Economics
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.
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 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.
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.
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).
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.
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.
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.
- Substitution effect
- Income effect.
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;
- Technology.
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.
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.
When markets do not work
Price ceiling - A regulation that makes it illegal to
charge a price higher than a specified level. When a price ceiling is
applied to rents in housing markets, it is called a rent ceiling.
Black market - An illegal trading arrangement in which buyers and sellers do business at a price higher than legally imposed price ceiling.
Minimum wage law - A regulation that makes hiring labor below a specified wage illegal.
Externalities – Social costs, but no private costs.
Consumption & Utility
A household’s consumption choices are determined by
- Budget constraint
- Preferences
Utility - The benefit or satisfaction that a person gets from the consumption of a good or service.
Total utility - The total benefit or satisfaction that a person gets from the consumption of goods and services.
Marginal utility - The change in total utility resulting from a one-unit increase in the quantity of a good consumed.
Consumer equilibrium - A situation in which a consumer has
allocated his or her income in the way that, given the prices of goods
and services, maximizes his or her total utility.
Understanding Costs
Short run - Period of time in which the quantity of at least one input
is fixed and the quantities of the other inputs can be varied.
Long run - Period of time in which the quantities of all inputs can be
varied. Inputs whose quantity can be varied in the short run are called
variable inputs. Inputs whose quantity cannot be varied in the short run
are called fixed inputs.
Firm’s total cost - The sum of the costs of all the inputs it uses in production.
Fixed cost -The cost of a fixed input.
Variable cost - The cost of a variable input.
Total fixed cost - The total cost of fixed inputs.
Total variable cost - The cost of the variable inputs.
Marginal cost - The increase in total cost for increasing output by one unit.
Average fixed cost (AFC) - Total fixed cost per unit of output.
Average variable cost (AVC) - Total variable cost per unit of output.
Average total cost (ATC) - Total cost per unit of output.
Long-run average cost curve - Traces the relationship between the lowest
attainable average total cost and output when both capital and labor
inputs can be varied.
Economies of scale - As output increases, long-run average cost decreases.
Diseconomies of scale - As output increases, long run average cost increases.
Perfect Competition
There are many firms, each selling an identical product.
There are many buyers.
There are no restrictions on entry into the industry.
Firms in the industry have no advantage over potential new entrants.
Firms and buyers are completely informed about the prices of the product of each firm in the industry.
Firms in perfect competition are said to be price takers. A price taker
is a firm that cannot influence the price of a good or service.
Imperfect Competition
Monopoly - An industry that produces a good or service for
which no close substitute exists and in which there is one supplier
that is protected from competition by a barrier preventing the entry of
new firms.
Price discrimination - The practice of charging some
customers a lower price than others for an identical good or of charging
an individual customer a lower price on a large purchase than on a
small one, even though the cost of servicing all customers is the same.
Monopolistic competition - A market structure in which a
large number of firms compete with each other by making similar but
slightly different products.
Oligopoly - A market structure in which a small number of producers compete with each other.
Business Cycles
Economic developments should be judged in the context of trends and cycles.
Trends - The trend is the long-term rate of economic expansion.
Cycles - The cycle reflects short-term fluctuations around
the trend. There are always a few months or years when growth is above
trend, followed by a period when the economy contracts or grows below
trend.
Long-term growth - In the long term the growth in economic
output depends on the number of people working and output per worker.
Output per worker grows through technical progress and investment in new
plant, machinery and equipment. Investment and productivity are
therefore the basis for continued and sustained economic expansion.
Recession - A period during which real GDP decreases – the growth rate of real GDP is negative – for at least two successive quarters.
Consumption expenditure - The amount spent on consumption
goods and services. Saving is the amount of income remaining after
meeting consumption expenditures.
Savings – What remains out of income after consuming.
Capital - The plant, equipment, buildings, and inventories
of raw materials and semi-finished goods that are used to produce other
goods and services. The amount of capital in the economy is a crucial
factor that influences GDP growth.
Investment - The purchase of new plant, equipment, and
buildings and the additions to inventory. Investment increases the
stock of capital. Depreciation is the decrease in the stock of capital
that results from wear and tear and the passage of time.
