Economics
Economicsis the social
science that analyzes the production, distribution, and consumption of goods
and services. The term economics comes from the Ancient Greek “oikonomia”,
where ‘oikos’means "house" and ` nomos’ means “custom" or "law".
In this sense “oikonomia” means "management of a household, or "rules
of the house"
There are a variety of
modern definitions of economics. Some of the differences may reflect evolving
views of the subject or different views among economists.
Alfred Marshall provides a still widely-cited definition in his textbook
Principles of Economics (1890) that extends analysis beyond wealth and from the
societal to the macroeconomic level:
-----Economics is a study
of man in the ordinary business of life. It enquires how he gets his income and
how he uses it. Thus, it is on the one side, the study of wealth and on the
other and more important side, a part of the study of man.
Lionel Robbins (1932) developed implications of what has been termed "perhaps
the most commonly accepted current definition of the subject".
----Economics is a science
which studies human behaviour as a relationship between ends and scarce means
which have alternative uses.
Lastly we can say that, the theories,
principles, and models that deal with how the market process works. It
attemptsto explain how wealthis created and distributed in communities, how
people allocateresources that are scarce and have many alternative uses, and
other such matters that arise in dealing with human wants and their satisfaction.
Importance/objective
of economic
The Importance /advantages/
Objectives of the study of economics are as under:
(1) Intellectual Value:
The knowledge of Economics
is very useful as it broadens our outlook, sharpens our intellect, and
inculcates in us the habit of balanced thinking. The study of Economics makes
us realize that we as human beings are dependent upon one another for our daily
needs. This feeling creates in us the intelligent appreciation of our position
and the spirit of co-operation with others.
(2) Practical Advantages:
The practical advantages of
Economics are much more important than its theoretical advantages. These
advantages can be looked at from the individual and community point of view.
(3) Personal Stake in Economics:
From personal point of
view, the study of Economics is useful as it enables each of us to understand
better and appreciate more intelligently the nature and significance of our
money earning and money spending activities. With the knowledge of Economics, the
consumer can better adjust his expenditure to his income. The study of
Economics is also useful to a producer. It suggests him the ways of bringing
about the most economical combinations of the various factors of production at
his disposal. It also helps in solving the various intricacies of exchange.
From the study of Economics, one can easily judge as to why the prices have
risen or fallen. The knowledge of Economics also explains us as to how the
reward of various factors of production is determined. Thus, we find that
every’ individual can rightly hope to become a better and more efficient
consumer, producer and businessman, if he has the working knowledge of
economics.
(4) Economics for the Leader:
The study of economics is
not only helpful from the individual point of view but it is also very useful
for the welfare of the community. It enables a statesman to understand and
better grasp the economic and social problems facing the country. Every
government has to tackle different kinds of economic problems such as
unemployment, inflation, over production, under-production, imposition of
tariffs and control, problem of monopolies, etc. the statesman can successfully
solve these problems, if he has thorough knowledge of the subject of Economics.
The knowledge of Economics for a finance minister is also indispensable. He has
to raise revenue by imposing taxes on the incomes of the people for meeting the
necessary expenditure of the government. Economics here comes to his rescue and
guides him as to how the taxes could be levied and collected.
(5) Poverty and Development:
The greatest advantage of
Economics is that it helps in removing traces of poverty from the country. Take
the case of Pakistan; we in Pakistan are confronted with different kinds of problems.
For example, low-per capita income, low productivity of agriculture, slow
development of industries, fast increase in population, under-developed means
of communication and transport, etc. The study of Economics helps in devising
ways and means and suggesting practical measures in solving these problems.
(6) Economics for the citizen:
Such being, the importance
of study of Economics, it is rightly remarked by Wooten that “you cannot be in
real sense a citizen unless you are also in some degree an economist”. He is
perfectly right in giving the statement. The world is so fast changing that we
are completely now living in a world dominated by economic forces and economic
ideas. If the people of any country do not have the working knowledge of an economic
system; then the government of that country can easily hoodwink citizens have
knowledge of Economics, then the government will be very vigilant and spend the
money in a wise manner.
The importance of the study
of Economies can also be judged from this fact that the daily newspapers cannot
be understood without some knowledge of Economics. The newspapers often
describe complicated economic problems such as inflation, balance of payment,
balance of trade, imperfect markets, dumping, co-operative farming,
sub-division and fragmentation of holdings, mechanization of agriculture, If
you do not have working knowledge of Economics, you cannot understand these
diverse problems.
From brief discussion, we conclude, that the knowledge of Economics is very useful. As such it is necessary that every citizen, worker, administrator, consumer, etc., should have at least working knowledge of it. In the words of Sir Henry Clay:
“Some study of Economics is at one a
practical necessity and a normal obligation”.
Production: Production is the conversion of input into
output. The factors of production and all other things which the producer buys
to carry out production are called input. The goods and services produced are
known as output. Thus production is the activity that creates or adds utility
and value. In the words of Fraser, "If consuming means extracting utility
from matter, producing means creating utility into matter". According to
Edwood Buffa,
“Production is a process by which goods and
services are created"
What are the Factors of Production? As already stated, production is a process of
transformation of factors of production (input) into goods and services
(output). The factors of production may be defined as resources which help the
firms to produce goods or services. In other words, the resources required to
produce a given product are called factors of production. Production is done by
combining the various factors of production. Land, labor, capital and
organization (or entrepreneurship) is the factors of production (according to
Marshall).
We can use the word CELL to help us remember
the four factors of production: C- capital; E-Entrepreneurship; L- land: and L-
labor.
1. The ownership of the
factors of production is vested in the households.
2. There is a basic
distinction between factors of production and factor services. It is these
factor services, which are combined in the process of production.
3. The different units of a
factor of production are not homogeneous. For example, different plots of land
have different level of fertility. Similarly laborers’differ in efficiency.
4. Factors of production
are complementary. This means their co-operation or combination is necessary
for production.
5. There is some degree of substitutability
between factors of production. For example, labour can be substituted for
capital to a certain extent.
The firm is an organization
that combines and organizes labor, capital and land or raw materials for the
purpose of producing goods and services for sale. The aim of the firm is to
maximize total profits or achieve some other related aim, such as maximizing
sales or growth. The basic production decision facing the firm is how much of
the commodity or services to produce and how much labor, capital and other
resources or inputs to use to produce that output most efficiently. To answer
these questions, the firm requires engineering or technological data on
production possibilities (the so called production function) as well as
economic data on input and output prices.
Production refers to the
transformation of inputs or resources into outputs of goods and services. For
example: IBM hires workers to use machinery, parts and raw materials in
factories to produce personal computers. The output of a firm can either be a
final commodity (such as personal computer) or an intermediate product such as
semiconductors (which are used in the production of computers and other goods).
The output can also be a service rather than a good. Examples of services are
education, medicine, banking, communication, transportation and many others. To
be noted is, that production refers to all of the activities involved in the
production of goods and services, from borrowing to set up or expand production
facilities, to hiring workers, purchasing raw materials, running quality
control, cost accounting and so on, rather than referring merely to the
physical transformation of inputs into outputs of goods and services.
Inputs are the resources
used in the production of goods and services. As a convenient way to organize
the discussion, inputs are classified into labor. (Including entrepreneurial
talent), capital and land or natural resources. Each of these broad categories
however includes a great variety of the basic input. For example, labor
includes bus drivers, assembly line workers, accountants, lawyers, doctor’s
scientists and many others. Inputs are also classified as fixed or variable.
Fixed inputs are those that cannot be readily changed during the time period
under consideration, except at very great expense. Examples of fixed inputs are
the firm's plant and specialized equipment. On the other land, variable inputs
are those that can be varied easily and on the very short notice. Examples of
variable inputs are most raw materials and unskilled labor.
The time period during which at least one
input is fixed is called the short run, while the time period when all inputs
are variable is called the long run. The length of the long run depends on the
industry. For some, such as the setting up or expansion of a dry cleaning
business, the long run may be only few months or weeks. For others, much as the
construction of new electricity, generating plant, it may be many years. In the
short run, a firm can increase output only by using more of the variable inputs
together with the fixed inputs. In the long run, the same increase in output
could very likely be obtained more efficiently by also expanding the firm's
production facilities. Thus we say that the firm operates in the short run and
plans increases or reductions in its scale of operation in the long run. In the
long run, technology usually improves, so that more output can be obtained from
a given quantity of inputs or the same output from less input.
Production is the process
by which inputs are transformed in to outputs. Thus there is relation between
input and output. The functional relationship between input and output is known
as production function. The production function states the maximum quantity of
output which can be produced from any selected combination of inputs. In other
words, it states the minimum quantities of input that are necessary to produce
a given quantity of output.
The production function is
largely determined by the level of technology. The production function varies
with the changes in technology. Whenever technology improves, a new production
function comes into existence. Therefore, in the modern times the output
depends not only on traditional factors of production but also on the level of
technology.
The production function can
be expressed in an equation in which the output is the dependent variable and
inputs are the independent variables. The equation is expressed as follows:
Q= f (L, K, T……………n)
Where,
Q = output
L = labour
K = capital
T = level of technology
n = other inputs employed
in production.
There are two types of
production function - short run production function and long run production
function. In the short run production function the quantity of only one input
varies while all other inputs remain constant. In the long run production
function all inputs are variable.
Assumptions of Production
Function
The production function is
based on the following assumptions.
1. The level of technology
remains constant.
2. The firm uses its inputs
at maximum level of efficiency.
3. It relates to a
particular unit of time.
4. A change in any of the
variable factors produces a corresponding change in the output.
5. The inputs are divisible into most viable
units.
The production function is
of great help to a manager or business economist. The managerial uses of
production function are outlined as below:
1. It helps to determine
least cost factor combination: The production function
is a guide to the entrepreneur to determine the least cost factor combination.
