The economic objectives of individuals, firms and the government

In economics we assume that people act rationally, and that they do what is best for themselves. Even when people give money to good causes they get a warm feeling from their benevolence. Another way of saying this is that we assume people are welfare maximizers. An underlying assumptionof economics is that people are both rational and trying to maximize their own welfare. If the world were full of mad and irrational people, economics would be a very different subject.

Yet there are some problems with the assumption that people are rational. People do behave differently, and from our own point of view other people’s behaviour might seem irrational and it is very hard to predict what any one individual will do. However, it is much easier to observe how a large population behaves. Groups are much more predictable. For example, economists agree that if we paid nurses more, more people would want to become nurses.

Consumers (households)
If you were given a hundred pounds, economists assume that you would spend this so the satisfaction you gained from spending it would be the greatest. For example if you hate seafood, we would be amazed if you spent all the money on crab sandwiches. If you like chocolate, it would be unsurprising if you used some of the money on it, although it might be a little irrational if you spent all £100 on Mars bars. Eating too much chocolate would make you ill. Most likely you will spread the spending around, balancing expenditure on chocolate, cinema tickets and drinks in a way that gave you the greatest amount of satisfaction.

Economists in the 19th century tried to measure how much satisfaction people got by asking them to express how much they enjoyed different products. The word ‘Utils’ was used to mean a unit of satisfaction, but this approach did not work well. Whilst in a subject like mathematics it is straightforward to agree on what a centimetre is because we all have rulers with identical scales, there is no way in economics of agreeing what one unit of satisfaction feels like. A more successful approach has been to get consumers to reveal their preferences and this can be done by asking them which choice they prefer. Faced with two identical products, a rational consumer would choose the cheapest one.

The term labour is used in economics to define people who are engaging in paid work. On the whole, we expect workers to be interested in how much they are paid and to try to maximize this. This is a rather simplistic approach and workers will be interested not just in the pay, but also the working conditions, the fringe benefits and holidays. Therefore we assume that workers will try to maximize the rewards they get, and balance this against the time and effort spent working. Although some people may want to work at the weekends for extra pay some people will value leisure time more highly than the money and so economists don’t think everyone will work harder if you offer them more, but we do expect people who are offered two identical jobs to accept the one with the highest pay.

One assumption that causes economists great problems is the profit motive. A whole system of economics called Neo-classical economics depends to a high degree on the assumption that businesses try to make as much profit as possible. This is the difference between the revenue (the total amount of money a firm receives from selling its products) and all the costs of producing the goods. However, in the real world not all businesses do maximize their profits and not-for-profit organizations such as: OXFAM, Christian Aid, Greenpeace, sports clubs and many private schools all exist.

Governments are the main economic agent in nearly all economies, save somewhere like Somalia that has no effective government to speak of. Governments affect economies in a variety of ways:

a. Taxation
Governments have levied taxes for as long as there have been governments. Little could be achieved otherwise. There are a myriad of different taxes, the main ones are income tax, which as the name suggests is a tax on people’s earnings and value added tax (VAT), which is a tax on expenditure. There are even taxes to pay when we die called death duties or inheritance tax. These taxes are not just charged in order to raise revenue for the government. Some taxes such as those on alcohol and tobacco are levied to discourage people from consuming them because they are thought to be harmful.

b. Government spending
The government uses the money it receives through taxation on a whole range of things. The largest items of expenditure in the UK are: education, healthcare and social security. Social security covers a whole range of payments but it mainly consists of unemployment pay (Job-Seekers Allowance in the UK), sickness benefits and old age pensions.

c. Laws
Governments pass legislation covering the entirety of human life. There are laws to say how long we must go to school for, laws to stop us harming other people, and laws to regulate our behaviour. The law is split into two halves, civil and criminal. Breaking a criminal law may result in fines or jail sentences, whilst breaking civil laws may result in another person or business taking us to court. If you lose a civil case you may end up paying compensation to the person suing you.

In a market economy laws are vital to the operation of the price-system. It is impossible for a shopkeeper to charge you for an apple if you are free to take the apple for nothing. The law defines taking apples from shopkeepers without paying as theft, and you may ultimately be sent to jail for stealing if the offence is serious, otherwise expect a judge to sentence you to community service. It should be obvious to see that the whole capitalist system would collapse if the law did not protect private property. For this to happen, there needs to be a police force, law courts, and prisons. In economics we are fond of the term ‘property rights’. Without property rights being enforced a country would end up like Somalia very quickly.

d. Defence
One obvious area of government activity is in defence from foreign powers. This requires spending money for the army, navy and air-force. Did you know that income tax was first charged in the UK to pay for the war against Napoleon and was only meant to be temporary?

e. The provision of goods and services
Between the 1950s and 1990s the UK government was heavily involved in producing goods and services. The Labour government of 1945 was socialist; this meant it believed in controlling ‘the commanding heights’ of the economy, not leaving it to the capitalists. From 1945 onwards the state took into ownership, shipyards, coal-mines, transport companies, gas and electric providers, telecommunications and a host of other businesses.
To secure for the workers by hand or by brain the full fruits of their industry and the most equitable distribution thereof that may be possible upon the basis of the common ownership of the means of production, distribution and exchange, and the best obtainable system of popular administration and control of each industry or service
Clause IV of the constitution of the Labour Party (removed by Tony Blair in 1995)
By the time Labour's leader Prime Minister Clement Attlee left office in 1951, industries employing 10 per cent of the workforce and controlling 20 per cent of all capital expenditure had been nationalised.

In the 1980s the conservative government of Mrs. Thatcher began a reversal of this trend and privatised most of what preceding Labour governments had nationalised. Today the government still owns a number of businesses such as the BBC, the National Health Service, the Post Office. Network Rail is a publicly owned business that has been nationalised (1947), privatised (1994) and renationalised (2002), owns the railway lines. It owns most of the train tracks in the UK and charges commercial businesses such as Virgin Rail to use the network for a fee.

Economics and politics are separate academic subjects. But this is an artificial distinction made by teachers and universities. Mastering everything is impossible so we break life down into more manageable pieces and call them subjects. In reality a student of economics is not going to get very far without some understanding of government and politics as well.

Case Study

The Royal Mail was privatised in 2013. Click on the picture below.