introduction to economics(basic concepts-theory of demand)

In order to study and pass  General Certificate Of Education Advanced level Economics one must grasp the basic concepts that form the foundation of the study of the subject.This material, if diligently studied shall provide all the economic concepts that are needed to understand the scope of economics.

As a student you are required to realize the importance of completing all blank spaces in your learning guide.The completed module will then constitute your powerful revision guide.You are also required to do all exercises and tests that are given in order to check your understanding and comprehension of what you are learning.

Basic Economic Ideas

economics and the economic problem


scarcity,choice and resource allocation

economics is the science which studies human behavior as a relationship between ends(unlimited wants) and scarce means(resources) which have alternative  uses . 

                                                                                   Professor Lionel Robins(1932)

 if you have challenges with understanding the definition lets examine it step by step.As we analyze Professor Lionel Robbins's  definition of economics the following points stand out :

1- economics is a science 

2- economics studies human behavior

3-economics studies the relationship between "ends"(unlimited wants) and scarce means(scarce resources)

4-economics studies alternative use of resources

To clarify the above points and as an introduction to economics read the following study material.

Major Points of Lionel Robbins Definition of Economics

Following are the points:

1. Ends (Unlimited Wants)

Human beings have unlimited wants. They are constantly making efforts to satisfy unlimited wants with limited resources. The nature of these unlimited wants is such that if one want is satisfied another want arises. It is impossible that a person has all of his wants fulfilled. So the struggle to produce more goods or get more income continues for the whole life.

2. Means (Scarcity of Resources)

Resources are of two types, non-economic and economic resources. Non-economic resources are air, sea, water etc. These resources are unlimited in supply and are fee. Economic resources are the things and services which are limited or scarce in supply and command a non-zero price. Economics is concerned with all the natural human and man made resources that are used in the production of goods and services. These resources are also called inputs.

According to Robbins the unlimited ends and the scarce resources provide a foundation for the field of economics. Since the human wants are unlimited and the means to satisfy them are scarce or limited in supply, therefore an economic problem arises. If all the things were freely available to satisfy then unlimited human wants there would not have arisen any scarcity hence no economic goods, no need to economic and no economic problem.

3. Alternative Uses

The third important proposition of Robbins definition is the scarce resources available to satisfy human wants have alternative uses. For example if a piece of land is used for the production of sugarcane it cannot be utilized for the growth of another crop at the same time. Man therefore, has to choose the best way of utilizing the scarce resources which have alternative uses and choices are the problems confronting to the society. The choices to be made are:

What goods shall be produced and in what quantity?

How the goods and services should be distributed

Summing up, the definition of economics by Robbins based on satisfaction of human wants with scarce resources which have alternative uses.

ECONOMICS AS A SOCIAL SCIENCE

The nature of economics

Economics is the scientific study of the ownership, use, and exchange of scarce resources - often shortened to the science of scarcity. Economics is regarded as a social science because it uses scientific methods to build theories that can help explain the  behavior of individuals, groups and organizations. Economics attempts to explain economic behavior, which arises when scarce resources are exchanged.

In terms of methodology, economists, like other social scientists, are not able to undertake controlled experiments in the way that chemists and biologists are. Hence, economists have to employ different methods, based primarily on observation and deduction and the construction of abstract models.

As the social sciences have evolved over the last 100 years, they have become increasingly specialized. This is true for economics, as witnessed by the development of many different strands of investigation including micro and macro economics, pure and applied economics, and industrial and financial economics. What links them all is the attempt to understand how and why exchange takes place, and how exchange creates benefits and costs for the participants.

The study of economics

The study of economics involves three related investigations. 

  1. Why scarce resources are exchanged?
  2. How consumers and producers behave as they interact with each other in markets, in their attempt to achieve mutually beneficial exchange?
  3. The role of government in compensating for the limitations of markets in achieving mutually beneficial exchange?

The methods used by economists

Economists use scientific observation and deduction in their investigations. To achieve this they:

Describe and measure the exchanges they observe

Economists describe changes in economic variables, and measure these changes over time. For example, economists describe and measure how interaction in markets determines the prices of such diverse products as motor cars, houses, haircuts, and computer software. Measurement in economics can take many forms, including measuring absolute and relative quantities and values. When measuring relative values it is common to use index numbers

Explain how interactions arise and create costs and benefits

Economists try to explain the effects, or results, of economic transactions. For example, economists can explain why, despite bubbles and crashes,  the long-run trend in house prices in the UK has been upwards over the last 30 years, and can identify those who have been affected positively and negatively by this increase. Of course, economists also try to explain the short-term movements in prices, and how they also have costs and benefits. 

Propose hypotheses, construct, and apply ‘models’ to test these hypotheses. 

Like all scientists, economists develop hypotheses to explain why economic behavior takes place, and then construct models to test these hypotheses. For example, economists may propose that price rises are caused by excess demand, and then attempt to construct a model of price that explains how excess demand can raise price. Economists frequently use versions of the demand and supply model to help explain events such as house price trends and movements. Economic models usually employ graphical and mathematical analysis to help explain and illustrate such economic processes.

Gather data to put into the model

Models must be tested against the real world, which means gathering statistical data about real events. In this way, a model can be improved and revised when necessary. 

Predict behavior based on these models. 

The ultimate goal of the economist is to predict future behavior. For example, by using a demand and supply model and by inputting real data about the housing market, economists can show that even a small fall in bank lending can trigger behavior that leads to a significant fall in house prices in the short run. The ultimate value of an economic model is that it can accurately predict the onset and the effect of an economic event. The better the model is, the more useful it is in helping economists make predictions. 

Economists assume that economic events and phenomena do not occur at random, but are determined by underlying and understandable causes. Unlike the pure scientist, economists cannot undertake controlled experiments, so they must test their models in different ways. Statistical analysis of actual economic data can provide a flow of information from which to build models and test hypotheses. For example, by gathering data about changes in house prices it is possible to deduce factors that cause house prices to go up or down, and by how much. Economists use index numbers to help make comparisons between countries and over time. 

Correlation analysis can help determine the strength of particular causal relationships so that strong and weak relationships can be identified. For example, it might be possible to demonstrate that, of all the factors that have contributed to falling house prices, the reduced availability of credit is the single biggest factor.

The role of the professional economist

Professional economists apply their skills of description, analysis, model building, and prediction to generate knowledge and, from this, provide advice to private firms, to governments and other organizations. 

Providing knowledge

  1. The first function of the economist is to provide information, called economic intelligence, from which decisions can be made. For firms to survive and succeed, they need to take many decisions, but each decision carries with it a risk. The professional economist can help reduce such risks by gathering and analyzing economic intelligence. This economic intelligence is only useful when it can be put into an economic model, and then applied to the decisions that need to be taken. 
  2. The second function of the professional economist is to interpret the data that has been gathered and provide informed advice to firms, organizations, and governments about the likely costs and benefits of the decisions they make.

In providing advice, the economist will always make an assessment of the other options that could have been chosen. For example, a large petrol refiner and retailer may be faced with a significant rise in the costs of crude oil – should it now raise price? After having made an assessment of all the pricing options, and having taken account of the likely response of rivals, the firm’s chief economist may advise it to hold price constant – perhaps the least ‘common sense’ answer.

To find out why, see:oligopoly

Positive and normative economics

As a social science, economics attempts to use the principles and methods of science to explain economic behavior. This involves making positive statements about the economic world.

Positive statements are those that can be verified, and are factual, such as:

‘.. House prices have fallen by 15% over the last year...’

In contrast, normative statements are based on opinion and value judgement. Statements suggesting that something ‘ought to’ happen, or that something is ‘unfair’, are normative because they are matters of opinion.

For example, ‘..the recent fall in house prices is unfair to the rich..’. 

This statement cannot be tested because it not based on anything testable. If there is an agreed definition of fairness, and it can be measured, then it might be possible to test the effect of the change in house prices on the degree of fairness experienced by a certain identifiable group of people defined as rich.  Therefore, this statement is normative, impossible to verify, and based on opinion rather than fact. 

The ceteris paribus rule

Economics is a social science, and, unlike the physical sciences, cannot engage in controlled experimentation to demonstrate how variables are connected.

In the real world, economic variables  such as price and income, are constantly changing, and this creates a problem in demonstrating the relationship between variables. For example, a fall in price is likely to lead to a rise in consumer demand if we assume nothing else changes.

Of course, for independent reasons, income could also fall while demand does not rise.  The fall in price could have been counteracted by a fall in income. The ceteris paribus rule, that all other things remain the same, is used whenever attempting to demonstrate the link between economic variables. 

please read the following definitions of economics as a social science and then complete the fill-in exercise 

Economics is categorized as a “social science” alongside anthropology, psychology and sociology.  Which makes complete sense considering that economics studies the relationships that dictate how we produce and consume goods and services within the society.   But you wouldn’t know that from the way many economists discuss economics.  Too often economists try to establish economics as an empirical science grounded in some sort of natural phenomena.

I was thinking about all of this as I was reading this piece by John Hilsenrath who was discussing Hayek’s views on this matter:

“His central grievance was the field’s long-running infatuation with scientific method and certitude. It was an impossible and misleading task for economists, he said. In their “vain search for quantitative and numerical constants,” Mr. Hayek argued, economists were constantly overlooking essential facts and misunderstanding the complexity of the social mechanisms under their microscopes.”

Hayek has this dead right even if we might have disagreed on how to apply it.  In the search for quantitative and numerical constants we often overlook just how much our economic system resembles the soft science and not the natural sciences.  And it can lead to extremely misguided thinking on certain matters.

Of course, the economy is not grounded in anything resembling the natural sciences.  There’s very little that’s “natural” about our economic system.  The economy is made up of the sum of the decisions of the people who operate within that system.  And the system exists, to a large degree, in our heads as records of accounting.   These records can be erased, created from thin air, manipulated, etc.  And the people creating those records are driven in large part by their own biases.  They react inefficiently and irrationally.  Mister Market, as Warren Buffet likes to say, is often manic.