Profit can be maximized only by minimizing the cost of production. In order to
minimize the cost of production, inputs are to be substituted. The production
function helps in substituting the inputs.
2. It helps to determine
optimum level of output: The production function
helps to determine the optimum level of output from a given quantity of input.
In other words, it helps to arrive at the producer's equilibrium.
3. It enables to plan the
production: The production function helps the
entrepreneur (or management) to plan the production.
4. It helps in decision-making: Production function is very useful to the management to take decisions
regarding cost and output. It also helps in cost control and cost reduction. In
short, production function helps both in the short run and long run
decision-making process.
Define Inflation: Inflation can be defined as a sustained or
continuous rise in the general price level or, alternatively, as a sustained or
continuous fall in the value of money.
Several things should be noted about this
definition. First, inflation refers to the movement in the general level of
prices. It does not refer to changes in one price relative to other prices.
These changes are common even when the overall level of prices is stable and
the rise in the price level must be somewhat substantial and continue over a
period longer than a day, week, or month.
Economists wake up in the
morning hoping for a chance to debate the causes of inflation. There is no one
cause that's universally agreed upon, but at least two theories are generally
accepted:
Demand-Pull Inflation
This theory can be
summarized as "too much money chasing too few goods". In other words,
if demand is growing faster than supply, prices will increase. This usually
occurs in growing economies.
Cost-Push Inflation
When companies' costs go up, they need to
increase prices to maintain their profit margins. Increased costs can include
things such as wages, taxes, or increased costs of imports.
Almost everyone thinks
inflation is evil, but it isn't necessarily so. Inflation affects different
people in different ways. It also depends on whether inflation is anticipated
or unanticipated. If the inflation rate corresponds to what the majority of
people are expecting (anticipated inflation), then we can compensate and the
cost isn't high. For example, banks can vary their interest rates and workers
can negotiate contracts that include automatic wage hikes as the price level
goes up.
Costs/ affects arise when there is unanticipated inflation:
1.
Creditors lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free
loan.
2.
Uncertainty about what will happen next makes corporations and consumers less
likely to spend. This hurts economic output in the long run.
3.
People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
4.
The entire economy must absorb repricing costs ("menu costs") as
price lists, labels, menus and more have to be updated.
5.
If the inflation rate is greater than that of other countries, domestic
products become less competitive.
People often complain about
prices going up, but they often ignore the fact that wages should be rising as
well. The question shouldn't be whether inflation is rising, but whether it's
rising at a quicker pace than your wages.
Lastly,
inflation is a sign that an economy is growing. In some situations, little
inflation (or even deflation) can be just as bad as high inflation. The lack of
inflation may be an indication that the economy is weakening. As you can see,
it's not so easy to label inflation as either good or bad - it depends on the
overall economy as well as your personal situation.
Money is any good that is
widely used and accepted in transactions involving the transfer of goods and
services from one person to another. Economists differentiate among three
different types of money: commodity money, fiat money, and bank money.
The functions of money
The function of money can be categorized in two classes. These
are-
A. Primary or main function
B. secondary or Supporting function
Primary or main function
Money is often defined in
terms of the four functions or services that it provides. Money serves as a
medium of exchange, as a Measure of Value, Standard of Deferred Payments and as
Store of Value.
1.
Medium of Exchange:
The most important function
of money is to serve as a medium of exchange or as a means of payment. To be a
successful medium of exchange, money must be commonly accepted by people in
exchange for goods and services. While functioning as a medium of exchange,
money benefits the society in a number of ways:
(a) It overcomes the
inconvenience of baiter system (i.e., the need for double coincidence of wants)
by splitting the act of barter into two acts of exchange, i.e., sales and
purchases through money.
(b) It promotes
transactional efficiency in exchange by facilitating the multiple exchange of
goods and services with minimum effort and time,
(c) It promotes allocation
efficiency by facilitating specialization in production and trade,
(d) It allows freedom of
choice in the sense that a person can use his money to buy the things he wants
most, from the people who offer the best bargain and at a time he considers the
most advantageous.
2.
Measure of Value:
Money serves as a common
measure of value in terms of which the value of all goods and services is measured
and expressed. By acting as a common denominator or numeraire, money has
provided a language of economic communication. It has made transactions easy
and simplified the problem of measuring and comparing the prices of goods and
services in the market. Prices are but values expressed in terms of money.
Money also acts as a unit
of account. As a unit of account, it helps in developing an efficient
accounting system because the values of a variety of goods and services which
are physically measured in different units (e.g, quintals, metres, litres,
etc.) can be added up. This makes possible the comparisons of various kinds,
both over time and across regions. It provides a basis for keeping accounts,
estimating national income, cost of a project, sale proceeds, profit and loss
of a firm, etc.
To be satisfactory measure
of value, the monetary units must be invariable. In other words, it must
maintain a stable value. A fluctuating monetary unit creates a number of
socio-economic problems. Normally, the value of money, i.e., its
purchasing power, does not remain constant; it rises during periods of falling
prices and falls during periods of rising prices.
3.
Standard of Deferred Payments:
When money is generally
accepted as a medium of exchange and a unit of value, it naturally becomes the
unit in terms of which deferred or future payments are stated.
Thus, money not only helps
current transactions though functions as a medium of exchange, but facilitates
credit transaction (i.e., exchanging present goods on credit) through its
function as a standard of deferred payments. But, to become a satisfactory
standard of deferred payments, money must maintain a constant value through
time ; if its value increases through time (i.e., during the period of falling
price level), it will benefit the creditors at the cost of debtors; if its
value falls (i.e., during the period of rising price level), it will benefit
the debtors at the cost of creditors.
4.
Store of Value:
Money, being a unit of
value and a generally acceptable means of payment, provides a liquid store of
value because it is so easy to spend and so easy to store. By acting as a store
of value, money provides security to the individuals to meet unpredictable
emergencies and to pay debts that are fixed in terms of money. It also provides
assurance that attractive future buying opportunities can be exploited.
Money as a liquid store of
value facilitates its possessor to purchase any other asset at any time. It was
Keynes who first fully realised the liquid store value of money function and
regarded money as a link between the present and the future. This, however,
does not mean that money is the most satisfactory liquid store of value. To
become a satisfactory store of value, money must have a stable value.
Secondary or Supporting
function
1.
Transfer of Value:
Money also functions as a
means of transferring value. Through money, value can be easily and quickly
transferred from one place to another because money is acceptable everywhere
and to all. For example, it is much easier to transfer one lakh rupees through
bank draft from person A in Amritsar to person B in Bombay than remitting the
same value in commodity terms, say wheat.
2.
Distribution of National Income:
Money facilitates the
division of national income between people. Total output of the country is
jointly produced by a number of people as workers, land owners, capitalists,
and entrepreneurs, and, in turn, will have to be distributed among them. Money
helps in the distribution of national product through the system of wage, rent,
interest and profit.
3.
Maximization of Satisfaction:
Money helps consumers and
producers to maximize their benefits. A consumer maximizes his satisfaction by
equating the prices of each commodity (expressed in terms of money) with its
marginal utility. Similarly, a producer maximizes his profit by equating the
marginal productivity of a factor unit to its price.
4.
Basis of Credit System:
Credit plays an important
role in the modern economic system and money constitutes the basis of credit.
People deposit their money (saving) in the banks and on the basis of these
deposits, the banks create credit.
5.
Liquidity to Wealth:
Money imparts liquidity to various forms of
wealth. When a person holds wealth in the form of money, he makes it liquid. In
fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be
converted into money.
Unemployment occurs when
people are without work and actively seeking work.
According to the ILO
guidelines, a person is unemployed if the person is (a) not working, (b)
Currently available for work and (c) seeking work. Here a person is to be
considered unemployed if he/she during the reference period simultaneously
satisfies being:
(a)‘Without work’, i.e.,
were not in paid employment or self-employment as specified by the
international definition
(b)‘Currently available for
work’, i.e., were available for paid employment or self-employment during the
reference period; and
(c)‘Seeking work’, i.e.,
had taken specific steps in a specified recent period to seek paid employment
or self-employment.
In the words of Fairchild,
“unemployment is forced and involuntary separation from remunerative work on
the part of the normal wages and normal conditions.”
According to Sergeant
Florence, “unemployment has been defined as the idleness of persons able to
work.”
Lastly we can say that When a person is
failed to get any job and unable to found the means of livelihood, we call him
an unemployed person. Thus, unemployment means lack of absence of employment.
In other word unemployment is largely concerned with those persons who
constitute the labor force of the country, who are able bodied and willing to
work, but they are gainfully employed. Unemployment, therefore, is the lack of
earning or idleness on the part of a person who is able to work.
As unemployment is a
universal problem and is found in every country more or less, therefore, it is
categorised into a number of types. The chief among them are stated below:
1) Structural unemployment:
Basically Bangladesh's
unemployment is structural in nature. It is associated with the inadequacy of
productive capacity to create enough jobs for all those able and willing to
work. In Bangladesh not only the productive capacity much below the needed
quantity, it is also found increasing at a slow rate. As against this, addition
to labour force is being made at a first rate on account of the rapidly growing
population. Thus, while new productive jobs are on the increase, the rate of
increasing being low the absolute number of unemployed persons is rising from
year to year.
2) Disguised unemployment:
Disguised unemployment
implies that many workers are engaged in productive work. For example, in
Indian villages, where most of unemployment exists in this form, people are
found to be apparently engaged in agricultural works. But such employment is
mostly a work sharing device i.e., the existing work is shared by the large
number of workers. In such a situation, even if many workers are withdrawn, the
same work will continue to be done by fewer people.
It follows that all the
workers arte not needed to maintain the existing level of production. The
contribution of such workers to production is nothing. It is found that the
very large numbers of workers on Indian farms actually hinder agricultural
works and thereby reduce production.
