The market for bicycles is often said to generate external benefits such as reduced traffic congestion and reduced air pollution.

Explain how economic theory suggests consumers act rationally to decide whether or not to buy a bicycle, and how producers of bicycles act rationally to determine their level of output. [10]

A rational consumer and producer aims to maximise utility and profits respectively. They will first gather information on the expected benefits, expected costs and constraints before making their decision. If constraints could be overcome, the final decision will depend on whether the expected benefits outweigh the costs. Subsequently, the intended and unintended consequences need to be considered before new decisions are made.

An individual consumer uses the economic decision making process in making a rational decision to maximise his/her utility (satisfaction). In deciding whether or not to buy a bicycle, an individual consumer make use of this process, taking several factors into consideration. The rational decision making by consumers is based on the assumption that the bicycle purchased is for use as a mode of transport. Due to the fundamental economic problem of scarcity, choices have to be made. The consumer has to consider the constraints he/she is currently experiencing, such as the financial constraint especially if the price of the bicycle takes up a significant proportion of his/her income. There could also be space constraint, especially if the consumer stays in a relatively small apartment, thus there may not be sufficient space to accommodate a bicycle at home. The consumer also considers the expected benefits and costs of buying a bicycle. There is possible health benefit to an individual consumer since cycling is considered a form of exercise. There can also be benefit in terms of savings enjoyed by the consumer if he/she decides to cycle instead of taking public transport to work. The price of the bicycle will be the explicit cost while other cost includes the cost to maintain the bicycle (e.g. cost to change tyre), and implicit (opportunity) cost as the money spent on the bicycle could be used to purchase another item. The consumer also gathers information related to traffic rules for cyclists and whether there are public parking space for bicycles.

When the expected marginal private benefits exceeds the expected marginal private costs while taking into consideration the constraints and consequences, consumers will decide to buy a bicycle. With reference to Figure 1 above, the consumer will decide to buy bicycle if MPB is larger than MPC. The consumer will decide to buy up to Qm units of bicycle where MPB=MPC. In general, most consumers are likely to purchase 1 unit of bicycle (i.e. Qm=1) while for other consumers, they may decide to purchase 2 or more units of bicycles (i.e Qm>1). Similar to a consumer, a producer also uses the economic decision making process in making a rational decision to determine the level of output for bicycles, so that the producer can maximise the profit. The producer has to consider possible constraints such as number of labours and machines available to produce the bicycles, as well as financial constraint. The producer also considers the benefits and costs when determining the level of output for bicycles. The benefit refers to the revenue generated from selling the bicycles and the cost refers to the cost incurred from producing the bicycles. The costs includes explicit costs such as the costs of labours and raw materials, and possible implicit (opportunity) cost, such as the forgone rental if the factory was owned by the producer and previously rented out. The producer also gathers information related to the use of bicycles on roads and the estimated number of consumers likely to use cycling as a form of transport or exercise.

When the expected marginal private benefits exceeds the expected marginal private costs while taking into consideration the constraints and consequences, a producer will decide to continue producing bicycles. The profit maximising output will be determined when the expected marginal private benefits is equal to the expected marginal private costs at Qm.