Economics: The Basics When wants exceed the resources available to satisfy them, there is scarcity. Faced with scarcity, people must make choices. Economics is the study of the choices people make to cope with scarcity. Choosing more of one thing means having less of something else. The opportunity cost of any action is the best alternative forgone.
The Basics (Cont..) Microeconomics - The study of the decisions of people and businesses and the interaction of those decisions in markets. The goal of microeconomics is to explain the prices and quantities of individual goods and services. Macroeconomics - The study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. The goal of macroeconomics is to explain average prices and the total employment, income, and production. Positive statements - Statements about what is. Normative statements - Statements about what ought to be. Ceteris paribus - Other things being equal” or “if all other relevant things remain the same.
The Basics (Cont..) The fallacy of composition - What is true of the parts may not be true of the whole. What is true of the whole may not be true of the parts. The post hoc fallacy - The error of reasoning from timing to cause and effect. Economic efficiency - Production costs are as low as possible and consumers are as satisfied as possible with the combination of goods and services that is being produced. Economic growth - The increase in incomes and production per person. It results from the ongoing advance of technology, the accumulation of ever larger quantities of productive equipment and ever rising standards of education. Economic stability - The absence of wide fluctuations in the economic growth rate, the level of employment, and average prices.
The Modern economy Economy - A mechanism that allocates scarce resources among alternative uses. This mechanism achieves five things: What, How, When, Where, Who. Decision makers - Households, Firms, Governments. Household - Any group of people living together as a decision-making unit. Every individual in the economy belongs to a household. Cont…
Firm - An organization that uses resources to produce goods and services. All producers are called firms, no matter how big they are or what they produce. Car makers, farmers, banks, and insurance companies are all firms. Government - A many-layered organization that sets laws and rules, operates a law-enforcement mechanism, taxes households and firms, and provides public goods and services such as national defense, public health, transportation, and education. Market - Any arrangement that enables buyers and sellers to get information and to do business with each other.
Role of Government Not so very long ago, economic planning and public ownership of the means of production were the wave of the future. Planners cannot find out what needs to be done to co-ordinate the production of a modern economy. Even if a technically feasible plan could be drawn up, there is no reason to believe it will be implemented. How could a central planner know better than the consumers what the individual woman wants? Planners can only provide users with what they believe they should want. Because prices bear no relation to costs, there is no way to calculate what production needs to increase and what production needs to be reduced. Cont….
The state has three functions: To provide things - known as public goods - that the market cannot provide for itself; To internalize externalities or remedy market failures; To help people who, for a number of reasons, do worse from the market or are more vulnerable to what happens within it than society finds tolerable. In addition to providing public goods, governments directly finance or provide certain merit goods. Such goods are consumed individually. But society insists on a certain level or type of provision. The role of the state in a modern market economy is, in short, pervasive. The difference between poor countries and richer ones is not that the latter do less, but that what they do is better directed (on the whole) and more competently executed (again, on the whole). Cont….
The first requirement of effective policy is a range of qualities credibility, predictability, transparency and consistency . The more the government focuses on its essential tasks and the less it is engaged in economic activity and regulation, the better it is likely to work and the better the economy itself is likely to run. If one needs a large number of bureaucratic permissions to do something in business, the officials have an opportunity to demand bribes. Once it is known that a government is prepared to create such exceptional opportunities, there will be lobbying to create them. Then there is not just the corruption of the government, but the waste of resources in such 'rent-seeking' or 'directly unproductive profit-seeking activities'. Governments are natural monopolies over a given territory. One of the strongest arguments for an open economy is that it puts a degree of competitive pressure on government. Cont….
Factors of Production Factors of production - The economy’s productive resources; Labor, Land, Capital, Entrepreneurial ability. Land - Natural resources used to produce goods and services. The return to land is rent. Labor - Time and effort that people devote to producing goods and services. The return to labour is wages. Capital - All the equipment, buildings, tools and other manufactured goods used to produce other goods and services. The return to capital is interest. Entrepreneurial ability - A special type of human resource that organizes the other three factors of production, makes business decisions, innovates, and bears business risk. Return to entrepreneurship is profit.