This makes the study of economics extremely tricky because we’re dealing in uncertainties at most times.  Thankfully, we seem to be making good progress in fields like behavioral finance, but I do worry that the “science envy” of many economists continues to plague views and progress.

Economics is the study of social behavior guiding in the allocation of scarce resources to meet the unlimited needs and desires of the individual members of a given society.  

Economics seeks to understand how those individuals interact within the   social structure to address key questions about the production and exchange of goods   and services. First, how are individual needs and desires communicated  such that the correct mix of goods and services become available? Second,  how does a society provide the incentives for these individuals to participate  in the production these goods? Third, how is production organized such  that maximum-possible quantities are made available given existing resources and production technology?. Finally, given that these individuals are at   one time involved in the production process and at other times seeking   to acquire the goods that have been produced, how are trading rules and exchange agreements established?

The above questions stress the importance of understanding the process of production. The goal here is to understand the basic features of production without getting mired in great technical detail. This is accomplished by developing a simple model that maintains the important features of what are, otherwise complex engineering relationships. Production is about the conversion of scarce resources into desired goods and services. These resources are often referred to as the factors of production --a short list that includes:             

  • Land (acreage            and raw materials)                    
  • Labor (unskilled, semiskilled, professional)         
  • Capital (machines, factories, transportation            equipment, and infrastructure) and            
  • Entrepreneurship (organizing the other factors of            production and risk-taking)            

This list is brief and yet complete intended to provide sufficient detail to model the input choices available to the producer. Accordingly, the combination of  Land, Labor, Capital,and Entrepreneurship will lead to the production of Apples, Wheat, Automobiles, Houses, a Freight Train, Education, or any other good or service.

However, we do live in a world of scarce resources. Scarcity refers to a physical condition where the quantity   desired of a particular resource exceeds the quantity   available in the absence of a rationing        system. Potential candidates for rationing systems include:           

  • Tradition and Culture, where the problem of allocation is addressed via social norms,customs and past history.            
  • Planning and Central Government Command, making use of complex mathematical tables to determine output goals and input requirements.                    
  • Voting and Political Procedures, communication about resource allocation among individuals thorough the development of a consensus  or perhaps majority rule.         
  • Markets - using a system of prices to act as a means  of communication about the availability of resources and the desire for those resources.             

Goods and services refer to:              

  • Final Goods and services -those products that are directly consumed by individuals to satisfy their needs and wants.            
  • Intermediate or Capital Goods -are those goods used to produce other goods.        

In the case of final goods, Needs represent those  goods and services  required for human survival.Needs are determined by nature, climate and region, and are often finite. Human Wants or Desires refer to        everything else. Human wants are determined by society and the culture in which an individual lives. These wants are indeed unlimited and represent the source of the problem facing all economic systems. 

We need to be careful in noting that Economics is not just about the production of goods and services. Equally important is developing an understanding about how wants and needs are communicated to the economic system, how to involve individuals in the production process and provide incentives for these individuals to specialize in areas of production where their talents are best used and then exchange goods with others. 

For your further reading on the introduction to economics here is more material from a different authors.

 NATURE OF ECONOMICS

  The term economics is derived from the word “oeconomicus” by Xenophon in 431 B.C. It is derived from two words economy and science. Economy means proper utilization of resources. It means economics is the science of economy or science of proper utilization of resources. It is comprised of theories, laws, principle related to utilization of resources so as to solve the economic problems, satisfy the human wants or need and so on. However, the economics is defined in different ways by different economists. There are mainly three definitions of economics:-a. classical or wealth definition (Adam Smith)-1776 A.Db. neo-classical or welfare definition (Alfred Marshall )-1890 A.Dc. modern or scarcity and choice definition (Lionel Robbins)-1932 A.D a. classical or wealth definition (Adam Smith)-1776 A.D                                   The famous classical economist Adam smith for the firs time defined economics as “science of wealth”. The definition was given in the book “an inquiry to the nature and the causes of wealth of nations” published in 1776 A.D. the book is popularly known as “wealth of nations”. According to smith, labor is the main source of income or wealth. More wealth is accumulated only if more labor is used. Economics explains the human behavior and activities they do for wealth. This definition was based upon the assumptions of full employment, perfect competition, no governmental interventions, money just as a medium of exchange and so on.                                     This definition has following main proposition:-i. economics is science of wealth. Labor is the only source of income. there is perfect competition in product as well as labor market. The government should not interfere the activities of people and business organizations. this definition is influenced by physiocracy and mercantilism.

Criticism:

Wealth definition has over emphasized wealth. Economics is science of human activities rather than only wealth. Adam smith considers only material things or wealth as subject matter of economics but human beings require some immaterial things like self esteem or dignity, social prestige, national identity and so on too. The immaterial things are called essential things for human satisfaction. Wealth definition is based upon the theory of subsistence wage which is known as iron law of wage. The law was against the workers and in favor of employers. Adam smith doesn’t explain about scarcity of resource and choice of best alternative for the use of resources. The problem of scarcity and choice is burning issue in the modern economics but he fails to explain about the problems of scarcity and choice. The wealth definition is based upon assumptions of full employment and perfect competition but none of these two is in existence. This definition is based upon the assumption of no intervention of government in economic activities of people and business organization but we find in every country more or less governmental intervention.b. neo-classical or welfare definition (Alfred Marshall )-1890 A.D .In 1890, Alfred Marshall, a famous neo-classical economist and a great contributor to micro economics defined economics as the science of material welfare. Here, the material welfare means the quantities of physical goods consumed by people. if the people are consuming large quantities of goods, they are said to have high level of welfare into two types.

1. material welfare

2. immaterial welfare according to him, only the material welfare is the subject matter of economics. He assumes every person is rational and s/he uses the resources in his/her possession very properly so as to maximize their own welfare. Economics is therefore the science that studies the rational behavior revealed by the people. Major propositions of Marshall’s welfare definition are:-1. Economics is science of material welfare2. Economics is social science i.e. science of mankind

3. Economics is the study of rational behavior of people revealed for maximization of material welfare. Criticisms:-This definition of economics a science of material welfare was assumed correct until the arrival of Lionel Robbins. He criticized the definition under the following aspects:

1. Classificatory activities of Marshall into material non material welfare, economics and non economic goods is only classificatory not analytical because single human cannot be material as well as non material according to the nature and purpose of work.

2. Non material activities like feeling of social service, human desire also satisfy human needs. This idea has not been prioritized

3. Non welfare consumption like harmful drugs, tobacco, and alcohol don’t promote social welfare but still are in the study of economics

4. Economics should study about total human beings but wealth definition doesn’t study about isolated people like saints, nuns, monks etc.c. modern or scarcity and choice definition (Lionel Robbins)-1932 A.D. According to Lionel Robbins, economics is the science of scarcity of the resources and the choice of best alternative for their utilization. The resources are limited in supply. Each resource is usable for different purposes. The wants or need of people are unlimited. The wants differ in importance. They differ from place to place, from time to time and from person to person. Some wants are more important whereas some are not. All wants cannot be fulfilled because of insufficiency of resources. Therefore, we have to go on utilizing the resources in such a way, so that, our more wants can be fulfilled leaving no one in most important wants unfulfilled. For it, we must select best ways for the utilization of the resources. We should have the complete information of resources available, needs of the country and their importance and ways for the utilization of resources. This definition is given in 1930 A.D after WWI. During third decade of the twentieth century, the European countries were badly in need of large quantities of resources for rehabilitation, construction of infrastructures, renovation etc. They were destructed in war. This definition is both normative and positive in nature. The major propositions are:

1. There is unlimited human needs or wants

2. There is scarce means of resources

3. There are alternative use of resources

4. There is need of choice

 Criticisms:        

 The definition is criticized in the following ways:

1. economic problems arises not only due to scarcity but due to under, miss  or over utilization of resources

2. economic problems arises due to inequality too

3. there is political consideration

4. needs and resources may vary superiority of Robbins definition over Marshall’s definition:

1. the definition is scientific

2. the definition is universally accepted

3. the definition has wide scope

4. the definition has science of choice

Microeconomics:

 The term microeconomics is derived from the word micro economy and science. The term micro is also derived from the Greek word micros which means small or tiny. Microeconomics is defined as the science of small or tiny part of the economy. It provides us the detail information of microeconomics units. The units are single consumer or consumer of a firm or an industry. A single firm or firms belonging to an industry is called worm’s eye view of an economy microeconomics we study about the relationships between microeconomic variables like utility, cost of purchasing, demand, supply, price, cost of production, and revenue from sale, profit or loss and so on, it is the study of behavior of consumers and firms.

Scope or subject matter of macroeconomics:

Scope means the subject matter. It means the area of application…

1. Study of wage level and employment level

The macroeconomics deals with wage level and employment level. The level of employment depends upon demand for labor and supply of labor. Both of these factors depend upon wage level. There are different theories of employment like classical theory, Keynesian theory, Kaltorian theory and other modern theory

2. The study of price level and output level.

Macroeconomics is concerned with determination of equilibrium price level and output level. The price level means average of the prices of goods and services bought and sold in the country in a year. The level of output depends upon aggregate demand and price level. There are different theories of determination of price level and output level. Among them, Keynesian theory of effective demand is very popular. The theories are the subject matter of macroeconomics

3. The study of trade cycle.

Macroeconomics is concerned with trade cycle too. It explains how the economics ups and downs occur, what are their causes, how the country can overcome fluctuation. There are different theories of trade cycle. Some of them are Schumpeter theory, Hessian theory, Calder’s theory etc.

4) Study of macroeconomic distribution.

The macroeconomics is the study of distribution of income, wealth or resources in the country among the people. It is the study of different theories, laws and principles of distribution of income in the form of wage, interest, profit and rent. It gives us knowledge of effects of high inequality in the distribution of income and wealth. It gives us remedies of unequal distribution and the economic problems due to the inequality

Normative or positive economics

Economics is both positive and normative science. It is the study of facts as well as ideal theories and principles too. It can be explained as following:

a) Positive economics. Economics is positive science. It is the study of facts or things in reality or existence. In economics the large number of economic problems or questions like what are produced, how goods are priced and distributed, how much profit is earned by firms, what different type of resources are available, how the resources are utilized, who are performing different economic activities, why the economic problems are occurring, why is the country suffering from unemployment, price instability, economic instability, import dependency and so on are put and answered. There are different theories laws and principles based upon facts we study in economics. That’s why economics is called positive science

b) Normative economics .

