Bradford Mba

7/27/2019 Bradford Mba

1/15

Business EconomicsDistance LearningBradford MBA

-H. 'L*r'


2/15

Introduction to EconomicsINTRODUCTIONNo matter where in the world you as a student of economics may live, the basic principlesof the subject and the basic economic problem remain the same. The economic problemrelates to a scarcity of economic resources compared to the unlirnited wants thatconsulxers have within each country. Finite resources and infinite wants mean that there isthe need for choice. Of course. the precise nature of this problern of scarcity may differ inits detail from country to country depending upon a whole range of factors such as thelevel of industrial development, the availability of indigenous natural resources and socialand political factors to name but a few. Despite differing in emphasis and detail, the centralproblem remains essentially the same, that is, no matter how wealthy the country,consumers have wants that will outstrip the ability to satisfy these wants.ln this first unit. we develop a theoretical framework which will enable you to understandthe problem of scarcity over choice and identify how different economic systems in theworld allocate these scarce resources in order to meet optimally the needs and desires ofthe people.Key reading: Begg and Ward, Chapter 1

OBJECTIVESBy the end of this unit, you should be able to:o define the economic problerr

define the concept ol'opportunity cost and understand its inrportancc in a variet-v ol'econouric situations but with panicular ref'erence to business

o recognise produclion possibility frontiers and lrow they rnay be appliedo clistinguish between different econornic systelns and identify key f'eatures of eacho develop an initial nppreciation of how econornists use diagrarns its a rneans of

e xplaining infonnation.

Bradford MBA 27


3/15

Studv Book: Business Economics

SCARCITY AND CHOICEFigure l.lz The basic economic problem

Resources

(*'*-fuUnlimited

Wants

Wants

Scarce

The basic economic problem occurs because the resources available to produce goods andservices are scarce in relation to the unlimited wants that society has (Figure 1.1). Thefactors of production - land, labour, capital and enterprise - can't produce everything thatpeople want so choices have to be made. The economic problem facing a government isdemonstrated in Figure 1.2.

Figure l.2z A governruent's economic problent

ResourcesIncomctax. VAT

Scarcc

Elcctirtns

A government receives income from tarxation and this incotle is scarce in relation to theunlirnited demand for services that the government would like to provide. Thegovernment needs to make a choice regarding its expenditure and the electorate has a voteon this decision at election time.

Unlimitcd

28 Bradtord MBA


4/15

Unit 1: Introduction to Economics

We can adapt this same approach to examine the economic problem faced by localgovernments or even your own household. For example, in the UK a local authorityreceives income from central government, from council tax and by charging for itsservices. If you consider the multi-demands placed upon local expenditure, it is clear thatimportant choices need to be made regarding priorities and time scales. If we bring thescenario even closer to home, you will appreciate the nature of the economic problem byexamining your own household incorne and wants. Your means and wants may be verydifferent frotn ten years ago, but you are a very fortunate individual indeed if you do notexperience the problem of scarce resources.

OPPORTUNITY COSTRead: Begg and Ward, pages 2-17When resources are scarce, how these resources are allocated is of great impofiance. Whenresources are used to satisfy a parlicular want, the opporlunity cost includes all the wantsthat could have been satisfied with these resources instead. You may wish to consider theopporlunity cost of the government increasing expenditure on education. The foregonealternatives include the extra resources that could have been allocated to the health serviceor the extra investment in an integrated transporl policy, etc. The concept of opportunitycost is extremely imporlant and iurplies that all resources have alternative uses and it servesto emphasise that economists should examine a range of options in decision making.