Economic Coordination Markets - Coordinate individual decisions through price adjustments. Command mechanism - A method of determining what, how, when, and where goods and services are produced and who consumes them, using a hierarchical organization structure in which people carry out the instructions given to them. Market economy - An economy that uses a market coordinating mechanism. Command economy - An economy that relies on a command mechanism. Mixed economy - An economy that relies on both markets and command mechanism.
Production Possibility Frontier The quantities of goods and services that can be produced are limited by the available resources and by technology. That limit is described by the production possibility frontier. Production Possibility Frontier (PPF) - The boundary between those combinations of goods and services that can be produced and those that cannot. Production efficiency - When it is not possible to produce more of one good without producing less of some other good. Production efficiency occurs only at points on the PPF. Economic growth - Means pushing out the PPF. The two key factors that influence economic growth are technological progress and capital accumulation. Cont…..
Technological progress - The development of new and better ways of producing goods and services and the development of new goods. Capital accumulation - The growth of capital resources. Absolute Advantage - If by using the same quantities of inputs, one person can produce more of both goods than some one else can, that person is said to have an absolute advantage in the production of both goods. Comparative Advantage - A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.
Law of Demand
Demand curve - Shows the relationship between the quantity demanded of a good and its price, all other influences on consumers’ planned purchases remaining the same.
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.
As the opportunity cost of a good increases, people buy less of that good and more of its substitutes.
Faced with a high price and an unchanged income, the quantities demanded of at least some goods and services must be decreased.
Substitute - A good that can be used in place of another good. Complement - A good that is used in conjunction with another good. Normal goods - Goods for which demand increases as income increases. Inferior goods - Goods for which demand decreases as income increases. If the price of a good changes but everything else remains the same, there is a movement along the demand curve. If the price of a good remains constant but some other influence on buyers’ plans changes, there is a change in demand for the good. A movement along the demand curve shows a change in the quantity demanded and a shift of the demand curve shows a change in demand.
Law of Supply
Law of supply – Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.
Supply of a good depends on:
The price of the good;
The prices of factors of production;
The price of other goods produced; Expected future prices;
The number of suppliers;
Supply curve - Shows the relationship between the quantity supplied and the price of a good, everything else remaining the same. If the price of a good changes but everything else influencing suppliers’ planned sales remains constant, there is a movement along the supply curve. If the price of a good remains the same but another influence on suppliers’ planned sales changes, supply changes and there is a shift of the supply curve. A movement along the supply curve shows a change in the quantity supplied. The entire supply curve shows supply. A shift of the supply curve shows a change in supply.
Equilibrium Equilibrium : A situation in which opposing forces balance each other. Equilibrium in a market occurs when the price is such that the opposing forces of the plans of buyers and sellers balance each other. The equilibrium price is the price at with the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. When both demand and supply increase, the quantity increases. The price may increase, decrease, or remain constant. When both demand and supply decrease, the quantity decreases. The price may increase, decrease, or remain constant. When demand decreases and supply increases, the price falls. The quantity may increase, decrease, or remain constant. When demand increases and supply decreases, the price rises and the quantity increases, decreases, or remains constant.
Elasticity The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. An increase in price increases the revenue on each unit sold. But an increase in price also leads to a decrease in the quantity sold. Whether the total expenditure increases or decreases after a price hike, depends on the responsiveness of demand to the price. Price elasticity of demand – A measure of the responsiveness of the quantity demanded of a good to a change in its price, other things remaining the same. It is the percentage change in demand divided by percentage change in price. Cont…
Inelastic demand - If the percentage change in the quantity demanded is less than the percentage change in price, then the magnitude of the elasticity of demand is between zero and 1, and demand is said to be inelastic. If the quantity demanded remains constant when the price changes, then the elasticity of demand is zero and demand is said to be perfectly inelastic. Elastic demand - If elasticity is greater than 1, it is elastic. If the quantity demanded is indefinitely responsive to a price change, then the magnitude of the elasticity of demand is infinity, and demand is said to be perfectly elastic.