Economics is normative science. It is the study of things ought to be. In economics, we study different ideal theories and principles. They are concerned with different economic problems. They give us ideas for overcoming of different economic problems. They are helpful to formulate proper policies and plans. They are helpful to solve the problems of unemployment, import dependency, improper allocation of resources, price and economic instability, unequal distribution of income and wealth and so on. Economics helps us to decide how much goods should be produced, how much they should be priced, hoe the government should control money supply, interest rate, public debt, government expenditure etc. , how the consumer should allocate the money to get maximum satisfaction from the expenditure, how the firms should combine the inputs to earn maximum profit and so on. This all have ethical importance. That’s why economics is call normative science.Economics is a science or an art.Economics is both art and science. It is called a science because it is the scientific study of relationships between economic variables, behavior of consumers and firms, nature of market and economy, effect of change in one or more economic variables on the others and so on. The different theories, laws and principles are studied in economics. All of them are generalized and simplified on the basis of facts so as to make them easily understandable. Therefore, economics is said to be science. Economics is an art. The different theories, laws are explained with the help of graphs, figures, tables, charts, equations etc. simplifying and generalizing them. Simplification is to make them easily understandable and generalization is to make them applicable to all economies. In order to explain theories, laws and relationships between economic variables we make some assumptions. The assumptions define the conditions for the application of theories, laws and\d the relationships. That’s why economics is an art.

Importance of microeconomics:

1. Important to the consumers.

Microeconomics provides the ways for proper allocation of money on different goods and services so that they can get maximum utility. There are different theories of consumers behavior, the theories explain how the consumers should spend the limited money they have to maximize their satisfaction

2. Important to the firms or businessmen.

The firms or businessmen use the microeconomic theories of consumer behavior, production, cost, market, revenue and so on to make proper economic decisions. The microeconomics helps them to know the purchasing power of ability to pay, proper combination of inputs to maximize cost or maximize profit, effects of change in tax rates, subsidies and so on

3. Important to the government.

Government can determine taxes, subsidies, wage level, allowances etc on the basis of effects of change in these factors on the demand for goods and services. Some goods are levied while some are subsidized. The salaries and allowances are adjusted on the basis of relationship between these variables and demand. Interest rate, exchange rate and money supply too are changed with the help of microeconomic theories.

4. Important for the study of other economic science.

Microeconomics helps us to study  other economic sciences like macroeconomics, public finance, monetary economics, labor economics, and international trade economics and so on. The theories and laws of these economic sciences are based upon micro economics theories and laws.

Importance of macroeconomics

1. To know the relationship between macro economics variables:

The macroeconomics helps us in the study of relationship between large numbers of macro economics variables. The variables are Aggregate consumption, Aggregate income, aggregate saving, Aggregate investment, Aggregate demand, Aggregate supply, Price level

2. To know the functioning of economy .    

Macroeconomics helps us to know how the economy functions, how it is regulated, For it macro economics provides us the knowledge of product market, labor market, capital market, land market, international trade market etc. it in forms us the country can achieve equilibrium only if all of the markets are in equilibrium.

3. To correct unfavorable balance of trade and payment .

Macroeconomics provides us different theories of international trade. It provides us different remedies of import dependency and greater outflow of money from the country. The government or country may adjust custom duty, exchange rate, transaction of gold etc to promote export and to reduce import.

4. To achieve high economic growth and employment level.

 With the help of theories and models of economic growth and employment we can induce investment increase in income and employment opportunities, thus, these are the importance of micro and macro economics.

Contrast normative and positive statements about Zimbabwe's economic policy in the past 5 years

To what extent is economics a science?

Define what is economics

Explain the economic problem in relation to Zimbabwe and south africa

opportunity cost

What is Opportunity Cost?

Lesson Objectives

After you finish this lesson you'll be able to:

  • Define concepts like scarcity and opportunity cost
  • Understand the different ways economics can measure value
  • Comprehend how benefits and costs are weighted when making a choice
  • Know why opportunity cost must be viewed in comparative terms

The basic economic problem is the issue of scarcity. Because resources are scarce but wants are unlimited, people must make choices. This lesson showcases the most important concept in macroeconomics, which is the concept of opportunity cost. Very simply, everyone has the same amount of hours in a day, but we all make different decisions about what we do, what we choose to buy, and how we spend our time. What determines these choices? Opportunity cost does. 

Every time you make a choice, there is a certain value you place on that choice. You might not know it or think about it, but every choice has a value to you. When you choose one thing over another, you're saying to yourself, I value this more than another choice I had. 

The opportunity cost of a choice is what you gave up to get it. If you have two choices - either an apple or an orange - and you choose the apple, then your opportunity cost is the orange you could have chosen but didn't. You gave up the opportunity to take the orange in order to choose the apple. In this way, opportunity cost is the value of the opportunity lost. 

Value: Benefits and Cost

Value has two parts to it. It has benefits as well as costs. If you choose an apple over an orange, maybe the apple costs less, but maybe you enjoy it more. So, looking at choice in terms of benefits and costs helps you make better economic decisions. To make a good economic decision, we want to choose the option with the greatest benefit to us but the lowest cost. 

Monetary Value

For example, if we graduate from college and suddenly find ourselves in the job market, there are choices to be made. Let's say that two jobs become available to us. We can either work for Company A or Company B. The job with Company A promises to pay us $20 an hour, while Company B offers to pay us only $10. Based on this information alone, of course most people would choose Company A. 

Why? Because Company A is paying a higher salary. But when you look at this kind of a choice in only dollar terms, you're only seeing it from the perspective of the benefits. Let's take that same example, but now we discover that the job for Company A requires a fancy dress suit that will cost you $1,500. You realize that the job with the higher salary may not be worth it to you. Now you're starting to think economically. You're thinking economically when you look at the value of a choice through the eyes of its benefits and costs. 

Whatever we choose, the opportunity cost is the value of the choice we could have had. The opportunity cost of working for Company A is the value of what we gave up to take the job. We gave up the value of working for Company B, so that is the opportunity cost of choosing to work for Company A. In this example, we focused more on the monetary costs. The challenge is, most people get stuck evaluating choices only in monetary terms, but there's more to the story. 

Value of Time

The value of a choice to you might be in terms of time or in terms of the enjoyment you could have experienced. When Benjamin Franklin originally explained this concept in his book, titled Advice to a Young Tradesman, he said that 'time is money.' He was trying to communicate the concept of opportunity cost by saying that what you do with your time, whether or not you are productive, can be just as important as any decision you make with money.

Opportunity Cost Examples

Here are a few examples:

Let's say you have only $100 to spend and you have two choices: you can eat at a nice restaurant or buy seven music albums instead. If you spend your $100 on buying the albums, the opportunity cost of that choice is the delicious meal you did not choose.

As I already said, this concept works for spending money, but it also works in regards to time. Let's say you only have two hours of free time. You could either go to a movie or visit the bookstore. If you choose to spend your time at the movies, the opportunity cost of this decision is the time you could have spent enjoying the bookstore.

You can apply the concept of opportunity cost to land as well. If we assume that land can either be used to produce corn, or it can be used for raising cattle to produce beef, but it cannot be used to do both at the same time, we have two choices and we must make a decision. Let's say we're already producing corn, but we want to switch to raising cattle so we can produce beef. In this case, the opportunity cost of switching from producing corn to raising cattle is the amount by which the production of corn decreases, because that's the value of our next best alternative.


  • How to Calculate Opportunity Cost

  • Learn the formula that reveals the economic value in any major choice between two possibilities. Every choice involves tradeoffs, and opportunity cost shows you how to measure these tradeoffs.   
  •     Best Economical Choice? So now we have a choice between two alternative possibilities. We can either choose one thing or another but not both. For example, we could choose to spend our time knitting or walking but not both. How do we know what the best economical choice is? By calculating the opportunity cost of each choice. Opportunity cost is a relative concept, which means that you're finding out how much of one thing you can produce in comparison to another thing.It's All Relative For example, if the two goods you're interested in are rice and wheat, then the opportunity cost of producing rice will always be in terms of wheat, and the opportunity cost of producing wheat will always be in terms of rice. The opportunity cost of choosing one possibility is the value of the possibility you gave up. It's what you sacrificed. It's not what you chose, but it's the next best alternative. Let's look at how to calculate opportunity cost using land as an example. In country A, we can use the same amount of scarce resources to produce two things, but we can only choose one thing at a time to produce.
  • Calculation Examples Let's say the two things we produce are corn and beef. We can use land to either produce corn or produce beef. The next thing we need to know in order to calculate opportunity cost is how much corn could we produce compared to how much beef we could produce. And remember that we're using the same amount of resources, so this kind of problem really is going to give us a basis for comparing two alternative choices. Let's say that in Country A, we can either produce 50 tons of corn, or as an alternative, we can produce 25 tons of beef. This is our tradeoff between producing these two things. Now we have all the information we need to calculate opportunity cost, but we need to know which opportunity cost we're trying to measure based on which possibility we want to choose. Let's start by looking at it from the corn perspective. The opportunity cost of producing 50 tons of corn is equal to how many tons of beef we could have produced, which of course is 25 tons. Therefore, the opportunity cost is found by solving this equation:50 tons of corn = 25 tons of beef what we really want to know is how much beef we could have produced if we choose to produce 1 ton of corn, but the question gave us 50 tons. To reduce this equation down, we divide each side by 25 and this gives us:2 tons of corn =1 ton of beef and then reducing it down one more time, gives us:1 ton of corn = ½ ton of beef. That's our answer. The opportunity cost of producing a ton of corn is ½ a ton of beef. We only looked at this choice from one perspective. Let's look at it from the opposite perspective. If Country A can either produce 50 tons of corn or 25 tons of beef, then what is the opportunity cost to them producing 25 tons of beef? It's the value of the next best alternative, which, of course, is producing 50 tons of corn. So, in this case, our equation is as follows:25 tons of beef = 50 tons of corn. Same equation, different order. Reducing this down, we get:1 ton of beef = 2 tons of corn. So what does this mean? It means that the opportunity cost of producing one ton of beef is equal to the 2 tons of corn we could have produced instead. We sacrificed 2 tons of corn in order to produce a ton of beef. Why do we care about this? Because we want to know what we're good at, so ultimately we can specialize in doing this instead of doing something we're not as good at. Opportunity cost reveals the value in any decision. Why should I spend all my time producing beef if I can use the same amount of resources and produce twice as much corn? Opportunity cost just revealed this to us. Economics is all about getting the best results with the least amount of effort or producing a larger quantity of one thing with the same amount of resources.How about another example? Let's say that in one hour on a Saturday night, I can either type 3 term papers or bake 1 dozen chocolate chip cookies. What is my opportunity cost of choosing to write a term paper? My equation looks like this:3 term papers = 12 chocolate chip cookies. Dividing by 3 on each side, I reduce it down to:1 term paper = 4 chocolate chip cookies. So, the opportunity cost to me of choosing to write a term paper during this one hour on a Saturday night is that I would sacrifice 4 cookies.
  • Lesson Summary .You can use this method to calculate the opportunity cost for any major choice, whether it's on the level of two goods or whether it's at an economy-wide level of choosing between capital goods and consumer goods. The economic skill you've just learned is the building block for creating the production possibility curve.
  • Lesson summaryTo summarize what we've talked about in this lesson, scarcity creates choice, and every choice has value to us. That value can be looked at in terms of benefits and in terms of cost. Value is not always measured in financial terms but sometimes measured in terms of time or enjoyment. The opportunity cost of a choice is what must be given up in order to take an opportunity. It's not the opportunity we chose, but the value of the next best alternative we didn't choose. Every major choice has an opportunity cost, and later on, you'll learn how to calculate it.                                                                                                                                                                                                                                                                                                                                                  

