In economic theory, a monopolist would determine the price and output that would maximise his profits. Discuss whether firms in the real world would always set prices at profit-maximising levels. [25]

This essay argues that, while according to economic theory, a rational monopolist would set MC = MR to maximise his profits, in the real world, firms sometimes do not want to maximise their profits because they sometimes have alternative aims like revenue maximisation, or are often unable to because of imperfect information and bounded rationality and depend on "rules of thumb" like cost-plus pricing.

On the one hand, a monopolist would rationally seek to maximise profits, using the MC = MR rule, or the profit maximisation rule (also known as the marginalist way or principle). A monopoly is defined as one dominant firm that produces a unique good with no close substitutes, for instance, De Beers in terms of diamonds or Microsoft in terms of the software that it produces. The market structure that a monopolist faces generally has very high barriers to entry, either in terms of natural barriers to entry like large economies of scale, or man-made barriers to entry like powerful legislation and patent rights, price setting power due to the large market share commanded by the monopolist, and often imperfect information exists in the market, just like it does in software and high capital-intensive technologies.

On the other hand, in the real world, firms often do not want to maximise profits. They may want to maximise their growth or revenue instead of profits. 

To maximise their growth and expansion, they could produce where AR = 0, which would maximise output, so as to extend their lead in the market and would thus promote the growth of their firm. 

To maximise revenue, firms could easily produce where MR = 0. This economic theory is particularly interesting. According to the famous economist William Baumol, if the aim of a firm is to maximise its sales instead of profits, one possibility is that it would produce where MR = 0. This is due to the issue of the division between ownership and control of a firm. With the separation of ownership and control in modern corporations, the issue is that managers of a firm, like the Chief Executive Officer or Managing Director, may seek prestige and higher salaries by trying to expand sales even if it were at the expense of profits, which would be shareholders’ interests. According to Baumol and Williamson, managers may seek to maximise their own utility rather than profit-maximise, which would benefit the firm. And according to Bearle and Means, the ownership of companies is spread out over a large number of shareholders with little individual power, while control and decision-making is in the hands of a few managers. 

However, some firms would aim to maximise their revenues but this would still be subject to "satisficing" – which means to reach at least a minimum level of profit, but a level which is lower than pure profit maximisation.

Another reason why firms may not maximise profits is that they are unable to do so, even if they are willing. According to Herbert Simon, decision makers face the situation of imperfect information and have to make decisions under uncertainty in the real world. Even though they may be rational or try to be, they eventually use what is known as “bounded rationality”, and therefore make decisions using the information that is available to them. Using Simon’s theory of bounded rationality necessitating satisficing, Cyert and March argued that real world firms aim for satisficing behaviour and even found empirical data to support their view. 

One alternative way of making pricing and output decisions is to use cost-plus pricing, which is basically to take P = AC + a mark up, which is why this method is called cost-plus pricing. Hall and Hitch would agree, as they argued that company executives often make decisions using “rules of thumb” rather than the marginalist way of MC = MR.

In conclusion, to a large extent firms in the real world do not aim at profit maximisation in the sense that they set MC = MR, and often are unwilling or unable to set MC = MR. They often operate under conditions of imperfect information and make bounded rational decisions, and may often use cost-plus pricing. However, to a large extent, firms that do not care at all about profits would not survive in the long run, and it is not a far stretch of the imagination to say that either by luck or by skill, in the long run, all firms would approximately reach a level of pricing and output that is profit maximising because firms that did not make profits would not have survived in the long run against their more rational and efficient competitors.

Economics Tutor's Comment - This is an excellent effort for the A levels that answers the economics question comprehensively. Also, the use of economic theory is very strong in this economics essay. Do think of which economics diagrams are needed to be drawn and explained in this essay to make it an even stronger paper that supports your case that you are making. Thank you for reading, and cheers.

JC Economics Essays - This useful and relevant economics essays site can help students studying economics do well at the A-Levels (Cambridge, A1/S, A2, H1/H2/H3 levels), and the international AS level economics examinations. IB students can also benefit from the top-quality economics content here. This economics website contributes useful economics content, lesson materials, examination tips and techniques, and model economics essays that students in both Singapore and the UK, as well as also all around the world, can use to excel in economics.

This excellent economics essay was jointly written and contributed by both SS and WT, the first, our editor of JC Economics Essays, and the second, our resident Economics expert who helps students understand the beauty of Economics and its applications in real life. (Some of the economics content for alternative theories of the firm was also learnt from economics modules/lessons at the University of Manchester - Business Economics in 2008.) Thank you for reading and cheers! 