PRODUCTION POSSIBILITY FRONTIERThe production possibility frontrer (PPF) allows the economist to demonstrate theconsequences of sotne decisions on how resources should be allocated. It -9ives aninclication as to how rnuch productior.t can take place if all the econorny's resources areused efflciently. In additiorr. it allows for a cornparison of production over tirne atrd anassessrnent of how effrcierrtlv society is usinc the resources at its disnosal.Considcr Filure 1.3. in which the output of the econolry is either capital or consunrcrgoods. Thesc indices could include anylhine: quns arrcl butter have otien beerr usecl asexitnrples in the past. Wc havc usecl clpital arrcl consumer gooiis since they rspresentrlassive categories of procluction as well as representing the diff'erent general consurtrptiorrchoices of households and businesses. The curve represents tlre PPF and thc PPFdernonstrates the various combinations of capital and consumer goods that could beproduced. Any point along the PPF represents a full utilisartion of resources and a ve'.,efficient econorny.

Bradford MBA 29


5/15

Study Book: Business Economics

Figure 1.3: Production p ossibility JrontierConsumer

goods

Capitalgoods

Points a, b, c, d and e all represent a full utilisation of scarce resources within an economy.With existing productive capacity the economy is unable to reach point x. The only waypoint x can be reached in future is through developing productive capacity, that is,through econotnic growth. Now consider point l'. Production is below the PPF and as suchrepresents an underutilisation of resources. A society in such a situation faces a majorchallenge if it is to allocate its resources more effectively.ACTIVITY 1.1

1. In theory all points along the PPF signify a well{unctioning economy. Can you identify,however, future problems that may occur with the extreme combinations of goodsproduced at points a and b?

2. Which represents the best combination c or e?

Answer to Activity 1.1At point rz, where all resources are used to produce capital goods there will bean extremely unhappy electorate with little choice of home-produced consumergoods to purchase. Consumer goods would have to be imported; in short, avery unbalanced econorny would occur. At point b, there are consurler goodsgalore. A materialist's paradise! But if all the resources are used to produceconsumer goods, then what will be used to produce capital goods when current

30 Bradford MBA


6/15

Unit 1: lntroduction to Economics

machinery becomes worn out? Can we import all the capital goods we need?Would that provide a balanced economy?The answer to question 2, is inconclusive. It is not really possible to say whichis the better combination, they are both theoretically as good as each other. Noinformation is given regarding the quality of the capital and consumer goodsvis-d-vis the foreign competition. More resources may be allocated to a sectoreither because it is extremely efficient or to make up for its relative weakness.

The PPF can be used to examine the concept of opportunity cost. Take an individual firrnthat has diversified its production and produces good A and good B.Figure 1.4: Production of good A and good B

Curlently the firrn is producing at point.r which represents rr, production of cood A urrtlb, production o1'good B. The firm, afier extensive urarkel research, decides that procluct llrepresents tlre nrore profitable long-tenl future and clecides to reallocate resources 1l'orlthe prodr.rction of good A to good B. This decision would invol ve a reductiorr in thcoutput of good A fiorn (ttIo u. (the opponunity cost) in order to increase the procluctiorrol' B l'rorn /r, lo i,-. point r.

Bradford MBA 31


7/15


ACTIVITY 1.2Consider Figure 1.5.

Figure 1.5 : P r o d ucti o n p o s sibility ./r o nti er g r ap hsConsumer

goods

1 . Which PPF could be used to represent the year 1750 and which the year 20O9?2. Which PPF represents a developed economy and which a developing economy?

Answer to Activity 1.2PPF, represents both tlre year l7-50 and the current developing econolny.Clearly, output is rrrore limited in 1750 since the ability to use resourcesefficiently would lrave been lirnited compared with today's econor.ny andsuccessive years ol'econornic growth will shift 2(X)9's output to PPF..

ECONOMIC SYSTEMSNo econornic system can solve the economic problenr. Different allocation systems offeralternative approaches to the problem. There are three main allocation systems, ret'erred toas a free market economy, a planned economy and a mixed economy. Each economicsysteln elttempts to answer three questions.

l. What to produce?

Capital goods

32 Bradford MBA


8/15

Unit 1: Introduction to Economics

2. How to produce?3. For whom to produce?In a planned or command economy, the important decisions regarding 'what', 'how' and'for whom'would be made by state officials or bureaucrats. These officials would havethe job of planning the production of the whole economy and would issue five-year plansto the whole of industry. Planning was such an enormous task that reality would rarelyresemble the out-of-touch ideas of the bureaucrats.