Applying the Production Possibilities Model


Applying the Production Possibilities Model

Lesson Objectives

Upon completing this lesson, you'll be able to:

  • Describe how the production possibilities curve works
  • Understand the role scarcity plays in production possibility
  • Analyze production quality of an economy based on a production possibilities curve analysis
  • Explain why the bow of a production possibilities curve is bowed outward
  • Determine trade-offs of various changes in production

Producers in the economy use a visual model, called the production possibilities curve, to make the most efficient production decisions and maximize output. Learn how this model reveals the tradeoffs of every production decision with the simplified example of an economy that produces only two goods.       

Production Possibilities Model

We're talking about the production possibilities model in this lesson. The classic version of the production possibilities model is the comparison between two goods that a nation can produce - either guns or butter - and it must choose between these two goods. Famous people in history have used this analogy, including William Jennings Bryan, Margaret Thatcher and even leaders in Nazi Germany. In fact, the song 'Guns Before Butter' was written in 1979 by Gang of Four about this concept.

This graph is used to show the production possibilities between two goods

The production possibilities model is a visual model of scarcity and efficiency. It simplifies the concept of how an economy can produce things using only two goods as an example. It's going to show us all the production possibilities we have between these two goods. It takes the concept of opportunity cost, which we already explored, and helps us make the best economic decision we can make, which is to say, the most efficient decision.

Important Assumptions

There are some important assumptions we need to talk about regarding the production possibilities model. The question we're trying to answer is this: How much of each good should we produce in order to produce them in the most efficient way? For example, how many term papers and cookies should I make to get the most efficient combination? Or how much corn versus how much beef should country A produce to be the most efficient? That's where the production possibilities model comes in.

There are three important assumptions involved in using the production possibilities model:

  1. Resources are used to maximize capacity (very important).
  2. Resources are scarce.
  3. Technology remains completely constant.

We're trying to use our resources to the fullest, but we only have limited, or scarce, resources. We're also assuming, right now, that the technology we use to produce our goods isn't changing at all. So, what are we really saying? If you are producing the right combination of two goods, then you're using your resources efficiently. Why is this important? Because it reveals to us all the tradeoffs of changing our production possibilities.

Tradeoffs in Production Possibilities

We can pick any two points on a production possibilities curve and explain the tradeoffs, or opportunity cost, of producing different combinations of these two goods. For example, if our economy is producing cars and computers only, we can choose to produce many different combinations of cars and computers. Since our resources are scarce, we can't produce as much as we want, but we can produce, for example, zero cars or ten computers. We could choose instead to produce five cars and zero computers. Why are these two numbers different? Because in this example, these two activities have different production rates.

When we compare the production rates, we can speak in terms of opportunity cost, like this: If we make ten computers, we lose the opportunity to make five cars and vice versa. By reducing this fraction down, we can say the opportunity cost of producing one car is two computers. As you can see, it takes more time and resources to produce a car than it does a computer, and the production possibilities model will show us this visually.

Now, I just said we could produce zero cars and ten computers or five cars and zero computers. But there are many other production possibilities in between these two that we could choose instead. With our finite resources, we could choose to produce two cars and six computers or four cars and two computers. Then again, we could produce three cars and four computers. When you account for all the possible combinations, given the opportunity cost of one car equals two computers, you end up with a line like the one you see here, in this simple example.

Law of Increasing Opportunity Costs

This law illustrates that switching from one good to another will increase costs

Okay, time out. I want to clarify something important. Although the production possibilities model shows a straight line in this example, in the real world, the production possibilities model is a curve. As you produce more and more of one good instead of another, the opportunity cost will increase because some of the resources in an economy are only capable of producing one type of good. Which means that switching from one good to another will increase costs, and the more you switch from one good to another, the more expensive it gets. We call this the law of increasing opportunity costs, but some people call it the law of diminishing returns, which is the same thing.

For example, if an economy is producing some combination of cars and computers, and it wants to produce more cars, it will have to give up the opportunity to produce some computers, right? What happens is that each time you choose to produce additional cars, you don't get the same benefit; you don't get the same return for making that decision. Expanding your equipment so you can make more cars instead of computers becomes more and more difficult and expensive as you continue to do it. The result is that you give up more and more computers each time you add additional cars, which means opportunity cost is increasing. As you move from one side of the curve toward the other, this dynamic of increasing opportunity cost, or diminishing returns, continues to happen. It continues to happen until you reach a point somewhere in the middle where there is no benefit to producing more of one good and less of another. This is why the production possibilities curve is bowed outwards. It's bowed outwards, or shaped like a curve, because of the law of increasing opportunity costs.

Production Possibilities Curve

Here are some facts that we know to be true about all production possibilities curves. One is that any point outside the curve is not attainable. Any point outside of the curve is not a production possibility, because our resources are scarce, which means we have a capacity we won't be able to go over; a limit we can't exceed. It's our barrier of production.

The other fact we know is that any point inside the production possibilities curve is possible, but it's not efficient. The curve itself is an efficiency curve, which means it's showing us all the ways we can simultaneously produce two goods efficiently. That means any point that's inside the curve is not using all of our resources. So, if we choose to produce one car and two computers, we're producing less than our capacity. We have the resources to produce more stuff, but we choose not to.

To review, any point outside the curve is not possible, and points inside the curve are possible but not efficient. When you're a business or a firm and you're trying to maximize your profit, you're very concerned about producing at your capacity so you can earn the greatest profit. If you're an individual, you may be concerned about maximizing your income, but you're also concerned about maximizing your time, or perhaps, your enjoyment.

So, why is the production possibilities curve bowed outwards? To answer this, let's talk about what's happening when we make a move from one point on the curve to another. The curve represents the fact that there is an opportunity cost for every production possibility. If we want to switch from producing zero cars to one car, we know that we could only produce eight computers instead of ten. The opportunity cost of this switch is the value of what we gave up to get it, which in this case means we would have to give up the opportunity to produce two computers, or at least this is how we've been simplifying it.

But in reality, it can cost a lot more to reallocate resources than simply handing over the metal that was meant for computers to the car manufacturer, particularly when we shift our resources toward making only cars or only computers. If we push to make much more of one product than the other, then production is less efficient, and we have a higher opportunity cost.

Lesson Summary

To summarize what we've talked about with the production possibilities model:

  • Scarcity leads to choice, and every choice has tradeoffs, which we call opportunity costs.
  • The production possibilities curve shows the opportunity costs of producing two goods in an economy.
  • An economy that is perfectly efficient will produce on the curve instead of inside or below the curve.
  • The curve is bowed outwards because of the law of increasing opportunity costs.

Now that you know what the curve is, you'll be able to recognize situations and scenarios that can change it, and this will help you understand how a nation attempts to increase its productivity.

Shifts in the Production Possibilities Curve



Shifts in the Production Possibilities Curve

Lesson Objectives

By the end of this lesson you'll be able to:

  • Summarize the production possibilities frontier
  • Define consumer and capital goods
  • Recognize causes for shifts in the production possibilities curve
  • Portray shifts in production on a graph

In this lesson you will learn how changes inside an economy lead to changes in the production possibilities of a nation. See how different scenarios from everyday life lead to shifts in the production possibilities curve.       

Production Possibilities Frontier

The production possibilities frontier (PPF) is an economic model used to illustrate how people and nations should decide what goods to produce, how much to produce, and for whom they should produce it. It's a model and a concept that looks at only two goods at a time. For example, what combination of cars and computers should a nation produce?

The Production Possibilities Curve

The production possibilities curve illustrates all the possible combinations of how we can produce these two goods given the constraints we have, including the fact that resources are scarce. The question we're answering in this lesson is, 'What causes the production possibilities curve to shift?'

Before we answer this, let's review some of the basic ideas about the production possibilities curve, using two types of curves. Let's say we have a production possibilities curve showing the production of two goods: cars and computers.

Consumer and Capital Goods

Economists also use the PPF model to illustrate two categories of goods, both consumer goods and capital goods. So here is what that PPF curve looks like.