Assess whether a radical reconsideration of the more traditional approaches to policy evaluation employed by economists is called for. [35]

H3 A level Economics Cambridge N2010 Q2 essay response

A controlled experiment generally compares the results obtained from an experimental sample against a control sample. 

“To determine the effectiveness of specific policy initiatives, we need to know how the target populations are likely to respond. This can only be discovered by conducting controlled experiments.” 

In the light of this statement, assess whether a radical reconsideration of the more traditional approaches to policy evaluation employed by economists is called for. [35]

There has been a rise of interest in experiments in economics. Experiments have been proven to be a useful tool for testing some economic theories but their effectiveness can be occasionally doubtful due to limits or flaws in experimental design. While some would argue that we should reconsider the approaches to policy evaluation in economics and adopt empirical methods such as in behavioural economics and experimental economics, some insist that the traditional approaches are still the best method when it comes to policy evaluation, and some kind of middle ground should be reached. 

First, the reasons why economists are interested in experimental economics and behavioral economics are quite obvious. Throughout the development of economics as a discipline, the use of mathematics and deduction usually plays an important role in constructing economic claims. Economics aims to abstract economic phenomena from the complexity of the world and model the behaviors of the economic agents using mathematical tools. During this process, economists make general assumptions of the population and ignore individual anomalies as they feel that according to the law of the large numbers, the aggregate pattern will not be affected by a few cases of anomalies. This method has allowed economists to produce many useful theories. 

However, the limitations are often also obvious. The need to make general assumptions may mean that the theories developed can be incapable of accounting for reality if the assumptions are wrong. Even though Milton Friedman argues that unrealistic assumptions can still produce good economic theories, it seems counter intuitive to claim that an unrealistic assumption can give us more confidence in producing good economic claims than an accurate one. This view is often taken by behavioural economists and experimental economists who want better and more accurate assumptions in economic modelling. 

In fact, the development of behavioral economics and experimental economics show that economists may want to seriously reconsider the methods of constructing economic claims. There are many cases where the traditional way of developing economic theories resulting in inaccurate explanation and prediction. For example, the standard model posits that when the price of an item falls, the quantity demanded will rise to the same extent that the quantity demanded will fall when the price goes up. However, what is observed is that when the price of an item falls, the quantity demanded increases more than the quantity demanded falls when the price goes up. By analysing the results of field experiments and laboratory experiments regarding this anomaly, behavioral economists, Daniel Kahneman and Amos Tversky, explain that this is due to “loss aversion”, which means that people have a stronger tendency to avoid losing than to acquire gains. Losing means paying more than what they used to pay; gaining means paying less than what they used to pay. From this case, we observe that the traditional method can sometimes fail to produce accurate theories, and behavioural economics has moved beyond the rationality assumption in order to construct a better account of this economic phenomenon. As the question states, “we need to know how the target populations are likely to respond”. When it comes to policy evaluation, it is important for the economists to consider the nature of the target audiences. The best way is to select representatives from the target populations and conduct experiments to find out their likely responses to the policy. It seems a better way as compared to the traditional approach which can be wrong or only when the conditions of the theories are satisfied in the real world. 

However, we should also recognize that controlled experiments in the new approaches can be flawed and thus produce inaccurate results. There is a reason why controlled experiments are not usually used in economics. In economic studies, the subject is people who are inconsistent, volatile and ever changing. Since the subject can be exposed to many factors that can easily change their reactions, experimental results can be wrong if the relevant factors are not controlled wisely. For example, in a dictator game where the experimenter researches on the tendency of the agents pursuing fairness in a transaction, the results are different when the experimenter is observing the actions of the volunteers. This example shows that careless experimental designs are likely to distort the experimental results. Even if the experiments are carefully planned and conducted, it may be unwise to generate the result from the volunteers to the target population because there can be self-selection into the experiments and the nature of the target population can be different from the representatives. Besides, it is also showed by research that people are likely to behave differently in experiments and real world decisions. Therefore, flaws in experiments can result in wrong predictions and finally the policy implemented may not produce expected results. 

Finally, we should recognize that both the traditional approach and the new method have their merits, and we should consider the nature of the target population before we consider which way to use in policy evaluation. When a policy is concerning a large population, the traditional way could be better since the theories produced in this way are usually more capable of accounting for behaviors of a large population. It is unwise to use controlled experiments because the population is too large and too risky for generalization of experimental results. However, new findings from behavioral economics and experimental economics can be parameterized into the standard model to better account for reality. For example, loss aversion is incorporated into many theories regarding financial markets to better explain and predict the market trend. Such finding can assist economists to give a more accurate prediction of the likely responses to the policy by the target population. On the other hand, when the target population is small in size, it can be advisable to use controlled experiments to test out the likely responses of the population as they are more likely to be accurate when the conditions of the theories are held in reality. The theory of inequality aversion is a good example to show that theories derived from controlled experiments can yield surprisingly accurate result when the nature of the population can be known. 

