There is no mystery to what an ‘economy’ is. Whether we are talking about the economy of a group of countries such as the European Union, or the economy of one particular country, such as the United Kingdom, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behaviour of an economy reflects the behaviour of the individuals who make up the economy, we start our study of economics with four principles of individual decision-making.
C A S E S T U D Y
A Decision of Life and Death
Millions of people every day use medicinal drugs for a variety of reasons but mostly because taking them brings some benefit. In some cases, the use of medicinal drugs helps to alleviate relatively mild conditions but for a large number of patients, for example, those suffering from different types of can- cer, such drugs can literally mean the difference between life and death. In recent years there have been a large number of drugs developed by compa- nies to help cancer sufferers. The complexity of the illness, however, means that the cost of developing such drugs can be extremely high. In Europe, the European Medicines Agency (EMA) evaluates and supervises medicines for human and animal use. In the UK, the National Institute for Health and Clin- ical Excellence (NICE) carries out a similar role and licenses drugs for use within the National Health Service (NHS). It has to decide whether to recom- mend drugs for use within the NHS. It balances out the costs of using a drug against the benefits to patients. It also considers the wider costs and benefits as well. If the costs outweigh the benefits then it may reject the use of the drug under the NHS.
One example of such a rejection occurred in November 2009. The drug in question was called sorafenib or, to give it its brand name, Nexavar. The drug is produced by German pharmaceutical company Bayer and is for treatment of hepatocellular carcinoma (HCC). This is a cancer of the liver, a disease which affects around 3 000 people in the UK every year. Of these, around
600–700 would benefit from the drug; it is not a cure but extends the life of patients for up to six months. Given the life expectancy of patients with this illness, this can be a significant benefit. The prognosis for liver cancer suf- ferers is poor; 80 per cent die within a year of diagnosis and 95 per cent die within five years.
Despite the benefits, NICE rejected the use of the drug on the NHS because the cost of licensing greatly outweighed the benefits. This was not simply the financial cost of administering the drug, estimated at £3 000 per month, but the wider costs in terms of the benefits to other patients with other illnesses that would have to be foregone. The NHS budget, like most other health bud- gets across Europe, is limited. Decisions have to be made on who to treat and who not to because resources are scarce in relation to demand. NICE decided that the money that could be spent on sorafenib could be better spent on treating other patients; the value of the benefits to those patients would out- weigh the value of the benefits to liver cancer sufferers. Andrew Dillon, chief executive of NICE, said: ‘The price being asked by Bayer is simply too high to justify using NHS money which could be spent on better value cancer treatments.’
For liver cancer sufferers the decision by NICE was a major blow. The deci- sion means that some will be deprived of additional months of good quality life which they could have had if they had access to the drug. For other can- cer patients, the decision might be good news – it may mean there is more money available to treat them and that money may result in a longer period of good quality life. The decision may seem like a cold and calculating one, but in simple economics terms it makes sense.
Principle 1: People Face Trade-offs
The first lesson about making decisions is summarized in an adage popular with economists: ‘There is no such thing as a free lunch’. To get one thing that we like, we usually have to give up another thing that we also like. Making decisions requires trading off one goal against another.
Consider a student who must decide how to allocate her most valuable resource – her time. She can spend all of her time studying economics; she can spend all of her time studying psychology; or she can divide her time between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent in the gym, riding a bicycle, watching TV, napping or working at her part-time job for some extra spending money.
Or consider parents deciding how to spend their family income. They can buy food, clothing or a family holiday. Or they can save some of the family income for retirement or perhaps to help the children buy a house or a flat when they are grown up. When they choose to spend an extra euro on one of these goods, they have one less euro to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs.
The classic trade-off is between ‘guns and butter’. The more we spend on national defence (guns) to protect our country from foreign aggressors, the less we can spend on consumer goods (butter) to raise our standard of living at home. Also important in modern society is the trade-off between a clean environ- ment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations give us the benefit of a cleaner environment and the improved levels of health that
come with it, they have the cost of reducing the incomes of the firms’ owners, workers and customers.
Another trade-off society faces is between efficiency and equity. Efficiency means that society is getting the most it can from its scarce resources. Equity means that the benefits of those resources are distributed fairly among society’s members. In other words, efficiency refers to the size of the economic cake, and equity refers to how the cake is divided. Often, when government policies are being designed, these two goals conflict.