Every point along the curve is efficient; points outside the curve are unobtainable or inefficient

In any economy, investments into capital goods will do more to increase economic growth than investments into consumer goods will. For both of these types of curves, every point along the curve is efficient, meaning this combination of producing two goods is at our capacity. We're producing the most that we can with the least amount of costs. Movement along this curve reveals the trade-offs that are required to produce more or less of a good. We said that any point inside the curve is not efficient, and any point outside the curve is unobtainable.

The best example in history of when America's economy was inside the curve was during the Great Depression. At that time, unemployment was extremely high, and production was extremely low. But eventually, during World War II, our economy moved from inside the curve to somewhere on the curve. Now we're producing things as fast as we can, largely driven by the war, but we are on the curve. Even though we were producing a lot more, we still had a limit, a capacity that we couldn't exceed, unless something major changed. That's why any point that is outside the curve is not possible.

The production possibilities curve, whether it is showing two specific goods, such as cars and computers, or two types of goods, such as capital goods and consumer goods, shows us how much is produced, which means it's showing us a picture of output.

Shifts in the PPF Curve

So, now we can talk about shifts in the entire curve. The basic idea is that anything that causes economic output to increase or decrease will shift this curve. In any economy, the major goal that you're trying to achieve is growth, which is to say, producing increasing amounts of the goods and services that consumers demand.

An outward shift in the curve reflects growth, while an inward shift means decreasing output

Given the fact that resources are scarce, we have constraints, which is what the curve shows us. When the economy grows and all other things remain constant, we can produce more, so this will cause a shift in the production possibilities curve outward, or to the right. If the economy were to shrink, then, of course, the curve would shift to the left. When the curve shifts outward, or to the right, that means output is increasing. When the curve shifts inward, or to the left, that means output is decreasing.

Shifts in the production possibilities curve are caused by changes in these things:

•Advances in technology

•Changes in resources

•More education or training (that's what we call human capital)

•Changes in the labor force

Shifts in Technology

Let's briefly explore each one of these and see how they shift the curve. Probably what you hear about most in economics is how changes in technology affect the curve.

For example, let's say the country discovers a new technology, such as a new computer system that improves productivity. Anything that improves the productivity of workers is good. This causes output to increase, so the production possibilities curve shifts outward, or to the right. On the other hand, let's say a major war causes destruction of capital equipment in the country.  This would cause output to decrease, so in this case, the production possibilities curve shifts inward, or to the left.

Shifts in Resources

Changes in resources are also going to shift the curve - for example, if a country discovers a new energy source, like new solar panels, let's say. This causes output to increase, which shifts the production possibilities curve outwards, or to the right. On the other hand, if the country gets devastated by a major hurricane, it's not too difficult to imagine that this setback would make it more difficult to produce things. This causes output to decrease, which in turn shifts the production possibilities curve inward, or to the left.

Shifts in Education and Training

Now let's talk about education and training. When more people in the work force get educated or trained, we refer to that as human capital. Education and training increase knowledge, and knowledge tends to increase productivity, so this would shift the production possibilities curve to the right.

Shifts in Labor Force

Finally, if there was a sudden increase in the labor force, either from a population boom or, more likely, from immigration, then the production possibilities curve shifts outward, or to the right. Why is this? It's because more people working means more production possible.

This works in reverse as well. If the country experiences more unemployment, then the unemployment rate goes up. That means the labor force is shrinking, so more people are not working and not being productive. This would decrease the output of the nation, and shift the production possibilities curve inward, or to the left.

Lesson Summary

To summarize, the production possibilities frontier (PPF) is a model that helps us decide what to produce, how to produce it, and for whom to produce it.

Consumer goods are final goods that are purchased directly by consumers, while capital goods represent machinery, tools, and equipment, or anything that is used to produce consumer goods.

Shifts in the production possibilities curve are caused by things that change the output of an economy, including advances in technology, changes in resources, more education or training (that's what we call human capital) and changes in the labor force. Increases in the production possibilities curve are represented by shifts outward, or to the right, while decreases are represented by shifts inward, or to the left.

Decision making at the margin

The margin: decision making at the margin

 Since all the economic resources are scarce, we all need to make choices. One might think while reading the O level lessons that we make choices whether to use this or that. However, for necessities, we cannot make a decision whether to use or not to use them. For example, even if the prices of water increases, we still will use water, we cannot bring the consumption of water to zero. However, increase in prices may result in people trying to reduce the consumption a little bit.This is where the concept of decision making at the margin comes in. A choice at the margin is, the decision to do a little more or a little less of something.

Many would argue that, one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people “need” water.

But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in Male’ totals about 14000 tons per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your flower plants less? Could a higher price cause people to reduce their use, say, to 13500 tons per day? or to 13000? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin.

Division of Labour

Division of Labour

Division of labour is an economic concept which states that dividing the production process into different stages enables workers to focus on specific tasks. If workers can concentrate on one small aspect of production, this increases overall efficiency – so long as there is sufficient volume and quantity produced.

This concept was popularised by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Famously, he used the example of a pin factor. Adam Smith noted how the efficiency of production was vastly increased because workers were split up and given different roles.

Why is division of labour more efficient?

  1. Workers need less training as they only have to master a small number of tasks
  2. It is faster to use one particular tool and do one job.
  3. No time is wasted with a worker dropping a tool and then picking up another, every time he needs to moved onto a new item.
  4. There is no need to move around the factory, the work can be brought to the worker.
  5. Workers can concentrate on those jobs which best suit their skills.

When production has very high volumes, division of labour is necessary to get economies of scale.

Potential problems of division of labour

  • If workers are highly specialised, then the job can become very boring and repetitive. This can lead to low labour morale.
  • If workers lose the motivation to concentrate and do a good job, mistakes may creep in as they get bored.
  • An assembly line could grind to a halt if there is a blockage on one particular area.
  • Adam Smith himself recognised this potential problem and advocated education of the workforce so that they wouldn’t get too demoralised by their repetitive job.

Examples of division of labour

Ford motor factories. In the 1920s, H.Ford made use of the assembly line to increase the productivity of producing motor cars. On the assembly line, there was division of labour with workers concentrating on particular jobs.

Food production. A very basic example of division of labour could be seen in food gathering. In early societies, men would be the hunters, women and children would prepare the food and collect berries. The idea was that it was a very simple division of labour to enable the best use of different skill sets.

Nowadays, there is even greater division of labour in food production. Farmers will buy seeds, fertilisers and tractors from different companies. They will just concentrate on one aspect of food production. The tools and food processing is handled by different workers and a different stage in the production cycle.

Globalisation and division of labour

Globalisation has enabled a division of labour by country. For example, the developing world concentrates on the production of primary products. This involves low-paid labour to do the labour intensive work of picking coffee beans. The beans are then transported to developed countries, where other workers process, package and market the product.

efficient resource allocation


Efficient Allocation of Resources

An efficient allocation of resources is: That combination of inputs,   outputs and distribution of inputs, outputs such that any change in the economy   can make someone better off (as measured by indifference curve map) only by   making someone worse off (pareto efficiency).

Also, efficiency is obtained when there is:


  1. Efficiency in production: Producing the greatest value of goods and services     with given resources.       
  2. Efficiency in consumption: Production, consumption, and distribution conforming     to people's values based on willingness-to-pay.      
  3. Efficiency of system: All mutual advantageous gains from trade are exhausted.

Also, efficiency is obtained when the three marginal conditions   have been met:

 

  1. Marginal Condition for Exchange: To attain a pareto maximum, the     marginal rate of substitution between any pair of consumer goods must be the     same for all individuals who consume both goods.      
  2. Marginal Condition for Factor Substitution: To attain a pareto maximum,     the marginal rate of technical substitution between any pair of inputs must     be the same for all producers who use both inputs.       
  3. Marginal Condition for Product Substitution: To attain a pareto maximum,     the marginal rate of transformation in production must equal the margainal     rate of substitution in consumption for every pair of commodities and for     every individual who consumes both.

Also, efficiency is obtained when property rights are non-attenuated.   That is, they are:


  1. Completely specified
  2. Exclusive
  3. Enforceable and enforced
  4. Transferable

Also, a perfectly competitive market leads automatically to an   efficient distribution of consumer goods among consumers.

Perfect competition leads automatically to an efficient allocation   of production resources among producers.


economic systems

Free market economies

Markets enable mutually beneficial exchange between producers and consumers, and systems that rely on markets to solve the economic problem are called market economies. In a free market economy, resources are allocated through the interaction of free and self-directed market forces. This means that what to produce is determined consumers, how to produce is determined by producers, and who gets the products depends upon the purchasing power of consumers. Market economies work by allowing the direct interaction of consumers and producers who are pursuing their own self-interest. The pursuit of self-interest is at the heart of free market economics.

command economies

Command economies

The second solution to the economic problem is the allocation of scarce resources by government, or an agency appointed by the government. This method is referred to as central planning, and economies that exclusively use central planning are called command economies. In other words governments direct or command resources to be used in particular ways. For example, governments can force citizens to pay taxes and decide how many roads or hospitals are built. 

Command economies have certain advantages over free market economies, especially in terms of the coordination of scarce resources at times of crisis, such as a war or following a natural disaster. Free markets also fail at times to allocate resources efficiently, so remedies often involve the allocation of resources by government to compensate for these failures.



Mixed economies

There is a third type of economy involving a combination of market forces and central planning, called mixed economies. Mixed economies may have a distinct private sector, where resources are allocated primarily by market forces, such as the grocery sector of the UK economy. Mixed economies may also have a distinct public sector, where resources are allocated mainly by government, such as deference, police, and fire services.  In many sectors, resources are allocated by a combination of markets and panning, such as healthcare and, which have both public and private provision.

In reality, all economies are mixed, though there are wide variations in the amount of mix and the balance between public and private sectors. For example, in Cuba the government allocates the vast majority of resources, while in Europe most economies have an even mix between markets and planning.

Economic systems can be evaluated in terms of how efficient they are in achieving economic objectives.


Transition economies

A transition economy is one that is changing from central planning to free markets. Since the collapse of communism in the late 1980s, countries of the former Soviet Union, and its satellite states, including Poland, Hungary, and Bulgaria, sought to embrace market capitalism and abandon central planning. However, most of these transition economies have faced severe short-term difficulties, and longer-term constraints ondevelopment.

