Vauxhall Ampera

1 267

1 272

1 169

175

455

4

 

Volvo XC90 T8

813

38

 

 

 

 

 

Renault Kangoo Z.E

785

740

663

 

 

 

 

Porsche Panamera S E-Hybrid

475

395

241

 

 

 

 

Volvo V60 Plug-in Hybrid

410

337

232

 

 

 

 

Peugeot iOn

405

374

368

26(2)

251

124

 

Mercedes-Benz B-Class Electric Drive

303

162

0

 

 

 

 

Mitsubishi i MiEV

252

251

266

1(2)

107

125

27

Smart electric drive

215

212

205

3(2)

13

 

63

Citroën C-Zero

213

167

202

45(2)

110

46

 

Kia Soul EV

193

145

20

 

 

 

 

BMW 225xe

163

 

 

 

 

 

 

Volkswagen e-Up!

154

142

118

 

 

 

 

Mercedes-Benz S500 PHEV

125

157

14

 

 

 

 

Volkswagen e-Golf

123

114

47

 

 

 

 

Chevrolet Volt

119

122

124

23(2)

67

 

 

Renault Fluence Z.E.

79

70

73

7(2)

67

 

 

Ford Focus Electric

22

19

19

 

 

 

 

Mercedes-Benz Vito E-Cell

22

23

23

 

 

 

 

Mia electric

15

15

14

 

 

 

 

Volkswagen Passat GTE

1

 

 

 

 

 

 

BYD e6

0

0

0

50(2)

 

 

 

Total registrations

66 374

47 920

21 504

3 586

2 254

1 082

138

Notes: NA: not available. Registrations figures seldom correspond to same sales figure.

(1) Registrations at the end of a period are cumulative figures. (2) CYTD through June 2013.

Source: Wikipedia, “Plug-in electric vehicles in the United Kingdom”

In 2010 there were nly 138 electric vehicles in total registered in the UK. They were indeed an unusual sight at that time – and good luck to you if you had one and you happened to run out of power in the middle of a journey. In 2011 this (small) number increased sevenfold – an increase that was driven mostly by the successful introduction of Nissan Leaf (635 electric Nissans were registered in the UK that year). And since then the number of electric vehicles registered in the country has increased with spectacular speed, at an average rate of 252% per year.

There is clearly strong interest in electric vehicles – an interest likely to increase as their price becomes more competitive. However, they are still very expensive items to buy, especially when compared with their conventional fuel-engine counterparts. What makes electric cars expensive? One thing is the cost of purchasing and maintaining a battery that can deliver a reasonable range. But the cost of batteries is falling, as more and more companies realise the potential of this new market and join the R&D race. As mentioned in a special report that was published recently in the FT:

The cost of lithium-ion batteries has fallen by 75 per cent over the past eight years, measured per kilowatt hour of output. Every time battery production doubles, costs fall by another 5 per cent to 8 per cent, according to analysts at Wood Mackenzie.

There is no doubt that more research will result in more efficient batteries, and will increase the interest in electric cars not only by consumers but also by producers, who already see the opportunity of this new global market. Does this mean that prices will necessarily fall further? You might think so, but then you have to take into consideration the availability and cost of mining further raw materials to make these batteries (such as cobalt, which is one of the materials used in the making of lithium-ion batteries and nearly half of which is currently sourced from the Democratic Republic of Congo). This may lead to bottlenecks in the production of new battery units. In which case, the price of batteries (and, by extension, the price of electric cars) may not fall much further until some new innovation happens that changes either the material or its efficiency.

The good news is that a lot of researchers are currently looking into these questions, and innovation will do what it always does: give solutions to problems that previously appeared insurmountable. They had better be fast because, according to estimates by Wood Mackenzie, the number of electric vehicles globally is expected to rise by over 50 times – from 2 million (in 2017) to over 125 million by 2035.

How many economists does it take to charge an electric car? I guess we are going to find out!

Articles

Information

Questions

  1. Using a demand and supply diagram, explain the relationship between the price of a battery and the market (equilibrium) price of a plug-in electric vehicle.
  2. List all non-price factors that influence demand for plug-in electric vehicles. Briefly explain each.
  3. Should the government subsidise the development and production of electric car batteries? Explain the advantages and disadvantages of such intervention and take a position.

Each year for the past 60 years, the ONS has published ‘Family Spending’, which ‘gives an insight into the spending habits of UK households, broken down by household characteristics and types of spending’. The latest issue, covering the financial year ending 2017, has just been released.

To mark the 60th anniversary, the ONS has also published a blog, Celebrating 60 years of Family Spending, which compares spending patterns in 2017 with those in 1957. The blog looks at the percentage of the family budget spent on various categories, such as food, clothing, housing, tobacco and alcohol. Some of the percentages have changed dramatically over the years; others have hardly changed at all.

Before you read on, of the six categories mentioned above, which do you think have increased, which fallen and which stayed the same? What is your reasoning?

Differences in patterns of consumption partly reflect incomes. In 1957, real household income was £381 in today’s prices; today it’s £544 (43% more). You would expect, therefore, that a greater proportion of household incomes today would be spent on more luxurious goods, with a higher income elasticity of demand.

Other changes in consumption patterns reflect changes in tastes and attitudes. Thus there has been a huge fall in the proportion of household income spent on tobacco – down from 6% in 1957 to 1% in 2017.

Three of the biggest changes over the 60 years have been in housing costs, food and clothing. Housing costs (rent, mortgage interest, council tax, maintenance and home repairs) have doubled from around 9% to around 18% (although they were around 20% before the huge fall in interest rates following the financial crisis of 2007–8). Expenditure on food, by contrast, has fallen – from around 33% to around 16%. Expenditure on clothing has also fallen, from around 10% to around 5%.

Expenditure on alcohol, on the other hand, having risen somewhat in the 1970s and 80s, is roughly the same today as it was 60 years ago, at around 3% of household expenditure.

Some of the explanations for these changing patterns can be found on the supply side – changing costs of production, new technologies and competition; others can be found on the demand side – changes in tastes and changes in incomes. Some goods and services which we use today, such as computers, mobile phones, many other electrical goods, high-tech gyms and social media were simply not available 60 years ago.

Articles

Celebrating 60 years of Family Spending ONS blog, Joanna Bulman (18/1/18)
How did households budget in 1957? BBC News, Simon Gompertz (18/1/18)
Rising burden of housing costs shown by 60-year UK spending survey Financial Times, Gemma Tetlow (18/1/18)

Data

Family spending in the UK: financial year ending 2017 ONS Statistical Bulletin (18/1/18)
All data related to Family spending in the UK: financial year ending 2017 ONS datasets (18/1/18)

Questions

  1. Why has expenditure on housing increased so much as a proportion of household expenditure? What underlying factors help to explain this?
  2. Why has expenditure on food fallen as a proportion of household expenditure? Are the explanations on both the demand and supply sides?
  3. What has happened to the proportion of expenditure going on leisure goods and services? Explain.
  4. What factors affect the proportion of expenditure going on motoring?
  5. Of the broad categories of expenditure considered in this blog, which would you expect to increase, which to decrease and which to stay roughly the same over the coming 10 years? Why?
  6. If expenditure on a particualar good falls as a percentage of total expenditure as income rises, does this make it an inferior good? Explain.