3) Cyclical unemployment:
Cyclical unemployment in
caused by the trade or business cycles. It results from the profits and loss
and fluctuations in the deficiency of effective demand production is slowed
down and there is a general state of depression which causes unemployment
periods of cyclical unemployment is longer and it generally affects all
industries to a greater or smaller extent.
4) Seasonal unemployment:
Seasonal unemployment
occurs at certain seasons of the year. It is a widespread phenomenon of Indian
villages basically associated with agriculture. Since agricultural work depends
upon Nature, therefore, in a certain period of the year there is heavy work,
while in the rest, the work is lean. For example, in the sowing and harvesting
period, the agriculturists may to engage themselves day and night.
But the period between the
post harvest and pre sowing is almost workless, rendering many without work.
Thus, seasonal unemployment is largely visible after the end of agricultural
works.
5) Underemployment:
Underemployment usually
refers to that state in which the self employed working people are not working
according to their capacity. For example, a diploma holder in engineering, if
for wants of an appropriate job, start any business may be said to be
underemployed. Apparently, he may be deemed as working and earning in a
productive activity and in this sense contributing something to production.
But in reality he is not
working to his capability, or to his full capacity. He is, therefore, not full
employed. This type of unemployment is mostly visible in urban areas.
6) Open Unemployment:
Open unemployment is a
condition in which people have no work to do. They are able to work and are
also willing to work but there is no work for them. They are found partly in
villages, but very largely in cities. Most of them come form villages in search
of jobs, many originate in cities themselves. Such employment can be seen and
counted in terms of the number of such persons.
Hence it is called upon
unemployment. Open unemployment is to be distinguished from disguised
unemployment and underemployment in that while in the case of former
unemployment workers are totally idle, but in the latter two types of
unemployment they appear to be working and do not seem to be away their time.
7) Voluntary Unemployment:
Voluntary unemployment
occurs when a working persons willingly withdraws himself from work. This type
of unemployment may be caused due to a number of reasons. For example, one may
quarrel with the employer and resign or one may have permanent source of
unearned income, absentee workers, and strikers and so on. In voluntary
unemployment, a person is out of job of his own desire. She does not work on
the prevalent or prescribed wages. Either he wants higher wages or does not
want to work at all.
8) Involuntary
unemployment:
Involuntary unemployment occurs when at a
particular time the number of worker is more than the number of jobs. Obviously
this state of affairs arises because of the insufficiency or non availability
of work. It is customary to characterise involuntary unemployment, not
voluntary as unemployment proper.
Ways and means to remove
unemployment in Society of Bangladesh removal of unemployment is the
responsibility of the state. The Constitutional of Bangladesh has the
“Directive Principles” of the State and enjoined this duty on the State
Government.
In Society we have already
seen that there is a good deal of unemployment. This removal of unemployment is
necessary for the prosperity of the nation. For this, the following steps have
to be taken:
1) Improvement in the
agricultural system:
We have already seen that
the agricultural system in Bangladesh is backward and underdeveloped. This
backwardness is responsible for a lot of unemployment. If the unemployment has
to removed, the system of agriculture has to be modernized and improved, for
this the following steps to be taken:
1) Holding should be consolidated and made
economic.
2)Methods of agriculture should be improved and
as far as possible farmers should be freed from dependence on nature.
3) System of crops should be planned
scientifically and improved. If more crops earned they would provide more
employment.
4) The farmers should be provided with good
seed, good fertilizer, healthy animals, modern implements and tools etc.
2) Adequate arrangement of
facilities of irrigation:
In villages the agriculture
very much depends on nature. If rains fail, the crops are destroyed. This
brings about a good deal of unemployment. Methods of irrigation should be made
more modern. They should also be adequate so that it may be possible for people
to water their fields.
3) Increasing the area of
cultivable land:
To day in the villages
there is a great pressure on land. The area under cultivation is not sufficient
to provide food to all the people of this country. Barren land should be broken
and made fertile. Other methods should also be made for improving the area of
cultivable land which is not normally fit for agriculture, also be improved and
made fit. This would remove unemployment in the villages.
4) Setting up and develop
the cottage and village industries:
In village, people have
seasonal employment in agriculture. Apart from it all the persons do not have
avenues for the employment. What is needed is to set up of industries so that
those who do not have land are employed in it. Apart from it, the
agriculturalists during dull season should get employment in these industries.
Women and land less laborers shall also be able to get employment if industries
are set up.
5) Improving the means of
transport and communication:
In villages there is need
to have proper roads and places where offices and stores for seeds etc, may be
set up. Public construction should be undertaken in the villages to provide
employment to the idle hands. This would improve the employment position in the
village. Apart from it, it would also add to the prosperity of the villages.
6) Construction of public
Transports, Roads etc:
It is necessary to improve
the means of transport and communication. This would have two fold advantages.
Firstly, the village people shall be able to send their products to markets for
sale and secondly, they shall also be able to go to such other places where
they can get employment. Apart from it, this would also provide employment to
many persons who shall engage themselves in the task of transporting these
people.
7) Organization of the
agricultural market:
There is need to organize
markets for the agricultural product. At present, there is dearth of such
market. This situation creates difficulties for the agriculturalists. On the one
hand, they are not able to get proper price and on the other hand they have to
suffer from other handicaps. If markets are organized, they would provide
employment to certain hands and also help the agriculturalists to get proper
price for their labor.
In fact Bangladesh is such a vast country and
unemployment is so large that “Herculean” efforts shall have to be made to
surmount this degree. Various economists and social thinkers have suggested
various ways for it. Many of these ways have also been incorporated in the Five
Year Plans. In spite of these Five Year Plans employment position is far from
satisfactory.
There are three main
factors that influence a demand’s price elasticity:
1. The availability of
substitutes
This is probably the most
important factor influencing the elasticity of a good or service. In general,
the more substitutes, the more elastic the demand will be. For example, if the
price of a cup of coffee went up by $0.25, consumers could replace their
morning caffeine with a cup of tea. This means that coffee is an elastic good
because a raise in price will cause a large decrease in demand as consumers start
buying more tea instead of coffee.
However, if the price of
caffeine were to go up as a whole, we would probably see little change in the
consumption of coffee or tea because there are few substitutes for caffeine.
Most people are not willing to give up their morning cup of caffeine no matter
what the price. We would, therefore, say that caffeine is an inelastic product
because of its lack of substitutes. Thus, while a product within an industry is
elastic due to the availability of substitutes, the industry itself tends to be
inelastic. Usually, unique goods such as diamonds are inelastic because they
have few - if any - substitutes.
2. Amount of income
available to spend on the good
This factor affecting
demand elasticity refers to the total a person can spend on a particular good
or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and
income stays the same, the income that is available to spend on Coke, which is
$2, is now enough for only two rather than four cans of Coke. In other words,
the consumer is forced to reduce his or her demand of Coke. Thus if there is an
increase in price and no change in the amount of income available to spend on
the good, there will be an elastic reaction in demand: demand will be sensitive
to a change in price if there is no change in income.
3. Time
The third influential factor is time. If the
price of cigarettes goes up $2 per pack, a smoker, with very little available
substitutes, will most likely continue buying his or her daily cigarettes. This
means that tobacco is inelastic because the change in the quantity demand will
have been minor with a change in price. However, if that smoker finds that he
or she cannot afford to spend the extra $2 per day and begins to kick the habit
over a period of time, the price elasticity of cigarettes for that consumer
becomes elastic in the long run.
Sometimes a country or an individual can
produce more than another country, even though countries both have the same
amount of inputs. For example, Country A may have a technological advantage
that, with the same amount of inputs (arable land, steel, labor), enables the
country to manufacture more of both cars and cotton than Country B. A country
that can produce more of both goods is said to have an absolute advantage.
Better quality resources can give a country an absolute advantage as can a
higher level of education and overall technological advancement. It is not
possible, however, for a country to have a comparative advantage in everything
that it produces, so it will always be able to benefit from trade.
An economy can focus on
producing all of the goods and services it needs to function, but this may lead
to an inefficient allocation of resources and hinder future growth. By using
specialization, a country can concentrate on the production of one thing that
it can do best, rather than dividing up its resources. For example, let's look
at a hypothetical world that has only two countries (Country A and Country B)
and two products (cars and cotton).
Each country can make cars
and/or cotton. Now suppose that Country A has very little fertile land and an
abundance of steel for car production. Country B, on the other hand, has an
abundance of fertile land but very little steel. If Country A were to try to
produce both cars and cotton, it would need to divide up its resources. Because
it requires a lot of effort to produce cotton by irrigating the land, Country A
would have to sacrifice producing cars. The opportunity cost of producing both
cars and cotton is high for Country A, which will have to give up a lot of
capital in order to produce both.
Similarly, for Country B,
the opportunity cost of producing both products is high because the effort
required to produce cars is greater than that of producing cotton. Each country
can produce one of the products more efficiently (at a lower cost) than the
other. Country A, which has an abundance of steel, would need to give up more
cars than Country B would to produce the same amount of cotton. Country B would
need to give up more cotton than Country A to produce the same amount of cars.
Therefore, County A has a comparative advantage over Country B in the
production of cars, and Country B has a comparative advantage over Country A in
the production of cotton.
Now let's say that both
countries (A and B) specialize in producing the goods with which they have a
comparative advantage. If they trade the goods that they produce for other
goods in which they don't have a comparative advantage, both countries will be
able to enjoy both products at a lower opportunity cost.
Furthermore, each country will be exchanging
the best product it can make for another good or service that is the best that
the other country can produce. Specialization and trade also works when several
different countries are involved. For example, if Country C specializes in the
production of corn, it can trade its corn for cars from Country A and cotton
from Country B. Determining how countries exchange goods produced by a
comparative advantage ("the best for the best") is the backbone of
international trade theory. This method of exchange is considered an optimal
allocation of resources, whereby economies, in theory, will no longer be
lacking anything that they need. Like opportunity cost, specialization and
comparative advantage also apply to the way in which individuals interact
within an economy.