The problems of transition economies include:

Rising unemployment

Many transition economies experienced rising unemployment as newly privatised firms tried to become more efficient. Under communism, state owned industries tended to employ more people than was strictly needed, and as private entrepreneurs entered the market, labour costs were cut back in an attempt to improve efficiency. As the newly established private firms became subject to greater competition some were driven out of the market, which created job losses. In addition, a reduction in the size of the state bureaucracy also meant that many employees of the state also lost their jobs.

Between 1990 and 1997, unemployment rose in the three selected transition economies and was consistently above more well-established, market-based economies like the UK. Of course, the global recession of 1990 - 92 accounts for some of the rising unemployment over that period. Market reforms adopted in these countries have gradually brought down unemployment in the transition economies, to be on a par with many established market economies.


Rising inflation

rising inflation

Many transition economies also experienced price inflation as a result of the removal of price controls imposed by governments. When this happened, the newly privatized firms began to charge prices that reflected the true costs of production. In addition, some entrepreneurs exploited their position and raised prices in an attempt to profit from the situation.Annual inflation in the transition economies between 1990 and 1997 averaged around 20%, but then fell, moving much closer to the average found in the market economies of Western Europe.


Lack of entrepreneurship and skills

Many transition economies suffered from a lack of entrepreneurs and entrepreneurship, which make it more difficult to reform their economies and promote market capitalism. In addition, there was also a skills gap with few workers having the necessary skills required by employers in the newly privatised firms. 

Corruption

It is alleged that corruption was widespread during the early years of transition in many former communist countries, and this inhibited the effective introduction of market reforms. Many products were poorly made and sold in unregulated and illegal markets, and many have claimed that criminal gangs and widespread racketeering filled the vacuum left by the deposed communist regimes.

Lack of infrastructure

The transition economies also suffered from a lack of real capital, such as new technology, which is required to produce efficiently. This was partly because of the limited development of financial markets, and because there was little inward investment from foreign investors. Clearly, this has changed as the transition economies have reformed, and joined the global market, which has encouraged inward investment (Foreign Direct Investment – FDI) from around the world.

Lack of a sophisticated legal system

Under communism, the state owned all the key productive assets, and there was little incentive to develop a sophisticated legal system that protected the rights of consumers, and regulated the activities of producers. Market-driven economies will only develop when citizens are granted extensive property rights, and can protect these rights through the legal process.This was large absent in the former communist transition economies. 

Moral hazard

The problem of moral hazard implies that inferior performance can arise when the risks associated with poor performance are insured against. For example, if individuals insure the contents of their house against theft, they are more likely to leave their windows open. In the context of transition economies, under communism people felt that the state would insure them against the risks associated with global competition, including the risk of losing their jobs. The consequence is that many workers remained inefficient and unproductive, knowing that employment prospects would not be reduced.

Inequality

Economic transition also led to rapidly increasing inequality as some exploited their position as entrepreneurs and traders in commodities, while others suffered from unemployment and rising inflation.

China’s economy: A remarkable transformation -case study

China’s economy: A remarkable transformation

            Richard Herd and Sean Dougherty Economics Department - See more at: 

China’s emergence as a leading world economy is not a complete surprise. Economists like Angus Maddison had predicted its resurgence some time ago (see references). The most remarkable aspect of this transformation has been the role of the private sector in achieving such a high rate of growth. Nonetheless, as can be expected following such a substantial re-orientation of what was once a state dominated economy, there are challenges ahead. 

The pace of economic change in China has been extremely rapid since the start of economic reforms just over 25 years ago. According to official statistics, economic growth has averaged 9.5% over the past two decades and seems likely to continue at that pace for some time. National income has been doubling every eight years. Such an increase in output represents one of the most sustained and rapid economic transformations seen in the world economy in the past 50 years.

The size of the economy, when adjusted for differences in purchasing power, is already larger than all but one or two OECD economies, depending on the purchasing power parity used for comparison. While average incomes are still below those in other middle income countries, there are large parts of the country that resemble developed East Asian countries just one generation ago and are proceeding along a similar rapid catch-up path. Many industries have become completely integrated into the world supply chain and, based on current trends, China could become the largest exporter in the world by the beginning of the next decade, with as much as 10% of global trade compared with 6% at present.

This extraordinary economic performance has been driven by changes in government economic policy that have progressively given greater rein to market forces. The transformation started in the agricultural sector more than two decades ago and was extended gradually to industry and large parts of the service sector, so that price regulation was essentially dismantled by 2000 outside the energy sector. During this period, the government introduced a pioneering company law that for the first time permitted private individuals to own limited liability corporations. The government also rigorously enforced a number of competition laws in order to unify the internal market, while sharpening the business environment by allowing foreign direct investment in the country, reducing tariffs, abolishing the state export trading monopoly and ending multiple exchange rates.

The momentum towards a freer economy has continued this decade with membership of the World Trade Organization leading to the reform of a large number of China’s laws and regulations and the prospect of further tariff reductions. In 2005, regulations that prevented privately-owned companies from entering a number of sectors of the economy, such as infrastructure, public utilities and financial services were abolished. Overall, these changes have permitted the emergence of a powerful private sector in the economy.

But that is not all. The government has also introduced wide ranging reforms into the state-owned sector that dominated the economy in the early 1990s. State-owned enterprises have been transformed into corporations and many have been listed on stock exchanges since these were re-opened 15 years ago. Since 1998, a policy of “letting small enterprises go” through privatisation and closure on the one hand, and restructuring large companies on the other, has proved successful. The number of state-controlled industrial enterprises fell by over one half in the following five years and their payroll dropped by over 14 million, thanks in part to the introduction of more flexible employment contracts. This process was helped by the creation of unemployment and welfare programmes.

These and other reforms have improved the framework for mobilising the resources generated by one of the highest rates of savings in any economy–the gross saving rate approaches half of GDP–generating a particularly rapid increase in the capital stock, although such growth estimates can only be approximate. Investment has also led to an increasingly urban society–a movement that has gone in step with a flow of people from the land into the service and manufacturing sectors of the economy. Since workers in agriculture have low productivity, this movement has given a sharp boost to growth.

Moreover, the government has pursued a policy of raising the educational qualifications of young people. It launched a programme to give all children nine years’ education, moving recently to ensure that all rural areas achieve this goal by 2006. Higher education has also been transformed. The wages for educated staff have been pushed up by the growing influence of a market economy.

Still, the high level of investment should not obscure the need for much better allocation of capital. To be sure, government debt has been stabilised at only one-third of that seen in the OECD area. But banks have not been lending on a commercial basis and so bad loans are equivalent to 30% of GDP and this will, eventually, have to be financed by the government. A start has been made on re-organising the major banks. A considerable effort is still needed to ensure that the whole of the banking system acts in a commercial manner. Moreover, capital markets need to be reformed: the state-owned shares of listed companies should be made tradable and both stock and bond markets need to be opened to private companies.

Better commercial laws are also needed, notably concerning both the start-up and closure of companies. A new company law is required to lower barriers to the formation of new enterprises, while a bankruptcy law is needed to formalise the rights of secured creditors and make it easier for private companies to obtain credit.

Such moves would consolidate the role of the private sector whose upsurge has been one of the most remarkable developments in China’s boom. Though precise measurement is difficult, a definition which considers as private all companies that are controlled neither by state nor collective shareholders suggests that the private sector was responsible for as much as 57% of the value-added produced by the non-farm business sector in 2003.

The growing importance of the private sector reaffirms a shift towards a market economy, but it also puts a premium on the maintenance of a stable macroeconomic environment, notably in the area of prices. However, the existence of a relatively fixed rate of exchange against the US dollar has exposed the economy to inflationary or deflationary impulses. Indeed, the past decade has seen considerable volatility in the inflation rate, almost eight times that in the United States and four times that in Western Europe. In the current cycle, currency inflows have led to a need to purchase dollar assets to stabilise the exchange rate and it has been difficult to avoid boosting the domestic money supply as a result of these transactions.

Overall, a policy of allowing greater flexibility in the exchange rate would allow the authorities to more easily adapt monetary policy to domestic concerns, so guarding against the risk of any further increase in inflation and allowing market forces to determine bank interest rates to a greater extent. The July 2005 revaluation of the currency, together with the associated change in the exchange rate arrangements, represents a step in this direction.

Imbalances

Understandably, rapid expansion and increased importance of the market have led to income inequalities opening up between people and regions. Nonetheless, absolute poverty has been reduced – indeed, by some accounts, over half of the reduction in absolute poverty in the world between 1980 and 2000 occurred in China. Moreover, even in the poorer western and central areas of China, the growth of incomes has been just one percentage point lower than for the country as a whole. This performance outweighs that of many developing countries, though it pales in relation to growth in the coastal areas of the country.

Increased public spending has helped lessen some of the inequalities in economic development. Programmes are now in place to reduce taxation and illegal fees in rural areas, so boosting incomes. But these policies need to be complemented by a reform of fiscal transfers to reduce the gaps between expenditure requirements and local revenues in the poorer parts of the country. Such initiatives could be usefully complemented by efforts to create a national, or at least provincial, labour market. At the moment, it is difficult for workers and their families to move permanently to a different area and if they succeed their right to rent their farm may be forfeited without compensation. Even for a temporary move, many permits are required and often local publicly-provided services are either not available to migrants or only available on unfavourable terms.

Still, rural-urban migration will bring increased urbanisation that will need to be managed carefully. At present, Chinese cities are more equally sized than those in other economies and government reports have highlighted the benefit of creating agglomeration along the coast and major rivers. Market forces are beginning to influence the residential sector as close to 70% of homes are now owner-occupied. However, the short length of commercial and residential leases (40 and 70 years, respectively) may constitute a barrier to high-quality development as buildings on the land revert to the state at the end of a lease.