In conclusion, the use of controlled experiments can be beneficial in revealing the likely responses of the target population to a policy, but any flaws in experimental design can distort the experimental results. Besides, when a population is large, it can be risky to generalize experimental results to the whole population because the nature of the subjects can be different. On the other hand, the traditional approach also faces the problem of giving wrong judgment when the assumption of ceteris paribus does not hold. Besides, it can fail to give an accurate account of economic behavior when human psychology which can motivate economic actions are constantly ignored in theory construction.  Eventually, what method to choose depends on the size of the target population, the volatility of the economic environment and the availability of information about the target population, but the use of controlled experiments can be introduce beneficial refinement to the traditional approach. 

JC Economics Essays: Once again, as this is the H1/ H2 A level economics examination season, and there is also the upcoming H3 Economics examination, just like in the previous post, I have decided to include a few H3 economics essays. This particular H3 economics essay on economic methodology was contributed by WXN and written under examination conditions of around 1 hour. Special thanks to WXN for his H3 economics contribution to my economics essay site. 

Some areas of improvement for WXN's economics essay could be: More examples could have been given in this essay, and more of the real world context could have been linked to this economics essay. Often times, an essay could benefit from more contextualisation. Also, the division between positive and normative economics could also have been discussed in this essay. Normative economics often lends itself better to economic policy-making and evaluation. Statistics, econometrics, and economic methods such as cliometrics could also have been discussed. The difference between the nature of economics as a social science, and science and mathematics could also have been discussed in this essay. Is economics like a science? Can experimentation play the same role for economics that it has played for the natural and more hard sciences? There are many areas in which this economics essay could have benefited from a wider scope and range.  

However, once again WXN did also do many things right for his economics essay, making all the right moves that make an excellent essay strong. He talked about Milton Friedman, the famous economist, who once wrote a major paper on economic methodology. He also rightly talked about experimental economics and behavioural economics, which are reconsiderations of traditional economic policy-making and evaluation. Perhaps, a distinction between policy-making and economic evaluation could have been made. All in all, given the time constraints and economics examination pressure, this H3 economics essay is quite strong. 

How would you have approached this economics question, and what would you have done differently or better? Please remember to think of ways for further improvement and always question the hidden and implicit assumptions in the question. As this is a H3 economics essay, there will always be room for exploration and discussion, as well as a multitude of perspectives. Demonstrate your reading and your thinking. 

Thank you for reading and cheers!

[Postscript: WXN and his batch of economics students achieved 100% A/B for H2 Economics and 100% Distinction/Merit for H3 Economics in the 2013 economics examinations. They worked hard and performed well, so it is not all my credit. Congratulations!]

“A good theory is one that explains much by little” (Milton Friedman). Discuss whether this is true of economic theories. [35]

H3 Economics Cambridge N2007 Q2 Economics Essay response

“A good theory is one that explains much by little” (Milton Friedman). Discuss whether this is true of economic theories. [35]

Milton Friedman once famously argued that “a good theory is one that explains much by little”, which suggests that a good economic theory should be able to offer an universal account for economic events using simple modelling. The more parsimonious the explanation, the better the economic model, ceteris paribus. This paper argues that such a statement is true as it is in line with the objective in constructing economic theories that are useful in terms of predictive power. However, this criteria does not apply in every situation as sometimes we must rely on economic theories which are more complicated or perhaps on the other hand limited in the range of application.

George Stigler suggested three criteria for us to evaluate all economic theories. These criteria are: tractability, generality, and correspondence with reality. Tractability refers to the easy manipulation of the model and the convenience of fitting the theory into other models. Generality refers to the extent in which the theory can be applied to a large population. The greater the extent, the better the theory is. Correspondence with reality refers to the capacity of the theories in producing explanations and predictions that cohere with the real world. Going with these criteria, we can see that what Milton Friedman suggests can be true. “Explains much by little” means that the theory can be used to account for many economic events or for events in many different situations and contexts. It also means that the theory is not complicated and should be easy to understand. Thus, it can be argued that any theory which fulfills the requirement of “a good theory” by Milton Friedman will be able to meet the “Tractability” and “Generality” requirements by Stigler. Friedman’s statement also seems to suggest that the theory should have an acceptable degree of correspondence with reality, otherwise it cannot be claimed to be able to “explain” the world. Therefore, Friedman’s statement is likely to be true for economic theories. One example to illustrate its validity is the "law" of demand and supply, which is a simple model but one which is able to capture the universal relationship of demand and supply and prices and quantity demanded.