Some earlier economists
defined Economics as follows:
According to Adam Smith-
“Economics is an inquiry into the nature and causes of the wealth of the
nations.’’
According to J.B. Say-“Economics
is a science which deals with wealth"
In the above definition
wealth becomes the main focus of the study of Economics. The definition of
Economics, as science of wealth, had some merits. The important ones are:
(i) It highlighted an
important problem faced by each and every nation of the world, namely creation
of wealth.
(ii) Since the problems of
poverty, unemployment etc. can be solved to a greater extent when wealth is
produced and is distributed equitably; it goes to the credit of Adam Smith and
his followers to have addressed to the problems of economic growth and increase
in the production of wealth.
The study of Economics as a
'Science of Wealth' has been criticized on several grounds. The main criticisms
leveled against this definition are;
(i) Adam Smith and other
classical economists concentrated only on material wealth. They totally ignored
creation of immaterial wealth like services of doctors, chartered accountants
etc.
(ii) The advocates of Economics as 'science
of wealth' concentrated too much on the production of wealth and ignored social
welfare. This makes their definition incomplete and inadequate. So it is very
critical to say that economics is a science of wealth or not.
i) Economics is a Positive
Science:
As stated above, Economics
is a science. But the question arises whether it is a positive science or a
normative science. A positive or pure science analyses cause and effect
relationship between variables but it does not pass value judgment. In other
words, it states what is and not what ought to be. Professor Robbins emphasized
the positive aspects of science but Marshall and Pigou have considered the
ethical aspects of science which obviously are normative.
According to Robbins,
Economics is concerned only with the study of the economic decisions of
individuals and the society as positive facts but not with the ethics of these
decisions. Economics should be neutral between ends. It is not for economists
to pass value judgments and make pronouncements on the goodness or otherwise of
human decisions. An individual with a limited amount of money may use it for
buying liquor and not milk, but that is entirely his business. A community may
use its limited resources for making guns rather than butter, but it is no
concern of the economists to condemn or appreciate this policy. Economics only
studies facts and makes generalizations from them. It is a pure and positive
science, which excludes from its scope the normative aspect of human behavior.
Complete neutrality between
ends is, however, neither feasible nor desirable. It is because in many matters
the economist has to suggest measures for achieving certain socially desirable
ends. For example, when he suggests the adoption of certain policies for
increasing employment and raising the rates of wages, he is making value
judgments; or that the exploitation of labour and the state of unemployment are
bad and steps should be taken to remove them. Similarly, when he states that
the limited resources of the economy should not be used in the way they are
being used and should be used in a different way; that the choice between ends
is wrong and should be altered, etc. he is making value judgments.
(ii) Economics is a
Normative Science:
As normative science,
Economics involves value judgments. It is prescriptive in nature and described
'what should be the things'. For example, the questions like what should be the
level of national income, what should be the wage rate, how the fruits of national
product be distributed among people - all fall within the scope of normative
science. Thus, normative economics is concerned with welfare propositions.
Some economists are of the view that value
judgments by different individuals will be different and thus for deriving laws
or theories, it should not be used.
Under this, we generally
discuss whether Economics is science or art or both and if it is a science
whether it is a positive science or a normative science or both. Often a
question arises - whether Economics is a science or an art or both.
(a) Economics is as science:
A subject is considered
science if
->It is a systematized
body of knowledge which studies the relationship between cause and effect.
It is capable of
measurement.
It has its own
methodological apparatus.
It should have the ability
to forecast.
If we analyse Economics, we
find that it has all the features of science. Like science it studies cause and
effect relationship between economic phenomena. To understand, let us take the
law of demand. It explains the cause and effect relationship between price and
demand for a commodity. It says, given other things constant, as price rises,
the demand for a commodity falls and vice versa. Here the cause is price and
the effect is fall in quantity demanded. Similarly like science it is capable
of being measured, the measurement is in terms of money. It has its own
methodology of study (induction and deduction) and it forecasts the future
market condition with the help of various statistical and non-statistical
tools.
But it is to be noted that
Economics is not a perfect science. This is because Economists do not have
uniform opinion about a particular event.
The subject matter of
Economics is the economic behavior of man which is highly unpredictable. Money
which is used to measure outcomes in Economics is itself a dependent variable.
It is not possible to make correct predictions about the behavior of economic
variables.
(b) Economics is as an art:
Art is nothing but practice
of knowledge. Whereas science teaches us to know art teaches us to do. Unlike
science which is theoretical, art is practical. If we analyse Economics, we
find that it has the features of an art also. Its various branches,
consumption, production, public finance, etc. provide practical solutions to
various economic problems. It helps in solving various economic problems which
we face in our day-to-day life.
Thus, Economics is both a science and an art.
It is science in its methodology and art in its application. Study of
unemployment problem is science but framing suitable policies for reducing the
extent of unemployment is an art.
Although the fundamental
economic problem of scarcity in relation to needs is undisputed it would not be
proper to think that economic resources - physical, human, financial are fixed
and cannot be increased by human ingenuity, exploration, exploitation and
development. A modern and somewhat modified definition is as follows:
"Economics is the
study of how men and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to
produce various commodities over time and distribute them for consumption now
and in the future amongst various people and groups of society".
-Paul A. Samuelson
The above definition is very comprehensive
because it does not restrict to material well-being or money measure as a
limiting factor. But it considers economic growth over time.
Robbinsgave a more scientific definition of Economics. His definition is
as follows:
"Economics is the
science which studies human behavior as a relationship between ends and scarce
means which have alternative uses".
Strengths of Robbins
Definitions
The definition deals with
the following four aspects:
(i) Economics is a science:
Economics studies economic human behavior
scientifically. It studies how humans try to optimize (maximize or minimize)
certain objective under given constraints. For example, it studies how
consumers, with given income and prices of the commodities, try to maximize
their satisfaction.
(ii) Unlimited ends: Ends refer to wants. Human wants are unlimited. When one want is
satisfied, other wants crop up. If man's wants were limited, then there would
be no economic problem.
(iii) Scarce means: Means refer to resources. Since resources (natural productive
resources, man-made capital goods, consumer goods, money and time etc.) are
limited economic problem arises. If the resources were unlimited, people would
be able to satisfy all their wants and there would be no problem.
(iv) Alternative uses: Not only resources are scarce, they have alternative uses. For
example, coal can be used as a fuel for the production of industrial goods, it
can be used for running trains, it can also be used for domestic cooking purposes
and for so many purposes. Similarly, financial resources can be used for many
purposes. The man or society has, therefore, to choose the uses for which
resources would be used. If there was only a single use of the resource then
the economic problem would not arise.
It follows from the
definition of Robbins that Economics is a science of choice. An important thing
about Robbin's definition is that it does not distinguish between material and
non-material, between welfare and non-welfare. Anything which satisfies the
wants of the people would be studied in Economics. Even if a good is harmful to
a person it would be studied in Economics if it satisfies his wants.
Criticism of Robbins
Definition:
No doubt, Robbins has made
Economics a scientific study and his definition has become popular among some
economists. But his definition has also been criticized on several grounds.
Important ones are:
(i)Robbins has made
Economics quite impersonal and colorless. By making it a complete positive
science and excluding normative aspects he has narrowed down its scope.
(ii)Robbins' definition is
totally silent about certain macro-economic aspects such as determination of
national income and employment.
(iii)His definition does not cover the theory
of economic growth and development. While Robbins takes resources as given and
talks about their allocation, it is totally silent about the measures to be
taken to raise these resources i.e. national income and wealth.
Some economists defined
Economics as a material well-being. Under this group of definitions the
emphasis is on welfare as compared with wealth in the earlier group. Two
important definitions are as follows:
"Economics is a study
of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the
attainment and with the use of the material requisites of well-being. Thus, it
is on the one side a study of wealth and on the other and more important side a
part of the study of the man",
-Alfred Marshall
"The range of our
inquiry becomes restricted to that part of social welfare that can be brought
directly or indirectly into relation with the measuring rod of money"
-A.C. Pigou.
In the first definition
Economics has been indicated to be a study of mankind in the ordinary business
of life. By ordinary business we mean those activities which occupy
considerable part of human effort. The fulfillment of economic needs is a very
important business which every man ordinarily does. Professor Marshall has
clearly pointed that Economics is the study of wealth but more important is the
study of man. Thus, man gets precedence over wealth. There is also emphasis on
material requisites of well-being. Obviously, the material things like food,
clothing and shelter, are very important economic objectives.
The second definition by
Pigou emphasizes social welfare but only that part of it which can be related
with the measuring rod of money. Money is general measure of purchasing power
by the use of which the science of Economics can be rendered more precise.
Marshall's and Pigou's
definitions of Economics are wider and more comprehensive as they take into
account the aspect of social welfare. But their definitions have their share of
criticism. Their definitions are criticized on the following grounds.
(i)Economics is concerned
with not only material things but also with immaterial things like services of
singers, teachers, actors etc. Marshall and Pigou chose to ignore them.
(ii)Robbins criticized the welfare definition
on the ground that it is very difficult to state which things would lead to
welfare and which will not. He is of the view that we would study in Economics
all those goods and services which carry a price whether they promote welfare
or not.
Monopoly
One firm
Complete barrier to entry
Total control over price
One product
Oligopoly
2-3 firms
High barrier to entry
Control majority of output
Similar/identical products
Monopolistic Competition
Many Firms
Few artificial barriers to
entry
Slight control over price
Differentiated products
Perfect (Pure) Competition
Many Buyers and Sellers
Identical Products
Informed Buyers and Sellers
Free Market Entry and Exit
Consumer Income
Income goes up; consumers
will buy more shifting demand to the right. Goes down, consumers will buy less
shifting demand to the left.
Consumer Expectations
If consumers think prices, for economy,
technology, etc., will change in the future this will have an effect on their
consumption of today.
Population
Population increases the number of consumers
and can shift demand to the right. Decreases shift to the left.