Consider, for instance, policies aimed at achieving a more equal distribution of economic well-being. Some of these policies, such as the social security system or unemployment insurance, try to help those members of society who are most in need. Others, such as the individual income tax, ask the financially successful to contribute more than others to support the government. Although these policies have the benefit of achieving greater equity, they have a cost in terms of reduced efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and pro- duce fewer goods and services. In other words, when the government tries to cut the economic cake into more equal slices, the cake gets smaller.
Recognizing that people face trade-offs does not by itself tell us what decisions they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of econom- ics. Society should not stop protecting the environment just because environmen- tal regulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nevertheless, acknowledging life’s trade-offs is important because people are likely to make good decisions only if they understand the options that they have available.
Quick Quiz Does the adage‘there is no such thing as a free lunch’ simply refer to the fact that someone has to have paid for the lunch to be provided and served? Or does the recipient of the‘free lunch’also incur a cost?
Principle 2: The Cost of Something is What You Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of some action is not as obvious as it might first appear.
Consider, for example, the decision whether to go to university. The benefit is intellectual enrichment and a lifetime of better job opportunities. But what is the cost? To answer this question, you might be tempted to add up the money you spend on tuition fees, books, room and board. Yet this total does not truly repre- sent what you give up to spend a year at university.
The first problem with this answer is that it includes some things that are not really costs of going to university. Even if you decided to leave full-time educa- tion, you would still need a place to sleep and food to eat. Room and board are part of the costs of higher education only to the extent that they are more expen- sive at university than elsewhere. Indeed, the cost of room and board at your university might be less than the rent and food expenses that you would pay liv- ing on your own. In this case, the savings on room and board are actually a ben- efit of going to university.
The second problem with this calculation of costs is that it ignores the largest cost of a university education – your time. When you spend a year listening to
equity
the property of distributing economic pros- perity fairly among the members of society
lectures, reading textbooks and writing essays, you cannot spend that time work- ing at a job. For most students, the wages given up to attend university are the largest single cost of their higher education.
The opportunity cost of an item is what you give up to get that item. When making any decision, such as whether to go to university, decision makers should be aware of the opportunity costs that accompany each possible action.
In fact, they usually are. University-age footballers who can earn millions if they opt out of higher education and play professional football are well aware that their opportunity cost of going to university is very high. It is not surprising that they often decide that the benefit is not worth the cost.
Quick Quiz Assume the following costs are incurred by a student over a three-year course at a university: • Tuition fees at€3 000 per year =€9 000
• Accommodation, based on an average cost of€4 500 a year =€13 500
• Opportunity cost based on average earnings foregone of€15 000 per year
=€45 000 • Total cost =€67 500 • Given this relatively large cost why does anyone want to go to university?
Principle 3: Rational People Think at the Margin
Decisions in life are rarely black and white but usually involve shades of grey. At dinner time, the decision you face is not between fasting or eating as much as you can, but whether to take that extra serving of fries. When examinations roll around, your decision is not between completely failing them or studying 24 hours a day, but whether to spend an extra hour revising your notes instead of watching TV. Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that ‘margin’
means ‘edge’, so marginal changes are adjustments around the edges of what you are doing.
In many situations, people make the best decisions by thinking at the margin.
Suppose, for instance, that you asked a friend for advice about how many years to stay in education. If he were to compare for you the lifestyle of a person with a Ph.D. with that of someone who finished secondary school with no qualifica- tions, you might complain that this comparison is not helpful for your decision.
Perhaps you have already been at university for a few years but you’re getting a little tired of studying and not having enough money and so you’re deciding whether or not to stay on for that last year. To make this decision, you need to know the additional benefits that an extra year in education would offer (higher wages throughout your life and the sheer joy of learning) and the additional costs that you would incur (another year of tuition fees and another year of fore- gone wages). By comparing these marginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile.