Pollution is clearly another challenge. With five of the ten most polluted cities in the world being in China, air pollution is estimated to impose a welfare cost lying between 3% and 8% of GDP. Investments under the last two five-year plans have improved pollution controls markedly weakening the link between economic growth and increased pollution. The key to further improvements will be carefully monitoring emissions from major sites and then ensuring that local environmental bureaux effectively sanction infringements of standards. As in several other areas, this underlines the need for China to step up its institutional reforms and ensure that laws, of which there are many good ones on the books, are actually enforced.

China’s economic transformation has been impressive, offering many lessons as well as challenges. These are discussed in detail in the OECD’s first ever Economic Survey of China. The last decade might be characterised as an era of accelerating reforms; to sustain rapid growth over the next decade, reform momentum will need to be maintained and consolidated

 

match the terms to their definitions

  • opportunity cost
    A benefit, profit, or value of something that must be given up to acquire or achieve something else
  • normative and positive statement
    Positive economics is objective and fact based, while normative economics is subjective and value
  • transition economies
    an economy which is changing from a centrally planned economy to a market economy. Transition economies undergo a set of structural transformations intended to develop market-based institutions.
  • production possibility frontier
    shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed.
  • economics as a science
    the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.
  • scarcity
    is the fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs.

theory of demand

theory of demand

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period

                                                                

Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Economists give this a term - utility

Effective Demand

  • Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it

Latent Demand

  • Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product.

Derived Demand

The demand for a product X might be connected to the demand for a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise.

Steel is a cyclical industry which means that market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.

Zinc is a good example of a product with a strong derived demand. It has a wide-range of end users such as galvanised zinc used in cars and new buildings, die-casting used in door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc cream.

Transport as a Derived Demand

The demand for transport is the number of journeys consumers or firms are willing and able to purchase at various prices in a given time period. Transport is rarely demanded for its own sake, the journey, but for what the journey enables e.g. commuting, taking a holiday or distribution. When an economy is growing, there is an increase in derived demand for commuting, business logistics and transport for holiday purposes.

                                                                                                                                                                

The Law of Demand

There is an inverse relationship between the price of a good and demand.

  1. As prices fall, we see an expansion of demand.
  2. If price rises, there will be a contraction of demand.

Ceteris paribus assumption

Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable

                                                                                                                                                                

The Demand Curve

A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls:

1.The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure.  Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product.

2.The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.



The demand curve

  • As price falls, a person switches away      from rival products towards the product
  • As price falls, a person's willingness and      ability to buy the product increases
  • As price falls, a person's opportunity      cost of purchasing the product falls

Note: Many demand curves are drawn as straight lines to make the diagrams easier to interpret

The chart below shows average season ticket prices for English Premier League clubs. What factors affect the willingness and ability to pay for a season ticket? Why is there such a large difference in prices?



Consumer demand and price

consumer  demand and price

The relationship between price and quantity demanded is the starting point for building a model of consumer behaviour. Measuring the relationship between price and quantity demanded provides information which is used to create a demand schedule, from which a demand curve can be derived. Once a demand curve has been created, other determinants can be added to the model.


Demand schedules

A demand schedule shows the relationship between price and demand over a hypothetical range of prices. For example, the schedule opposite is based on a survey of college students who indicated how many cans of cola they would buy in a week, at various prices. 

Demand curves

At higher prices, the quantity demanded is less than at lower prices. A demand schedule indicates that, typically, there is an inverse relationship between the price of a product and the quantity demanded. This relationship is easiest to see when a graph is plotted, as shown.


Demand curves

Demand curves generally have a negative gradient indicating the inverse relationship between quantity demanded and price.

 There are at least three accepted explanations of why demand curves slope downwards:

  1. The law of diminishing marginal utility

  2. The income effect

  3. The substitution effect

Diminishing marginal utility

One of the earliest explanations of the inverse relationship between price and quantity demanded is thelaw of diminishing marginal utility. This law suggests that as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less. This can be explained as follows:

Most benefit is generated by the first unit of a good consumed because it satisfies all or a large part of the immediate need or desire.

A second unit consumed would generate less utility - perhaps even zero, given that the consumer now has less need or less desire.

With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, because the marginal utility falls.

Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the less the marginal utility and the less value derived - hence the rational consumer would be prepared to pay less for that unit. 

Utility

While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less the rational consumer would be prepared to pay.

The income effect

The income and substitution effect can also be used to explain why the demand curve slopes downwards. If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their demand.



Therefore, at a lower price, consumers can buy more from the same money income, and,ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income and force consumers to cut back on their demand.

The substitution effect

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one.


It is important to remember that whenever the price of any resource changes it will trigger both an income and a substitution effect.

Exceptions

It is possible to identify some exceptions to the normal rules regarding the relationship between price and current demand. 

Giffen Goods

Giffen goods are those which are consumed in greater quantities when their price rises. These goods are named after the Scottish economist Sir Robert Giffen, who is credited with identifying them byAlfred Marshall in his highly influential Principles of Economics (1895).

In essence, a Giffen good is a staple food, such as bread or rice, which forms are large percentage of the diet of the poorest sections of a society, and for which there are no close substitutes. From time to time the poor may supplement their diet with higher quality foods, and they may even consume the odd luxury, although their income will be such that they will not be able to save. A rise in the price of such a staple food will not result in a typical substitution effect, given there are no close substitutes. If the real incomes of the poor increase they would tend to reallocate some of this income to luxuries, and if real incomes decrease they would buy more of the staple good, meaning it is an inferior good. Assuming that the money incomes of the poor are constant in the short run, a rise in price of the staple food will reduce real income and lead to an inverse income effect. However, most inferior goods will have substitutes, hence despite the inverse income effect, a rise in price will trigger a substitution effect, and demand will fall. In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase.

Example

For example, a family living on the equivalent of just $150 a month, may purchase some bread (say 50 loaves at $2 each, which is the minimum they need to survive), and a luxury item at $50. If the price of bread rises by 25% to $2.50 per loaf, continuing to purchase 50 loaves would cost the individual $125, making the luxury unaffordable. They cannot reduce their consumption of bread, given that their current consumption is the minimum they require, and they cannot find a suitable substitute for their stable food. Not being able to afford the luxury would leave the family with an extra $25 to spend, and, given no alternatives to bread, they would purchase 10 more loaves each month. Hence the 25% price increase has resulted in a 20% increase in the demand for bread - from 50 to 60 loaves.

Veblen goods

Veblen goods are a second possible exception to the general law of demand. These goods are named after the American sociologist, Thorsten Veblen, who, in the early 20th century, identified a 'new' high-spending leisure class. According to Veblen, a rise in the price of high status luxury goods might lead members of this leisure class to increase in their consumption, rather than reduce it.  The purchase of such higher priced goods would confer status on the purchaser - a process which Veblen called conspicuous consumption.

Shifts in demand

Shifts in demand

The position of the demand curve will shift to the left or right following a change in an underlying determinant  of demand.

Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement. 

Demand schedule

A shift in demand to the right means an increase in the quantity demanded at every price. For example, if drinking cola becomes more fashionable demand will increase at  every price. 


Increase in demand

An increase in demand can be illustrated by a shift in the demand curve to the right.

Decreases in demand

Conversely, demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement. 

Demand schedule

For example, if the price of a substitute, such as fizzy orange, falls,  then less cola is demanded at each price, as consumers switch to the substitute.


Decreases in demand are shown by a shift of the demand curve to the left. 

Elasticity

Elasticity

Elasticity is a central concept in economics, and is applied in many situations. Basic demand and supply analysis tells us that economic variables, like price, income and demand, are causally related. Elasticity can provide important information about the strength or weakness of such relationships. 

Elasticity refers to the responsiveness of one economic variable, such as quantity demanded, to a change in another variable, such as price. 

Types of elasticity

There are four types of elasticity, each one measuring the relationship between two significant economic variables. They are:

Price elasticity of demand (PED), which measures the responsiveness of the quantity demanded to a change in price. PED can be mmeasured over a price range, called arc elasticity, or at one point, called point elasticity.

Price elasticity of supply (PES), which measures the responsiveness of the quantity supplied to a change in price.

Cross elasticity of demand (XED),which measures the responsiveness of the quantity demanded of one good, good X, to a change in the price of another good, good Y.

Income elasticity of demand (YED), which measures the responsiveness of the quantity demanded to a change in consumer incomes.

Price elasticity of demand

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded.   

The following equation enables PED to be calculated.


We can use this equation to calculate the effect of price changes on quantity demanded, and on therevenue received by firms before and after any price change. 

For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be:  

- 50% / + 20%  = (-) 2.5 

The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’. 

PED can also be:

  • Less than one, which means PED isinelastic. 

  • Greater than one, which iselastic.

  • Zero (0), which isperfectly inelastic.

  • Infinite (∞), which isperfectly elastic.

Cross elasticity of demand

Cross elasticity of demand (XED) is the responsiveness of demand for one product to a change in the price of another product. Many products are related, and XED indicates just how they are related.

The following equation enables XED to be calculated.


% change in (∆) quantity demanded of good A  % change in (∆) price of good B   

Substitutes

When XED is positive, the related goods are substitutes. For example, if the price of Coca Cola increases from 50p to 60p per can, and the demand for Pepsi Cola increases from 1m to 2m per year, the XED between the two products is:

+100/+20 = (+) 5  

The positive sign means that the two goods are substitutes, and because the coefficient is greater than one, they are regarded as close substitutes.

Complements

When XED is negative, the goods are complementary products. The equation is the same as for substitutes. 

For example, if the price of Cinema Tickets increases from £5.00 to £7.50, and the demand for Popcorn decreases from 1000 tubs to 700, the XED between the two products will be:

-30/+50  = (-) 0.6   

The negative sign means that the two goods are complements, and the coefficient is less than one, indicating that they are not particularly complementary.

Why does a firm want to know XED?

  1. Knowing the XED of its own and other related products enables the firm to map out its market. Mapping allows a firm to calculate how many rivals it has, and how close they are. It also allows the firm to measure how important its complementary products are to its own products.

  2. This knowledge allows the firm to develop strategies to reduce its exposure to the risks associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute.

  3. Risks can be reduced in a number of ways, including adopting the following strategies:  

  4.  