Consumer Tastes and Advertising
Consumer’s change over time the things that
they want. As they change their tastes, their demand shifts to the right or the
left.
Price of Related Goods
Complementary and Substitute items can have
an effect on what consumers will purchase and increase the demand for products.
Effects of Rising Costs
Input costs can have a major effect on the
production and supply of goods and services. Gas prices can limit the services
of a landscaper or paper delivery person.
Technology
Increases in the ability to
produce because of technological advances can shift the supply curve to the
right. Breakdowns in technology can shift it to the left.
Subsidies
Government payments to
firms can act as an incentive to produce more, which can affect supply. If
government removes subsidies the curve will shift left.
Taxes
Government taxation towards
firms can act as an incentive to produce, which can affect supply. If
government removes taxes the curve will shift left, increases shift right.
Future Expectations
How suppliers view the
future of the economy will affect their production of inventory today. If they
think the economy is strong they will increase production today and Vice versa.
Number of Suppliers
Firms increase whenever their profit is to be
made. They decrease whenever profit is reduced. Both will shift the curve to
the right or the left.
There are various concepts of
national income
Gross National Product
(GNP)
Gross national product is
defined as the total market value of all final goods and services produced in a
year. GNP includes four types of final goods and services, (i) Consumer goods
and services to satisfy the immediate wants of the people (ii) gross private
domestic investment on capital goods consisting of fixed capital formation,
residential constructions and inventories of finished and unfinished goods,
(iii) goods and services produced by government and (ir) net export of goods
and services'
GNP = government production
+ private output
Net National Product (NNP)
The second concept is Net
National Product. The capital goods like machinery wear out as a result of
continuous use. This is called depreciation. This is also called National
income at market prices. Hence NNP = GNP - depreciation.
National Income at factor
cost
National income at factor
cost denotes the sum of all incomes earner by the factors. GNP at factor cost
is the sum of the money value of the income produced by and accruing to the
various factors of production in one year in a country. It includes all items
of GNP less indirect tax. GNP at market price is always more than GNP at factor
cost as GNP at factor cost is the income which the factors of production
receive in return for their service alone.
National income at factor
cost = net national product - indirect taxes + subsidies.
Personal Income (PI)
Personal income is the sum
of all incomes received by all individuals during a given year. Some incomes
such as Social security contribution are not received by individuals; similarly
some incomes such as transfer payments are not currently earned, for example
Old Age Pension. Therefore,
Personal income = national income - social
security contribution - Corporate income taxes - undistributed corporate profit
+ transfer payment.
When supply and demand are
equal (i.e. when the supply function and demand function intersect) the economy
is said to be at equilibrium. At this point, the allocation of goods is at its
most efficient because the amount of goods being supplied is exactly the same
as the amount of goods being demanded.
Thus, everyone
(individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they
have produced and consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium
occurs at the intersection of the demand and supply curve, which indicates no a
locative inefficiency. At this point, the price of the goods will be P*and
the quantity will be Q*. These figures are referred to as equilibrium
price and quantity. In the real market place equilibrium can only ever be
reached in theory, so the prices of goods and services are constantly changing
in relation to fluctuations in demand and supply.
Studies of the linkage
between foreign direct investment and development have produced con-fusing and
sometimes contradictory results. Some have shown that foreign direct investment
(FDI) spurs economic growth in the host countries; others show no such effect.
Some find spill-over benefits to the host economy—that is, benefits not
appropriated by investors or in the form of superior wages—while others do not
discern these benefits.
For years, it has been
unclear whether developing countries benefit from devoting substantial
resources to attracting FDI. A government authority in a developing country
might, for example, grant a subsidy to a foreign-invested project if it
believed that the project would produce positive externalities or spillovers.
These could include managerial and worker training, technological learning that
is transferred outside the firm, an increase in supplier efficiency, and
demonstration effects through which the success of one investor persuades
others to invest in the host country. Yet it has proved extremely difficult to
measure such effects.
FDI that is integrated into
the global supply network of parent multinationals tends to be particularly
potent for host country development, while FDI oriented toward protected
domestic markets and hampered by joint venture and domestic content
requirements is not beneficial.
FDI produces different
results in different host countries, the economist offers guidance to
policymakers in both developing and developed countries on ways to ensure that
FDI aids rather than impedes development:
In countries with protected
and distorted economies, FDI is harmful to economic welfare.
Where there is little FDI,
the harm is little. Where FDI is large, however, the adverse effect on economic
welfare is also large. Conversely, in countries with low barriers to trade and
few restrictions on operations, foreign firms can increase the efficiency of
existing economic activity and introduce new activities with strongly favorable
effects on host country development. Consequently, host governments should
adopt open trade and investment policies.
Developing country hosts
should prohibit domestic content, joint venture, or technology sharing
requirements on foreign investment.
Such requirements neither
increase the efficiency of local producers nor produce host country growth. To
the contrary, such provisions interrupt intrafirm trade, which is a potent
source of host country growth, and lead to inefficient production processes,
outdated technology, and waste of host country resources.
Host countries should avoid
competing to give the best tax incentives to foreign investors.
Available resources for
promoting investment are better spent on improving local infrastructure, the
supply of information to investors, and education and training that benefits
foreign and local firms alike.
Developed countries should
back only FDI that promotes the economic welfare of developing country hosts.
Most national political risk insurance
agencies do not screen projects to eliminate those that require trade
protection. Such FDI hurts rather than helps hosts countries. Neither are
taxpayers in developed countries served by FDI projects that lower developing
country welfare and impede trade expansion. Thus these agencies should assess
the degree to which an FDI project promotes host country welfare as a criterion
for agreeing to insure it.
Opportunity cost is the
cost of any activity measured in terms of the value of the next best
alternative that is not chosen. It is the sacrifice related to the second best
choice available to someone, or group, who has picked among several mutually
exclusive choices.
The opportunity cost is a
key concept in economics, and has been described as expressing "the basic
relationship between scarcity and choice".
Example: The
difference in return between a chosen investment and one that is necessarily
passed up. Say you invest in a stock and it returns a paltry 2% over the year.
In placing your money in the stock, you gave up the opportunity of another
investment - say, a risk-free government bond yielding 6%. In this situation,
your opportunity costs are 4% (6% - 2%).
Scarcity is the fundamental economic problem that arises because
people have unlimited wants but resources are limited. Because of scarcity,
various economic decisions must be made to allocate resources efficiently.
Scarcity states that society has
insufficient productive resources to fulfill all human wants and needs.
Alternatively, scarcity implies that not all of society's goals can be pursued
at the same time; trade-offs are made of one good against others. In an
influential 1932 essay, Lionel Robbins defined economics as "the science
which studies human behavior as a relationship between ends and scarce means
which have alternative uses."
Cross Price Elasticity of
Demand refers to the percentage change in the quantity demanded of a given
product due to the percentage change in the price of another
"related" product. If all prices are allowed to vary, the quantity
demanded of product X is dependent not only on its own price (see elasticity of
demand) but upon the prices of other products as well. The concept of cross
price elasticity of demand is used to classify whether or not products are
"substitutes" or "complements". It is also used in market
definition to group products that are likely to compete with one another.
If an increase in the price
of product Y results in an increase in the quantity demanded of X (while the
price of X is held constant), then products X and Y are viewed as being
substitutes. For example, such may be the case of electricity vs. natural gas
used in home heating or consumption of pork vs. beef. The cross price
elasticity measure is a positive number varying from zero (no substitutes) to
any positive number. Generally speaking, a number exceeding two would indicate
the relevant products being "close" substitutes.
If the increase in price of Y results in a
decrease in the quantity demanded of product X (while the price of X is held
constant), then the products X and Y are considered complements. Such may be
the case with shoes and shoe laces.
The ability of a firm (or
group of firms) to raise and maintain price above the level that would prevail
under competition is referred to as market or monopoly power. The exercise of
market power leads to reduced output and loss of economic welfare.
Although a precise economic definition of
market power can be put forward, the actual measurement of market power is not
straightforward. One approach that has been suggested is the Lerner Index,
i.e., the extent to which price exceeds marginal cost. However, since marginal
cost is not easy to measure empirically, an alternative is to substitute
average variable cost. Another approach is to measure the price elasticity of
demand facing an individual firm since it is related to the firm’s price-cost
(profit) margin and its ability to increase price. However, this measure is
also difficult to compute. The actual or potential exercise of market power is
used to determine whether or not substantial lessening of competition exists or
is likely to occur.
The quantity demanded of a
particular product depends not only on its own price and on the price of other
related products, but also on other factors such as income. The purchases of
certain commodities may be particularly sensitive to changes in nominal and
real income. The concept of income elasticity of demand therefore measures the
percentage change in quantity demanded of a given product due to a percentage
change in income.
The measures of income elasticity of demand
may be either positive or negative numbers and these have been used to classify
products into "normal" or "inferior goods" or into
"necessities" or "luxuries". If as a result of an increase
in income the quantity demanded of a particular product decreases, it would be
classified as an "inferior" good. The opposite would be the case of a
"normal" good. Margarine has in past studies been found to have a negative
income elasticity of demand indicating that as family income increases, its
consumption decreases possibly due to substitution of butter.
Price discrimination occurs
when customers in different market segments are charged different prices for
the same good or service, for reasons unrelated to costs. Price discrimination
is effective only if customers cannot profitably re-sell the goods or services
to other customers. Price discrimination can take many forms, including setting
different prices for different age groups, different geographical locations,
and different types of users (such as residential vs. commercial users of
electricity).
Where sub-markets can be
identified and segmented then it can be shown that firms will find it
profitable to set higher prices in markets where demand is less elastic. This
can result in higher total output, a pro-competitive effect.
Price discrimination can
also have anti-competitive consequences. For example, dominant firms may lower
prices in particular markets in order to eliminate vigorous local competitors.