As another example, consider an airline company deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat aeroplane from London to Warsaw costs the airline €100 000. In this case, the average cost of each seat is €100 000/200, which is €500. One might be tempted to conclude that the airline should never sell a ticket for less than €500. In fact, however, the airline can raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay €300 for a seat. Should the airline sell it to him/her? Of course it should. If the plane has empty seats, the cost of adding one more pas- senger is minuscule. Although the average cost of flying a passenger is €500, the marginal cost is merely the cost of the airline meal that the extra passenger will opportunity cost
whatever must be given up to obtain some item–the value of the benefits foregone (sacrificed)
marginal changes
small incremental adjustments to a plan of action
consume (which may have gone to waste in any case) and possibly an extremely slight increase in the amount of aircraft fuel used. As long as the standby passen- ger pays more than the marginal cost, selling him or her a ticket is profitable.
As these examples show, individuals and firms can make better decisions by thinking at the margin. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
Principle 4: People Respond to Incentives
Because people make decisions by comparing costs and benefits, their behaviour may change when the costs or benefits change. That is, people respond to incen- tives. When the price of an apple rises, for instance, people decide to eat more pears and fewer apples because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, because the benefit of selling an apple is also higher. As we shall see, the effect of price on the behaviour of buyers and sellers in a market – in this case, the market for apples – is crucial for understanding how the economy works.
Public policy makers should never forget about incentives, because many pol- icies change the costs or benefits that people face and, therefore, alter behaviour.
A tax on petrol, for instance, encourages people to drive smaller, more fuel- efficient cars. It also encourages people to use public transport rather than drive and to live closer to where they work. If the tax were large enough, people would start driving electric cars.
When policy makers fail to consider how their policies affect incentives, they often end up with results they did not intend. For example, consider public pol- icy regarding motor vehicle safety. Today all cars sold in the European Union have to have seat belts fitted by law (although actual seat belt use – especially by rear-seat passengers – varies widely, with official estimates ranging from about 30 per cent of car occupants in some member states to around 90 per cent in others, notably Sweden).
How does a seat belt law affect car safety? The direct effect is obvious: when a person wears a seat belt, the probability of surviving a major car accident rises.
But that’s not the end of the story, for the law also affects behaviour by altering incentives. The relevant behaviour here is the speed and care with which drivers operate their cars. Driving slowly and carefully is costly because it uses the dri- ver’s time and energy. When deciding how safely to drive, rational people com- pare the marginal benefit from safer driving to the marginal cost. They drive more slowly and carefully when the benefit of increased safety is high. It is no surprise, for instance, that people drive more slowly and carefully when roads are icy than when roads are clear.
Quick Quiz The emphasis on road safety throughout Europe has increased over the last 25 years. Not only are cars packed with safety technology and devices but roads are also designed to be safer with the use of safety barriers and better road surfaces, for example. Is there a case, therefore, for believing that if people feel that they are safer in their cars there is an incentive to drive faster because the marginal cost is now outweighed by the marginal benefit?
Consider how a seat belt law alters a motorist’s cost–benefit calculation. Seat belts make accidents less costly because they reduce the likelihood of injury or death. In other words, seat belts reduce the benefits of slow and careful driving.
People respond to seat belts as they would to an improvement in road
conditions – by faster and less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents and so it will affect both motorists and pedestrians. The decline in safe driving has a clear, adverse impact on pedes- trians, who are more likely to find themselves in an accident but (unlike the motorists) don’t have the benefit of added protection.
At first, this discussion of incentives and seat belts might seem like idle specu- lation. Yet a 1981 study of seat belt laws in eight European countries commis- sioned by the UK Department of Transport showed that the laws did appear to have had many of these effects. Similar evidence was also presented in a 1975 study of US seat belt laws by the American economist Sam Peltzman. It does indeed seem that seat belt laws produce both fewer deaths per accident and more accidents. The net result is little change in the number of motorist deaths and an increase in the number of pedestrian deaths.
This is an example of the general principle that people respond to incentives.
Many incentives that economists study are more straightforward than those of the car-safety laws. No one is surprised that people drive smaller cars in Europe, where petrol taxes are relatively high, than in the United States, where petrol taxes are lower. Yet, as the seat belt example shows, policies can have effects that are not obvious in advance. When analysing any policy, we must consider not only the direct effects but also the indirect effects that work through incen- tives. If the policy changes incentives, it will cause people to alter their behaviour.
Quick Quiz List and briefly explain the four principles of individual decision-making.