Government Purchases - Governments buy goods and services, called government purchases, from firms.
Net taxes - Taxes paid to governments minus transfer payments received from governments.
Transfer payments - Cash transfers from governments to households and
firms such as social security benefits, unemployment compensation, and
subsidies.
Measuring Economic Activity
Total economic activity may be measured in three different but equivalent ways.
Add up the value of all goods and services produced in a given period of
time, such as one year. Money values may be imputed for services such
as health care which do not change hands for cash. Since the output of
one business (for example, steel) can be the input of another (for
example, automobiles), double counting is avoided by combining only
"value added", which for anyone activity is the total value of
production less the cost of inputs such as raw materials and components
valued elsewhere.
A second approach is to add up the expenditure which takes place when the output is sold.
Since all spending is received as incomes, a third option is to value producers' incomes.
Gross domestic product - GDP is the total of all economic
activity in one country, regardless of who owns the productive assets.
For example, India’s GDP includes the profits of a foreign firm located
in India even if they are remitted to the firm's parent company in
another country.
Gross national product - GNP, is the total of incomes earned by
residents of a country, regardless of where the assets are located. For
example, India’s GNP includes profits from Indian-owned businesses
located in other countries.
Omissions in GDP
Deliberate omissions: There are many things which are not in GDP, including the following.
- Transfer payments - For example, social security and pensions.
- Gifts. For example, $10 from an aunt on your birthday.
- Unpaid and domestic activities. If you cut your grass or paint your
house the value of this productive activity is not recorded in GDP, but
it is if you pay someone to do it for you.
- Barter transactions. For example, the exchange of a sack of wheat for a can of petrol.
- Second-hand transactions. For example, the sale of a used car (where the production was recorded in an earlier year).
- Intermediate transactions. For example, a lump of metal may be sold
several times, perhaps as ore, pig iron, part of a component and,
finally, part of a washing machine (the metal is included in GDP once at
the net total of the value added between the initial production of the
ore and its final sale as a finished item).
- Leisure. An improved production process which creates the same
output but gives more recreational time is recorded in the national
accounts at exactly the same value as the old process.
- Depletion of resources. For example, oil production is recorded at
sale price minus production costs and no allowance is made for the fact
that an irreplaceable part of the nation's capital stock of resources
has been consumed.
- Environmental costs. GDP figures do not distinguish between green and polluting industries.
- Allowance for non-profit-making and inefficient activities. The
civil service and police force are valued according to expenditure on
salaries, equipment, and so on (the appropriate price for these services
might be judged to be very different if they were provided by private
companies).
- Allowance for changes in quality. You can buy very different
electronic goods for the same inflation-adjusted outlay than you could a
few years ago, but GDP data do not take account of such technological
improvements.
Unrecorded transactions
GDP may under-record economic activity, not least because of the
difficulties of keeping track of new small businesses and because of tax
avoidance or evasion.
Deliberately concealed transactions form the black, grey, hidden or
shadow economy. This is largest at times when taxes are high and
bureaucracy is heavy. Estimates of the size of the shadow economy vary
enormously. For example, differing studies put America's at 4-33%,
Germany's at 3-28% and Britain's at 2-15%. What is agreed, though, is
that among the industrial countries the shadow economy is largest in
Italy, at perhaps one-third of GDP, followed by Spain, Belgium and
Sweden, while the smallest black economies are in Japan and Switzerland
at around 4% of GDP.
The only industrial countries that adjust their GDP figures for the
shadow economy are Italy and America and they may well underestimate its
size.
Expenditure
The expenditure measure of GDP is obtained by adding up all spending:
consumption (spending on items such as food and clothing)
+ investment (spending on houses, factories, and so on)
= total domestic expenditure
+ exports of goods and services (foreigners' spending)
= total final expenditure
- imports of goods and services (spending abroad)
= GDP
Government consumption - The level of government spending
reflects the role of the state. Government consumption is generally
10-20% of GDP, although it is higher in countries such as Denmark and
Sweden where the state provides many services. Changes in government
spending tend to reflect political decisions rather than market forces.