We should further question and closely examine the validity of these three criteria. It is virtually no debate that a simpler model is preferred to a complex model, assuming that they can both produce the same results. Friedman once argued that the process of constructing economic models is to abstract the rich complexity of the reality to relationships of quantifiable variables. The criterion of tractability is thus acceptable. He gives the example of maximization of profits by firms. In firm analysis, economists usually go by the assumption that firms seek to maximize profits. Friedman argues that this assumption allows us to analyze the market easily because all the firms are likely to behave in the same way as they are maximizing their profit since they will lose out due to natural selection if they behave in different ways. Thus, even if the reality is more complex than the theory, this single assumption allows us to abstract the key element of the market and analyze firm decisions with more convenience. Therefore, the criterion of using a simple model to explain economic phenomena is justified. 

Secondly, the criterion of generality is also an important requirement for any economic theory. It is noted that economic aims to capture universal economic behaviors, and therefore is more interested in how does a population behaves in aggregate level. Ultimately, economists aim to develop theories that can explain and predict economic behaviors, especially when it is related to policy making. Firstly, a theory that can account for a larger population is usually preferred to one that can account for a small population. Secondly, a large population enables economists to observe patterns in behaviors which may not be readily obvious in a small population. Therefore, the criterion of generality is also justified. 

In this case, Friedman’s claim that a good economic theory should be able to explain much by little is supported since the statement is in line with the objective in constructing economic knowledge. However, Friedman seems to assume that these two criteria should be placed in priority before the third criterion: correspondence with reality. He could be suggesting that we should not accept theories that can provide accurate predictions but are intractable or limited in the range of applications. 

Correspondence with reality is an important assumption because it is the ultimate test of the theories. Even though Friedman’s statement is true, it should be recognized that these three criteria are difficult to achieve simultaneously, and usually we should compromise one to improve another. For example, theories may predict very accurately but its range of applications is likely to be limited. On the other hand, when the theory is developed to account for a larger population, its accuracy is likely to be compromised. According to Daniel Hausman's reading of J. S. Mill, economics is an inexact science which can offer theories which have loose fit with reality. It seems difficult to achieve the same degree of accuracy in knowledge claims like in natural sciences while ensuring that the law is universal. 

It is sometimes difficult to judge which criterion should be placed in priority. Some argues that providing understanding is also an important requirement for economic theories. Ultimately, economics is the study of human behavior, and people are intuitively interested in understanding the mechanism of an economy. From this perspective, accuracy of economic theory should be placed as the priority and Friedman’s statement does not continue to serve as a yardstick to evaluate a theory. 

In conclusion, Friedman’s statement is in line with the objective of constructing economic claims that are universal, accurate and tractable. However, we may need different economic theories in different situations, and the requirement may not usually serve as a good indicator of good theory, especially in cases where accuracy of claims are taken as a more important quality than tractability and generality. Ultimately, a good theory is one that can serve our interests and is able to assist us in achieving our objectives. Thus Friedman’s claim is only true when we assume that the purpose of constructing economic theories is to provide an account for economic behaviours in the aggregate level. 

JC Economics Essays: As this is the A level examination season, and there is also the upcoming H3 Economics examination, I decided to include a few H3 economics essays in addition to the wide variety of economics papers (H1, H2, A levels, GCE/GCSE/AS) here on my economics site. This H3 economics essay was contributed by WXN and written under examination conditions of around 1 hour. Thank you WXN for your kind contribution. 

Some areas of improvement for this essay could be: a wider scope of exploration could have been conducted. He could have delved into Ockham's razor, the philosophy of positivism and empiricism, or launched into a small case study of theories of the firm where profit maximisation has been roundly criticised by Herbert Simon, Olivier Williamson, and other such famous economists, and the varied empirical studies that flatly contradicted theories. More recent economic theories and studies could also be utilised, such as Schelling's checkerboard model and the famous George Akerlof's lemons model. All of these could have added further depth and rigour to his paper, and made it even better. 

However, WXN did also do many things right, making all the right moves that make an economics essay strong. What do you think were the strong points in his essay? What did he do that you could learn from? For instance, WXN cited famous economists (and used their quotes to further his case, while signalling that he put in effort to study hard) and used a yardstick to evaluate the sentence. Given the time constraints and examination pressure, this H3 economics essay is actually quite strong. How would you have approached this essay, and what would you have done differently?

Thank you for reading and cheers!

[Postscript: WXN and his batch of economics students achieved 100% A/B for H2 Economics and 100% Distinction/Merit for H3 Economics in the 2013 economics examinations. They worked hard and performed well, so it is not all my credit. Congratulations!]