However, there is considerable debate as to whether price discrimination is
really a means of restricting competition.
Price discrimination is also relevant in
regulated industries where it is common to charge different prices at different
time periods (peak load pricing) or to charge lower prices for high volume
users (block pricing).
Public goods are those
which cannot be provided to one group of consumers, without being provided to
any other consumers who desire them. Thus they are “non-excludable.” Examples
include radio and television broadcasts, the services of a lighthouse, national
security, and a clean environment. Private markets typically under invest in
the provision of public goods, since it’s very difficult to collect revenue
from their consumers.
More broadly, public goods can refer to any goods
or services provided by government as a result of an inability of the private
sector to supply those products in acceptable quantity, quality, or
accessibility.
Gross
domestic product (GDP) is the market
value of all final goods and services
produced within a country in a given period of time. GDP per capita is
often considered an indicator of a country's standard of living. GDP is usually calculated on an annual basis. It
includes all of private and public consumption, government outlays, investments
and exports less imports that occur within a country.
The short formula of GDP
calculating-
GDP
= C + G + I + NX
Where:
"C" is
equal to all private consumption, or consumer spending, in a nation's economy
"G" is the sum
of government spending
"I" is the sum
of all the country's businesses spending on capital
"NX" is the nation's total net
exports, calculated as total exports minus total imports. (NX = Exports -
Imports)
Nostro and Vostro account normally uses in the foreign exchange
transactions of the banks or during currency settlement.
Nostro Account means the overseas account which is held by the
domestic bank in the foreign bank or with the own foreign branch of the bank.
For example the account held by Bangladesh Bank with bank of America in New
York is a Nostro account of the Bangladesh Bank.
Vostro Account means the account which is held by a foreign bank
with a local bank, so if bank of America maintains an account with Bangladesh
Bank it will be a vostro account for Bangladesh Bank.
It is a great point that
the account which is Nostro for one bank is Vostro for another so when
Bangladesh Bank opens a Nostro account with Bank of America, it is a Vostro
account for them and vice versa.
Sunk costs are costs which,
once committed, cannot be recovered. Sunk costs arise because some activities
require specialized assets that cannot readily be diverted to other uses.
Second-hand markets for such assets are therefore limited. Sunk costs are
always fixed costs, but not all fixed costs are sunk.
Examples of sunk costs are
investments in equipment which can only produce a specific product, the
development of products for specific customers, advertising expenditures and
R&D expenditures. In general, these are firm-specific assets.
The absence of sunk costs is critical for the
existence of contestable markets. When sunk costs are present, firms face a
barrier to exit. Free and costless exit is necessary for contestability. Sunk
costs also lead to barriers to entry. Their existence increases an
incumbents’commitment to the market and may signal a willingness to respond
aggressively to entry.
A joint venture is an
association of firms or individuals formed to undertake a specific business
project. It is similar to a partnership, but limited to a specific project
(such as producing a specific product or doing research in a specific area).
Joint ventures can become
an issue for competition policy when they are established by competing firms.
Joint ventures are usually justified on the grounds that the specific project
is risky and requires large amounts of capital. Thus, joint ventures are common
in resource extraction industries where capital costs are high and where the
possibility of failure is also high. Joint ventures are now becoming more
prevalent in the development of new technologies.
In terms of competition policy, the problem
is to weigh the potential reduction in competition against the potential
benefits of pooling risks, sharing capital costs and diffusing knowledge. At
present there is considerable debate in many countries over the degree to which
research joint ventures should be subject to competition law.
The general term for the assignment of
property rights through patents, copyrights and trademarks. These property
rights allow the holder to exercise a monopoly on the use of the item for a
specified period. By restricting imitation and duplication, monopoly power is
conferred, but the social costs of monopoly power may be offset by the social
benefits of higher levels of creative activity encouraged by the monopoly
earnings.
A special type of vertical
relationship between two firms usually referred to as the
"franchisor" and "franchisee". The two firms generally
establish a contractual relationship where the franchisor sells a proven
product, trademark or business method and ancillary services to the individual
franchisee in return for a stream of royalties and other payments. The
contractual relationship may cover such matters as product prices, advertising,
location, type of distribution outlets, geographic area, etc. Franchise
agreements generally fall under the purview of competition laws, particularly
those provisions dealing with vertical restraints.
Franchise agreements may facilitate entry of
new firms and/or products and have efficiency enhancing benefits. However,
franchising agreements in certain situations can restrict competition as well.
Dumping is the practices
by firms of selling products abroad at below costs or significantly below
prices in the home market. The former implies predatory; the latter, price
discrimination. Dumping of both types is viewed by pricing many governments as
a form of international predation, the effect of which may be to disrupt the
domestic market of foreign competitors. Economists argue, however, that price
discriminatory dumping, where goods are not sold below their incremental costs
of production, benefits consumers of the importing countries and harms only
less efficient producers.
Under the General Agreement on Tariffs and
Trade (GATT) rules, dumping is discouraged and firms may apply to their
respective government to impose tariffs and other measures to obtain
competitive relief. As in the case of or (see discussion under these headings),
predatory pricing selling below costs arguments have been advanced questioning
the economic feasibility of dumping at prices below costs over extended periods
of time.
The term refers to the
expansion of an existing firm into another product line or market.
Diversification may be related or unrelated. Related diversification occurs
when the firm expands into similar product lines. For example, an automobile
manufacturer may engage in production of passenger vehicles and light trucks.
Unrelated diversification takes place when the products are very different from
each other, for example a food processing firm manufacturing leather footwear
as well.
Diversification may arise for a variety of
reasons: to take advantage of complementarities in production and existing
technology; to exploit; to reduce exposure to risk; to stabilize earnings and
overcome economies of scope cyclical business conditions; etc. There is
mounting evidence that related diversification may be more profitable than
unrelated diversification.
A form of financing public investment, and
sometimes the direct provision of public services, in which finance is provided
by private investors (in return for interest), and private firms are involved
in the management of the construction or operation of the publicly-owned
facility. PPPs have been heavily criticized for increasing the cost of public
projects and generating undue profits for private investors.
In general, productivity
measures the effectiveness or efficiency of productive effort. Productivity can
be measured in many different ways. Physical productivity measures the actual
amount of a good or service produced (eg. tons of steel, or number of
haircuts).
Productivity can also be measured in terms of
the value of output. Most commonly, productivity is measured as the amount of
output produced over a certain period of work (e g. output per hour); this is
considered a measure of labour productivity. But other approaches are also
possible, including measurements of capital productivity (output relative to
the value or physical quantity of invested capital) and “total factor
productivity” (which is an abstract statistical measurement of the overall
effectiveness of production).
Neoclassical economics is the dominant
approach to economics currently taught and practiced in most of the world (and
especially dominant in Anglo-Saxon countries). It attempts to explain the
behavior of the economy on the basis of competitive, utility-maximizing
behavior by companies, workers, and consumers. Their actions in the markets for
both factors of production and final products will ensure that all available
resources are fully utilized (that is, the economy is supply-constrained) and
every factor is paid according to its productivity.
Most economic production requires the
producing firm or organization to make an initial investment (in real capital,
in engineering and design, in marketing) before even the first unit of
production occurs. As total production then grows, the cost per unit of that
initial investment shrinks. For this reason, most industries demonstrate
economies of scale, whereby the unit cost of production declines as the level
of output grows. Because of economies of scale, larger companies have an
advantage in most industries, and the economy usually operates more efficiently
when it is busy and growing (than when it is shrinking or stagnant).
Diff. bet
Normal and inferior goods
Normal and inferior goods are classification
given by economists to to goods judging on their behavior.
Normal good is the most common type. It is said a good is normal when it's consumption increases when the income increases. Like clothes, when your income increases you buy more clothes.
The opposite happens with inferior goods, of which consumption decreases when the available income increases. For example, used books and instant noodles: the more income you have the less used books and noodles you buy.
A normal good is a good that a person will be more likely to buy the higher their income becomes. An inferior good is a good a person will be less likely to buy the higher their income becomes.
Normal good is the most common type. It is said a good is normal when it's consumption increases when the income increases. Like clothes, when your income increases you buy more clothes.
The opposite happens with inferior goods, of which consumption decreases when the available income increases. For example, used books and instant noodles: the more income you have the less used books and noodles you buy.
A normal good is a good that a person will be more likely to buy the higher their income becomes. An inferior good is a good a person will be less likely to buy the higher their income becomes.
Definition of 'Inferior Good'
A
type of good for which demand declines as the level of income or real GDP in
the economy increases. This occurs when a good has more costly substitutes that
see an increase in demand as the society's economy improves. An inferior good
is the opposite of a normal good, which experiences an increase in demand along
with increases in the income level.
Inferior goods can be viewed as anything a
consumer would demand less of if they had a higher level of real income. An
example of an inferior good is public transportation. When consumers have less
wealth, they may forgo using their own forms of private transportation in order
to cut down costs (car insurance, gas and other car upkeep costs) and instead
opt to use a less expensive form of transportation (bus pass).
Good Y is a normal good since the amount
purchased increases from Y1 to Y2 as the budget constraint shifts from BC1 to
the higher income BC2. Good X is an inferior good since the amount bought
decreases from X1 to X2 as income increases.
Fixed, variable costs and break-even
The
break-even point of a business is the level of output or sales at which the
revenue received by the business is exactly equal to the cost of making (or
selling) that output. In the examples below we show you how to calculate the
break-even point of a retailer. However, the process described is exactly the
same for other types of firms such as manufacturers who will be concerned to
find the break-even level of output when they produce goods.
The sales revenue of the business is calculated at any level of sales by multiplying the price of the item, by the number of units sold.
Costs are divided into two main types:
Fixed costs are ones that do not vary with sales. Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc. For example, one of the fixed costs of a high street shop is the rent paid for the property. The rent is still the same whether the shop sells one item or thousands.