Private consumption - This is also called personal
consumption or consumer expenditure. It is generally the largest
individual category of spending. In the industrialised countries,
consumption is around 60% of GDP. The ratio is much higher in poor
countries which invest less and consume more.
Investment - Investment is perhaps the key structural
component of spending since it lays down the basis for future
production. It covers spending on factories, machinery, equipment,
dwellings and inventories of raw materials and other items. Investment
averages about 20% of GDP in the industrialised countries, but is nearer
30% of GDP in East Asian countries.
Income
The income measure of GDP is based on total incomes from production. It is essentially the total of:
wages and salaries of employees;
income from self-employment;
trading profits of companies;
trading surpluses of government corporations and enterprises;
income from rents.
These are known as factor incomes. GDP does not include transfer
payments such as interest and dividends, pensions, or other social
security benefits. The breakdown of incomes sheds additional light on
economic behaviour because it is the counterpart to expenditure in what
economists call the circular flow of money. It also provides a useful
basis for forecasting inflation.
Unemployment
Labour force or workforce - The number of people employed and self-employed plus those unemployed but ready and able to work.
Three factors affect the size of the labour force: population, migration and the proportion participating in economic activity.
Population. Birth rates in most industrial countries fell to replacement
levels or lower in the 1980s. This implies an older workforce and
higher old-age dependency rates (the number of retired people as a
percentage of the population of working age) in the future. 15-20% of
the population in industrial economies will be over 65 years of age.
Developing countries have young populations with up to 50% under 15
years. This suggests an expanding working-age population with potential
problems for housing and job creation.
Migration. In the industrial countries inflows of foreign workers
increased since the late 1980s and a substantial number of illegal
immigrants were granted amnesty in America, France, Italy and Spain.
Foreign-born persons account for over 5% of the labour force in America,
Germany and France; around 20% in Switzerland and Canada; and over 25%
in Australia.
Inward migration may be a bonus for some economies. For example, German
unification boosted that country's productive potential. However, large
numbers of refugees seeking asylum can have significant adverse effects
on income per head.
Wealthier developing countries, especially oil producers, have large
proportions of foreigners in their labour forces. Workers frequently
make a substantial contribution to the balance of payments in their home
countries by remitting savings from their salaries.
Participation. Participation rates (the labour force as a percentage of
the total population) generally increased in the 1980s and 1990s with
earlier retirement for men, especially in France, Finland and the
Netherlands, generally offset by more married women entering the labour
force, especially in America, Australia, Britain, New Zealand and
Scandinavia.
Women account for a smaller proportion of the workforce in Muslim
countries (20%) and a greater proportion in Africa (up to 50%) where
they traditionally work on the land.
The unemployment rate. Usually defined as unemployment as a percentage
of the labour force (the employed plus the unemployed). National
variations are rife: Germany excludes the self-employed from the labour
force; Belgium produces two unemployment rates expressing unemployment
as a percentage of both the total and the insured labour force. By
changing the definition, which governments are inclined to do, the
unemployment rate can be moved up or, more usually, down by several
percentage points.
The Balance Of Payments
Accounting conventions- Balance of payments accounts
record financial flows in a specific period such as one year. Financial
inflows are treated as credits or positive entries. Outflows are debits
or negative entries. When a foreigner invests in the country, there is a
capital inflow which is a credit entry. Conversely, the acquisition of a
claim on another country is a negative or debit entry.
Debits = credits. The accounts are double entry, that is, every
transaction is entered twice. For example, the export of goods involves
the receipt of cash (the credit) which represents a claim on another
country (the debit). By definition, the balance of payments must
balance. Debits must equal credits.
Current = capital. One side of each transaction is treated as a current
flow (such as a receipt of payment for an export). The other is a
capital flow (such as the acquisition of a claim on another country).
Arithmetically current flows must exactly equal capital flows.
Balances
The accounts build up in layers. Balances may be struck at each stage.