    Horizontal integration-  

    Horizontal integration usually means merging with a rival, such as the merger of brewing giants Anheuser-Busch InBev and SABMiller  in 2015. Horizontal integration occurs when two or more firms producing similar products merge with each other, or where one takes over the other.

                         

  5. Vertical integration -

    Vertical integration means merging with a complement producer, such as a record producer merging with or taking over a record store, or radio station.

     

  6. Alliances and collusion-

    Joint alliances with competitors can also take place, such as Sony-Ericsson combining resources to create mobile phones.

    Collusion is also a possibility. For example, firms may enter into price fixing agreements so that they avoid having to fight a price war. This is more likely to occur in oligopolostic markets, where there are only a few competitors.

utility theory

marginal utility theory

Marginal utility theory examines the increase in satisfaction consumers gain from consuming an extra unit of a good.

  • Utility is an idea that people get a certain level of satisfaction / happiness / utility from consuming goods and service.
  • Marginal utility is the benefit from consuming an extra unit

This utility is not constant. Often we get diminishing marginal utility. The first piece of chocolate cake gives more utility than the 7th piece.

Utility and price

  • One way to measure utility is to give the utility a monetary value.
  • For example, if I would pay £0.70 for a piece of cake, then we can say the utility is at least £0.70

How much to consume?

  • In the above example, if a piece of cake cost 70p, it would make sense to consume 2 pieces.
  • The first piece gives 100p of utility – which is greater than the price of 70p.
  • The second piece gives a utility equal to the price.
  • The third piece would give marginal utility of only 20 – which is less than the price of 70p


Consumer surplus

A Person’s Consumer Surplus from Petrol

This is the excess of what a consumer would have been prepared to pay compared to what they actually pay.

  • In the above diagram, at Q 500 litres, the MU is 80p > than the price = 50p. Therefore, a rational consumer will increase consumption of petrol, until the MU of petrol equals the price at 50p and a quantity of 800.
  • Marginal Consumer Surplus = The excess of a person’s total utility from the consumption of a good (MU) over the price paid: MCS = MU – P

Optimum level of consumption

For one good, the optimum level of consumption would be to consume a quantity of the good unto the point where MU = Price.

There’s no point paying 75p for cake if it only gives us 50p worth of utility.

Demand curve and Marginal Utility

Our demand curve is derived from our marginal utility.

If a good gives us more satisfaction, e.g. it becomes more fashionable, our MU and demand curve will shift to the right.

Choosing between different goods

In the real world, we are not just deciding how much of one good to buy. We are also deciding how to choose between different combinations of goods.

The Equi-Marginal principle in consumption states that consumers will maximise total utility from their incomes by consuming that combination of goods where:

MUa = Pa—–     —-MUb = Pb

For example, suppose bread = £1 and Chicken = £2.

  • Chicken is twice as expensive. Therefore, it would make sense to choose a quantity of chicken, where the marginal utility of chicken was twice the MU of bread.
  • Therefore, you would tend to buy less chicken to make sure the marginal utility of chicken justified its higher price.
  • If chicken was giving three times as much marginal utility but was only twice as expensive, it would make sense to buy more chicken until the marginal utility fell to that ratio.

Defining utility

  • Utilitarianism of Bentham and Mill – the accumulation of pleasure and subtraction of pain.
  • Cardinal utility – Neoclassical economists such as Alfred Marshall, Leon Walrus, and Carl Menger argued that utility could be measured in quantifiable measure (utils)
  • Ordinal utility – Hicks argued that consumers struggled to give definitive utils but could put different choices in order preferences. J.R. Hicks developed this theory of ordinal utility
  • Satisfaction of wants. Austrian school – Von Mises also argued it was harder to quantify utility. Satisfaction of wants could be measured to some extent but after that it was difficult.

Limitation of diminishing  marginal utility:

 

  1. Income, taste and habit:When income , taste and habit is changed then at that time consumer can get more satisfaction from additional unit.
  2. Time period:If there is very long time period interval between the consumption of different units of commodity at that time consumer may get more satisfaction from additional units.
  3. Rare collection:In the case of rare collection this law is not applicable because if a person has hobby to collect rare items like old stamp, coin, painting, etc then he/she gets more satisfaction from the collection of more commodity.
  4. Durable/ Individual goods:In the case of this goods this law is not applicable because consumer purchase this goo once at a time per personal use, as a result we can’t compare the marginal utility of different items.
  5. Abnormal man:In the case of abnormal man thislaw is not applicable for example druggist, drunker, gambler, mad man, etc get more satisfaction from the consumption of last unit.
  6. M.U of money remains constant:When one have high money its value is low but when there is less money its value is high but economics says that marginal utility of money remains constant so this law is not applicable.
  7. Utility can’t be measured in numbers:Utility is to be measured in rank i.e. high, low, satisfaction but can’t be expressed in numbers.


Indifference curves and budget lines

An indifference curve is a line showing all the combinations of two goods which give a consumer equal utility. In other words, the consumer would be indifferent to these different combinations.


indifference curve

Diminishing marginal utilityThe indifference curve is convex because of diminishing marginal utility. When you have a certain number of bananas – that is all you want to eat in a week. Extra bananas give very little utility, so you would give up a lot of bananas to get something else.



We can also show different indifference curves.

All choices on I2 give the same utility. But, it will be a higher net utility than indifference curve I1.

I4 gives the highest net utility. Basically, I4 would require higher income than I1.


Budget line

A budget line shows the combination of goods that can be afforded with your current income.

If an apple costs £1 and a banana £2, the above budget line shows all the combinations of the goods which can be bought with £40. For example:

  • 20 apples @ £1 and 10 bananas @£2
  • 10 apples @£1 and 15 bananas @£2


Optimal choice of goods for consumer

  • Given a budget line of B1, the consumer will maximize utility where the highest indifference curve is tangential to the budget line (20 apples, 10 bananas)
  • Given current income – IC2 is unobtainable.
  • IC3 is obtainable but gives less utility than the higher IC1
  • The optimal choice of goods, can also be shown with the equimarginal principle



Income-consumption curve

As income rises, you can afford to consume on higher indifference curves. This optimal choice will shift to the right. This we can plot consumption as income rises.


Impact of lower price

With a lower price of bananas (from £2 to £1.50), we can now afford more bananas with the same income. The budget line shifts to the right

With lower prices, we can now consume at a higher indifference curve of IC2, enabling more bananas and apples.

Income and substitution effect of a rise in price

When the price of a good rises. People buy less for two reasons

  1.  Income effect. This looks at the effect of a price increase on disposable income. If the price of a good increases, then consumers will have relatively lower disposable income. For example, if the price of petrol rises, consumers may not be able to afford to drive as much, leading to lower demand.
  2.  Substitution effect. This looks at the effect of a price increase compared to alternatives. If the price of petrol rises, then it is relatively cheaper to go by bus.


Income and substitution for a normal good 

  • A rise in price changes the budget line. You can now buy less of good Bananas. The budget curve shifts to B2
  • Consumption falls from point A to point C (fall in Quantity of bananas from Q3 to Q1

To find different substitution and income effects.

  • We draw a new budget line parallel to B2 but tangential to the first indifference curve.
  • Being tangential to first indifference curve it enables the consumer to obtain the same utility as before (as if there was no change in income.)
  • By focusing on B-3, we are examining the effect of price change – ignoring any income effect.
  • The change from A to B (Q3 to Q2) is purely due to the substitution effect and relative price change.

Income effect

  • However, income has fallen causing the consumer to choose from a lower indifference curve I2. The change due to income is therefore b to C (Q2 to Q1.)
  • In this case of a normal good, the income and substitution effect reinforce each other – both leading to lower demand.

Effect of rise in price for inferior good

  • The substitution effect (using parallel budget line of B-3) causes big fall from a to b.
  • However, the income effect leads to an increase in demand (Q1 to Q2)
  • Overall demand falls, but the substitution effect is partly offset by the income effect.
  • This is because when income falls, the decline in income causes us to buy more inferior goods because we can’t afford normal / luxury goods any more.


Giffen goods

A giffen good occurs when the income effect outweighs the substitution effect. This is quite rare, but it is theoretically possible for poor peasants who have a choice between expensive meat and cheap rice.A rise in price of rice, could make them eat more rice because the income effect means they no longer can afford to buy any meat.

economic systems

Markets enable mutually beneficial exchange betweenand systems that rely on markets to solve the economic problem are called In a free market economy, resources are allocated through the interaction of free and self-directed market forces. This means that what to produce is determined by how to produce is determined by

fill in the blanks in the questions that follow

economies that exclusively use central planning are called There is a third type of economy involving a combination of market forces and central planning, called

fill in the blanks in the questions that follow

An opportunity cost will usually arise whenever an economic agent chooses between alternative ways of allocating scarce resources. The opportunity cost of such a decision Any point on a PPF, such as points 'A' and 'B', is said to be efficient and indicates that an economy’s scarce resources are being fully employed. This is also called  

Carefully explain why a typical demand curve slopes downwards.

  • means a rational consumer will demand more of a commodity when its price falls
  • a consumer will demand less of a good when its price falls
  • a rational consumer will look for an extra product to increase his/her utility
  • the demand curve will continue to rise irregardless of changes in demand

Distinguish between normal and inferior goods.

  • Those goods whose demand rises with an increase in the consumer's income is called normal goods. Those goods whose demand decreases with an increase in consumer's income beyond a certain level is called inferior goods.
  • Those goods whose demand decreases with an increase in the consumers income is called normal goods and those goods whose demand increases with an increase in consumers income beyond a certain level are called inferior goods
  • Those goods whose demand decreases with a decrease in consumers income are normal goods.Those goods whose demand increases with an increase in consumer income are inferior goods

The following is a demand schedule for cheeseburgers for an individual.

  • Put your answer option here
  • Put your answer option here

Using an example of your own, distinguish between shifts of demand and movements along a demand curve.

What are the main underlying determinants of demand for the following:

study each scenario and describe how the demand curve will be affected by the changes in demand.

underlying determinants of demand

underlying determinants of demand