The sales revenue of the business is calculated at any level of sales by multiplying the price of the item, by the number of units sold.
Costs are divided into two main types:
Fixed costs are ones that do not vary with sales. Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc. For example, one of the fixed costs of a high street shop is the rent paid for the property. The rent is still the same whether the shop sells one item or thousands.
Variable
costs are ones
that vary with sales. Variable costs are costs that vary with output. Generally
variable costs increase at a constant rate relative to labor and capital.
Variable costs may include wages, utilities, materials used in production,
etc. For example, imagine that a
bookshop buys in books for an average price of £5 each. It then resells the
books for a higher price. For the bookshops the variable cost is £5 per unit.
Total costs are found by adding together fixed and variable costs.
To calculate break-even we now need to find out the point at which sales revenue just covers total cost i.e. fixed and variable costs combined.
A bookshop has fixed costs of £5,000 per week. It buys books from the publishers at an average cost of £5 each and sells them for an average price of £10 each. How many books does it need to sell to break even?
For every book sold the bookshop takes in £5 more of revenue, than it pays out in variable costs:
Total costs are found by adding together fixed and variable costs.
To calculate break-even we now need to find out the point at which sales revenue just covers total cost i.e. fixed and variable costs combined.
A bookshop has fixed costs of £5,000 per week. It buys books from the publishers at an average cost of £5 each and sells them for an average price of £10 each. How many books does it need to sell to break even?
For every book sold the bookshop takes in £5 more of revenue, than it pays out in variable costs:
We use the term contribution to describe the difference between sales revenue per item and variable cost per item. This is because each £5 is contributing £5 to paying off fixed costs of £5,000. You should now be able to calculate that to break-even the bookshop will need to sell exactly 1,000 books a week. Because:
See if you can do these examples yourself:
1. A bicycle shop has fixed costs of £20,000 per month. It buys in bicycles at an average cost of £100 and sells them for an average price of £200. How many bicycles will it need to sell to exactly break-even?
2. Here's an example involving a manufacturing company. A chocolate bar manufacturer has fixed costs of £500,000 per month. It sells chocolate bars and other chocolate products for an average price of 50 pence each. The variable costs of producing each product are 25p each. How many chocolate products would it need to make to exactly break-even?
Break-even
An important objective of a business is to at least break-even,
although making a profit is even more desirable. The break-even point is
calculated by dividing the fixed costs by the contribution per unit sold.
Unless it does, it cannot afford to modernise itself, install new technologies, or take commercial risks with, say, a new product range. Nor can it fulfil its social responsibilities and neither can it justify the investment of its owners - private individuals or institutions such as pension funds and insurance companies who need to seek the best possible long-term return on their resources.
Companies like Cadbury Schweppes, Nestle, Kraft and Coca-Cola are able to take a wider responsibility for the community and provide excellent opportunities for their employees, while providing good returns to shareholders because they are profitable enterprises.
The profit of a business is determined by the relationship between turnover and costs and is set out in the Profit and Loss (P&L) account.
Turnover - is the value of sales revenue.
Cost of sales - includes all the direct costs of making those sales, e.g. the cost of raw materials, direct labour etc.
Expenses - include the overheads of running the business e.g. rent and rates, heat and lighting.
The profit and loss is set out in the following way:
Profit and Loss Account of Better Leisure at 31 December 2005
Unless it does, it cannot afford to modernise itself, install new technologies, or take commercial risks with, say, a new product range. Nor can it fulfil its social responsibilities and neither can it justify the investment of its owners - private individuals or institutions such as pension funds and insurance companies who need to seek the best possible long-term return on their resources.
Companies like Cadbury Schweppes, Nestle, Kraft and Coca-Cola are able to take a wider responsibility for the community and provide excellent opportunities for their employees, while providing good returns to shareholders because they are profitable enterprises.
The profit of a business is determined by the relationship between turnover and costs and is set out in the Profit and Loss (P&L) account.
Turnover - is the value of sales revenue.
Cost of sales - includes all the direct costs of making those sales, e.g. the cost of raw materials, direct labour etc.
Expenses - include the overheads of running the business e.g. rent and rates, heat and lighting.
The profit and loss is set out in the following way:
Profit and Loss Account of Better Leisure at 31 December 2005
The operating profit is not the final profit. We also need to take away corporation tax paid on profits. Some money will also be distributed to shareholders in the form of dividends. So the final retained profit will be less than the operating profit.
Cash
Reserve Ratio (CRR)
A Cash Reserve Ration, also known as the Reserve Requirement is a regulation set by Central bank (Federal Reserve or the nation’s governing bank) which dictates the minimum amount (reserves) that a commercial bank (in some cases, any bank) must be held to customer notes and deposits. In simpler terms this is the amount the bank must surrender with/to the Central (governing) Bank.
A Cash Reserve Ration, also known as the Reserve Requirement is a regulation set by Central bank (Federal Reserve or the nation’s governing bank) which dictates the minimum amount (reserves) that a commercial bank (in some cases, any bank) must be held to customer notes and deposits. In simpler terms this is the amount the bank must surrender with/to the Central (governing) Bank.
It is a
percentage of bank reserves to deposits and notes. Cash reserve ratio is also
known as liquidity ratio or cash asset ratio and is utilized as a tool
(sometimes) in monetary policy and as a tool to influence the country’s interest
rates, borrowing and economy. The central banks in the western world refrain
from altering the reserve requirements or rarely do it as it would result in
the banks (that have lower excess reserves) facing immediate liquidity problems
and hence to implement their monetary policy, they prefer using open market
operations.
Repo
Rate
The repo rate also known as Repurchase Agreement is the rate at which the banks borrow from the Central Bank. It becomes typical for the banks to borrow from the central bank if there is an increase in the repo rate. Generally used to control the amount of money in the market, repo rate is usally a short-term measure which is used for short-term loans.
Reverse Repo
The Federal Open Market Committee adds reserves to the banking system and withdraws them after a specified period of time. So, reverse repo drains reserves initially and adds them back later. Hence, it can be used as a tool for stabilizing interest rates with the Federal Reserve using it in the past to adjust the Federal funds rate to match the target rate.
The repo rate also known as Repurchase Agreement is the rate at which the banks borrow from the Central Bank. It becomes typical for the banks to borrow from the central bank if there is an increase in the repo rate. Generally used to control the amount of money in the market, repo rate is usally a short-term measure which is used for short-term loans.
Reverse Repo
The Federal Open Market Committee adds reserves to the banking system and withdraws them after a specified period of time. So, reverse repo drains reserves initially and adds them back later. Hence, it can be used as a tool for stabilizing interest rates with the Federal Reserve using it in the past to adjust the Federal funds rate to match the target rate.
Fixed
Exchange Rates
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
Floating
Exchange Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market" (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market" (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.
An indifference curve
shows combination of goods between which a person is indifferent. The main attributes
or properties or characteristics of indifference curves are as follows:
(1) Indifference Curves are Negatively Sloped:
The indifference curves must slope down from
left to right. This means that an indifference curve is negatively sloped. It slopes
downward because as the consumer increases the consumption of X commodity, he
has to give up certain units of Y commodity in order to maintain the same level
of satisfaction.
In fig. 3.4 the two combinations of commodity
cooking oil and commodity wheat is shown by the points and b on the same
indifference curve. The consumer is indifferent towards points and b as they
represent equal level of satisfaction.
At point (a) on the indifference curve, the
consumer is satisfied with OE units of ghee and OD units of wheat. He is
equally satisfied with OF units of ghee and OK units of wheat shown by point b
on the indifference curve. It is only on the negatively sloped curve that
different points representing different combinations of goods X and Y give the
same level of satisfaction to make the consumer indifferent.
(2) Higher Indifference Curve Represents Higher Level:
A higher indifference curve that lies above
and to the right of another indifference curve represents a higher level of
satisfaction and combination on a lower indifference curve yields a lower
satisfaction.
In other words, we can say that the
combination of goods which lies on a higher indifference curve will be
preferred by a consumer to the combination which lies on a lower indifference
curve.
In this diagram (3.5) there are three
indifference curves, IC1, IC2 and IC3 which
represents different levels of satisfaction. The indifference curve IC3
shows greater amount of satisfaction and it contains more of both goods than IC2
and IC1 (IC3 > IC2 > IC1).
(3) Indifference Curve are Convex to the Origin:
This is an important property of indifference
curves. They are convex to the origin (bowed inward). This is equivalent to
saying that as the consumer substitutes commodity X for commodity Y, the
marginal rate of substitution diminishes of X for Y along an indifference
curve.
In this figure (3.6) as the consumer moves
from A to B to C to D, the willingness to substitute good X for good Y
diminishes. This means that as the amount of good X is increased by equal
amounts, that of good Y diminishes by smaller amounts. The marginal rate of
substitution of X for Y is the quantity of Y good that the consumer is willing
to give up to gain a marginal unit of good X. The slope of IC is negative. It is
convex to the origin.
(4) Indifference Curve Cannot Intersect Each Other:
Given the definition of indifference curve
and the assumptions behind it, the indifference curves cannot intersect each
other. It is because at the point of tangency, the higher curve will give as
much as of the two commodities as is given by the lower indifference curve.
This is absurd and impossible.
In fig 3.7, two indifference curves are
showing cutting each other at point B. The combinations represented by points B
and F given equal satisfaction to the consumer because both lie on the same
indifference curve IC2. Similarly the combinations shows by points B
and E on indifference curve IC1 give equal satisfaction top the
consumer.
If combination F is equal to combination B in
terms of satisfaction and combination E is equal to combination B in
satisfaction. It follows that the combination F will be equivalent to E in
terms of satisfaction. This conclusion looks quite funny because combination F
on IC2 contains more of good Y (wheat) than combination which gives
more satisfaction to the consumer. We, therefore, conclude that indifference
curves cannot cut each other.