What follows reflects the IMF'S methodology in the fifth edition of the
Balance of Payments Manual
Net exports of goods (exports of goods less imports of goods)
= the visible trade or merchandise trade balance
+ net exports of services (such as shipping and insurance)
= the balance of trade in goods and services
+ net income (compensation of employees and investment income)
+ net current transfers (such as payments of international aid and workers' remittances)
= the current-account balance (all the following entries form the capital and financial account)
+ net direct investment (such as building a factory overseas)
+ other net investment (such as portfolio investments in foreign equity markets)
+ net financial derivatives
+ other investment (including trade credit, loans, currency and deposits)
+ reserve assets (changes in official reserves), sometimes known as the bottom line
= overall balance
+ net errors and omissions
= zero
Thus the current account covers trade in goods and services, income and
transfers. Non-merchandise items are known as invisibles. All other
flows are recorded in the capital and financial account. The capital
part of the account includes capital transfers, such as debt
forgiveness, and the acquisition and/or disposal of non-produced,
non-financial assets such as patents. The financial part includes
direct, portfolio and other investment.
The balance of payments must balance. When we talk about a balance of
payments deficit or surplus, we mean a deficit or surplus on one part of
the accounts.
Fiscal Indicators
Fiscal indicators are concerned with government revenue and expenditure.
Level of government - Various problems of definition arise because of
different treatment of financial transactions by central government,
local authorities, publicly owned enterprises, and so on.
In an attempt to standardise, international organisations such as the
OECD focus on general government, which covers central and local
authorities, separate social security funds where applicable, and
province or state authorities in federations such as in North America,
Australia, Germany, Spain and Switzerland.
There is scope for manipulation, Spending can be shifted to publicly
owned enterprises which are generally classified as being outside
general government. Net lending to such enterprises is part of
government spending, but it is not always included in headline
expenditure figures.
Classification
Public spending may be classified in several different ways.
By level of government: central and local authorities, state or
provincial authorities for federations, social security funds and public
corporations.
By department: agriculture, defence, trade, and so on.
By function: such as environmental services, which might be provided by more than one department.
By economic category: current, capital, and so on.
Breaking down the economic effect of public spending into current and capital spending is a useful way to interpret it.
Current spending
Major categories of current spending include the following.
Pay of public-sector employees: this generally seems to rise faster than other current spending.
Other current spending: on goods and services such as stationery, medicines, uniforms, and so on.
Subsidies: on goods and services such as public housing and agricultural support.
Social security: including benefits for sickness, old age, family
allowances, and so on; social assistance grants and unfunded employee
welfare benefits paid by general government.
Interest on the national debt.
Taxes
Taxes can be Progressive or regressive
Progressive taxes take a larger proportion of cash from the rich than
from the poor, such as income tax where the marginal percentage rate of
tax increases as income rises.
Proportional taxes take the same percentage of everyone's income, wealth
or expenditure, but the rich pay a larger amount in total.
Regressive taxes take more from the poor. For example, a flat rate tax
of Rs. 5000, takes a greater proportion of the income of a lower-paid
worker than of a higher-paid worker.
Indirect taxes. Levied on goods and services, these include the following:
Value-added tax (VAT) charged on the value added at each stage of
production; this amounts to a single tax on the final sale price.
Sales and turnover taxes which may be levied on every transaction (for
example, wheat, flour, bread) and cumulate as a product is made.
Customs duties on imports.
Excise duties on home-produced goods, sometimes at penal rates to discourage activities such as smoking.
Indirect taxes tend to be regressive, as poorer people spend a bigger
slice of their income. They are charged at either flat or percentage
rates.
Budget deficits (spending exceeds revenues) boost total demand and
output through a net injection into the circular flow of incomes. As
with personal finances, a deficit on current spending may signal
imprudence. However, a deficit to finance capital investment expenditure
helps to lay the basis for future output and can be sustained so long
as there are private or foreign savings willing to finance it in a
non-inflationary way.
Budget surpluses (revenues exceed expenditure) may be prudent if a
government is building up a large surplus on its social security fund in
order to meet an expected increase in its future pensions bill as the
population ages.
Tighter or looser. Fiscal policy is said to have tightened if a deficit
is reduced or converted into a surplus or if a surplus is increased,
after taking into account the effects of the economic cycle. A move in
the opposite direction is called a loosening of fiscal policy.