(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:
One of the basic assumptions of indifference
curves is that the consumer purchases combinations of different commodities. He
is not supposed to purchase only one commodity. In that case indifference curve
will touch one axis. This violates the basic assumption of indifference curves.
In fig. 3.8, it is shown that the in
difference IC touches Y axis at point C and X axis at point E. At point C, the
consumer purchase only OC commodity of rice and no commodity of wheat,
similarly at point E, he buys OE quantity of wheat and no amount of rice. Such
indifference curves are against our basic assumption. Our basic assumption is
that the consumer buys two goods in combination.
GDP
|
GNP
|
|
Stands
for:
|
Gross Domestic
Product
|
Gross
National Product
|
Definition:
|
An
estimated value of the total worth of a country’s production and services, on
its land, by its nationals and foreigners, calculated over the course on one
year
|
An
estimated value of the total worth of production and services, by citizens of
a country, on its land or on foreign land, calculated over the course on one
year
|
Formula
for Calculation:
|
GDP =
consumption + investment + (government spending) +
(exports − imports)
|
GNP = GDP
+ NR (Net income inflow from assets abroad or Net Income Receipts) - NP (Net
payment outflow to foreign assets)
|
Uses:
|
Business,
Economic Forecasting
|
Business,
Economic Forecasting
|
Application
(Context in which these terms are used):
|
To see the
strength of a country’s local economy
|
To see how
the nationals of a country are doing economically
|
Layman
Usage:
|
Total
value of products & Services produced within the territorial
boundary of a country
|
Total value
of Goods and Services produced by all nationals of a country (whether within
or outside the country)
|
Country
with Highest Per Capita (US$):
|
Luxembourg
($87,400)
|
Luxembourg
($45,360)
|
Country
with Lowest Per Capita (US$):
|
Liberia
($16)
|
Mozambique
($80)
|
Country
with Highest (Cumulative):
|
USA
($13.06 Trillion in 2006)
|
USA (~
$11.5 Trillion in 2005)
|
Gross national income
The Gross national income (GNI) consists of: the
personal consumption expenditure, the gross private investment, the government
consumption expenditures, the net income from assets abroad (net income
receipts), and the gross exports of goods and services, after deducting two
components: the gross imports of goods and services, and the indirect business
taxes. The GNI is similar to the gross national product (GNP),
except that in measuring the GNP one does not deduct the indirect business
taxes.
A measure of
the wealth earned by nations through economic activites all around the world.
Gross
National Income comprises the total value of goods and services produced within
a country (i.e. its Gross Domestic Product), together with its income received
from other countries (notably interest and dividends), less similar payments
made to other countries. Also known as GNP.
It can be
calculated as follows :
GNI = Gross
Domestic Product + Net property income from abroad.
Net National Product - NNP'
The monetary value of finished goods and services produced by a
country's citizens, whether overseas or resident, in the time period being
measured (i.e., the gross national product, or GNP) minus the amount of GNP
required to purchase new goods to maintain existing stock (i.e., depreciation).
Alternatively, net national product (NNP) can be calculated as total payroll compensation + net indirect tax on current production + operating surpluses.
Alternatively, net national product (NNP) can be calculated as total payroll compensation + net indirect tax on current production + operating surpluses.
In other words, NNP is the amount of goods that can be consumed
within a nation each year without reducing the amount that can be consumed in
following years.
A.
Production Possibility Frontier (PPF)
Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.
Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources.
Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.
Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources.
 |
As we can see, in
order for this economy to produce more wine, it must give up some of the
resources it uses to produce cotton (point A). If the economy starts producing
more cotton (represented by points B and C), it would have to divert resources
from making wine and, consequently, it will produce less wine than it is
producing at point A. As the chart shows, by moving production from point A to
B, the economy must decrease wine production by a small amount in comparison to
the increase in cotton output. However, if the economy moves from point B to C,
wine output will be significantly reduced while the increase in cotton will be
quite small. Keep in mind that A, B, and C all represent the most efficient
allocation of resources for the economy; the nation must decide how to achieve
the PPF and which combination to use. If more wine is in demand, the cost of
increasing its output is proportional to the cost of decreasing cotton
production.
Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology whiles the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.
Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology whiles the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.
When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.
An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly.
B. Opportunity Cost
Opportunity cost is the value of what is foregone in order to have something else. This value is unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future because there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time and resources (income).
This is important to the PPF because a country will decide how to best allocate its resources according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.
Let's look at another example to demonstrate how opportunity cost ensures that an individual will buy the least expensive of two similar goods when given the choice. For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service.
Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.
C. Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy can focus on producing all of the goods and services it needs to function, but this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a country can concentrate on the production of one thing that it can do best, rather than dividing up its resources.
For example, let's look at a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose that Country A has very little fertile land and an abundance of steel for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton.
Each country can produce one of the products more efficiently (at a lower cost) than the other. Country A, which has an abundance of steel, would need to give up more cars than Country B would to produce the same amount of cotton. Country B would need to give up more cotton than Country A to produce the same amount of cars. Therefore, County A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) specialize in producing the goods with which they have a comparative advantage. If they trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower opportunity cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B.
Determining how countries exchange goods produced by a comparative advantage ("the best for the best") is the backbone of international trade theory. This method of exchange is considered an optimal allocation of resources, whereby economies, in theory, will no longer be lacking anything that they need. Like opportunity cost, specialization and comparative advantage also apply to the way in which individuals interact within an economy.
Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though countries both have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs (arable land, steel, labor), enables the country to manufacture more of both cars and cotton than Country B. A country that can produce more of both goods is said to have an absolute advantage. Better quality resources can give a country an absolute advantage as can a higher level of education and overall technological advancement. It is not possible, however, for a country to have a comparative advantage in everything that it produces, so it will always be able to benefit from trade.
Slope and Cost
Opportunity cost is measured by
the slope of the production possibilities curve. In particular, the slope of
the production possibilities curve is the opportunity cost of the good measured
on the horizontal
axis, which in this example is storage sheds.
This production possibilities curve presents opportunity cost values for
segments between each pair of points. The opportunity cost of producing the
first shed, moving from point A to point B is the schedule is 5 dozen crab puffs (or -5). The slope
of the production possibilities curve between points A and B is also -5.
Increasing Opportunity Cost
The production possibilities
schedule indicates that the opportunity cost of shed production increases as
more sheds are produced. At the top of the schedule, the opportunity cost of the
first shed is 5 dozen crab puffs. At the bottom of the schedule the opportunity
cost of the tenth shed is 200 dozen crab puffs.
The reason
for this pattern rests with the law
of increasing opportunity cost, one of the more important principles
studied in economics. The law of increasing opportunity cost states that the
opportunity cost of producing a good increases as more of the good is produced.
The law of
increasing opportunity cost results due to the third
rule of inequality, which in this case means that all resources are not
created equal.
- The
production of the first shed, moving from bundle A to bundle B, uses resources best suited
for shed production and least suited for crab puffs production. As such,
very few crab puffs are given up to produce one shed.
- However, as more sheds are produced, resources that are removed from crab puffs production are more suited for crab puffs production and less suited for shed production.
- With production of the tenth shed, going from bundle J to bundle K, the resources switched are those least suited for sheds and best suited for crab puffs. As such, a relatively large number of crab puffs are given up to produce one shed.
- As more sheds are produced, the opportunity cost of production increases.
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A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
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A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
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A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.)
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.)
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.
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As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
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At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.
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In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.
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Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.
Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.
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2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.
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Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.
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'Giffen Good'
A consumer good for which demand rises when the
price increases, and demand falls when the price decreases. This phenomenon is
notable because it violates the law of demand, whereby demand should increase
as price falls and decrease as price rises. To be a Giffen good, the item must
lack easy subsitutes and it must be an inferior good, or a good for which
demand declines as the level of income in the economy increases. Economists
disagree on whether Giffen goods exist and how common they are.
The other type of consumer good that violates the
law of demand is a Veblen good. Demand for Veblen goods increases as their
prices increase because people perceive them to be of higher quality. A
designer handbag would be an example of a Veblen good.
A veblen good is a good that people buy because it is
expensive, as a show of wealth. Therefore it is a superior good with respect to
income, but if the price falls, less of the good will be demanded.
Definition of 'Public Good'
A product that one individual can consume without
reducing its availability to another individual and from which no one is
excluded. Economists refer to public goods as "non-rivalrous" and
"non-excludable". National defense, sewer systems, public parks and
basic television and radio broadcasts could all be considered public goods.
One problem with public goods is the free-rider
problem. This problem says that a rational person will not contribute to the
provision of a public good because he does not need to contribute in order to
benefit.
For example, if Sam doesn't pay his taxes, he still benefits from the government's provision of national defense by free riding on the tax payments of his fellow citizens.
For example, if Sam doesn't pay his taxes, he still benefits from the government's provision of national defense by free riding on the tax payments of his fellow citizens.
Elasticity
The degree to which
a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products
may be more essential to the consumer. Products that are necessities are more
insensitive to price changes because consumers would continue buying these
products despite price increases. Conversely, a price increase of a good or
service that is considered less of a necessity will deter more consumers
because the opportunity cost of buying the product will become too high.
A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.
To determine the elasticity of the supply or demand curves, we can use this simple equation:
A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.
To determine the elasticity of the supply or demand curves, we can use this simple equation:
Elasticity = (%
change in quantity / % change in price)
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If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.
As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.
Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.
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Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.
A. Factors Affecting Demand Elasticity
There are three main factors that influence a demand's price elasticity:
1. The availability of substitutes - This is probably
the most important factor influencing the elasticity of a good or service. In
general, the more substitutes, the more elastic the demand will be. For
example, if the price of a cup of coffee went up by $0.25, consumers could
replace their morning caffeine with a cup of tea. This means that coffee is an
elastic good because a raise in price will cause a large decrease in demand as
consumers start buying more tea instead of coffee.
However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.
However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.
B. Income Elasticity of Demand
In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:
If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel.
Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is seven - highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.
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