The former pre-Gorbachev Soviet Union provides a good example of a plannedeconomy. The system was characterised by the extensive queuing that formed an essentialpart of everyday life. Subsidies meant officially low prices and queuing was, in essence, aform of rationing. Consider the opportunity cost involved in queuing and where theSoviet Union was in relation to its PPF. Gorbachev started the significant move towards amore market-oriented economy with peresfroika (economic reconstruction). The queuesbegan to disappear. The rrarket mechanism was now the means of satisfying the exchangebetween demand and supply. The market allowed prices to increase, consumers couldonly queue if they could afford the products. Our focus in Unit 2 is how the marketmechanism determines the price of products.

In a free market economy, the important decisions are left to free merrket forces. Theinteraction of consurners and producers determines what should be produced. The role ofthe government is to create the conditions for the free market to flourish. This type ofmarket structure will be the focus for much of the theory that follows in later units.A mixed economy is one that has both public and private sector ownership of resources.The state has some role in economic decision rnaking and plays an important role ineconomic mana-qement, but the bulk of resources are privately owned. The UK is u goodexarnple of a mixed economy with both private and public ownership of resources.Various privatisations since the early 1980s have moved the economy towards the ll'eemarket point on the continuutn. However, the econorlic systern is still essentially a ntixedeconotny with the government playing a substantial role in the allocation of resources.

SUMMARYRead: Summary in Begg and Ward, page 17-18In this unit, you have been introduced to the idea of scarcity and choice and howimportant this is to understanding the need for a good systern of resource allocation. Alleconotnic decisions involve an opportunity cost and economists need to weigh up a rangeof alternatives before irnporlant decisions can be made. The production possibilityfrontiers demonstrate the opportunity cost principle at work and show the need foreffective decisions regarding the 'how', 'what' and 'for whom' to produce if theeconomic system is to be efficient and to utilise scarce resources in an optimal way.

Bradford MBA 33


9/15


REVIEW ACTIVITYlmagine that a business is facing a sustained increase in demand for its products.1. Examine the opportunity cost of the tirm responding to this scenario by deciding to opena new faclory in another part of the country.2. Consider the opportunity cost of taking on additional full-time workers to meet this

increased demand.3. Would your answers to questions 1 and 2 be ditferent if the increased demand was likelv

to be temporary?4. lf applicable, how should your business respond to the situations described above?

ANSWERS TO REVIEW ACTIVITYl The key word in this question is 'sustained'. The sustained increase in demand lneans

the firm is able to plan more for the long term and make important strategic decisionsabout its future. Ifthe firm opens a new factory in another pafi ofthe country, thinkof all the costs that will be incurred. You may have heard entrepreneurs commentingupon the three most important aspects of where to site a new factory: location,location, location! Time and money will need to be spent researching this location.Once a location has been decided, the firm will need to pay:. rent for the premiseso costs of hiring a workforceo costs of training that workforceo capital costs of purchase of machineryo relocation expenses. where appropriute.The opportunity cost of openirrg il new plunt rlieht be to use the rnoney onexpandinn the original lactory. Tlrc llrnr coulcl take on adclitiorral workqrs.intplernent a night shifi. irrvest hcavilf in nc* nlrchinery lncl an autornatecl reduceproduction line, etc.

2. The finr could increase the amount of rrachinery used in the production process. Afully automated production line would the need for workers. Part of the productionprocess, for example, component supplies, could be contracted out.

3. If the increase in demand is likely to be temporary, the firm needs to retain flexibility.Opening a new factory may be a gamble. Why not pay workers oveftime or take ontemporary staff?

34 Bradford MBA


10/15

lssues relating to DemandINTRODUCTIONIn most economies, markets are the principal ways in which scarce resources are allocatedto the production of goods and services. A market is anywhere there is a buyer and seller.In essence, markets operate through the price mechanism which co-ordinates the buyersand sellers. For example, as prices rise relative to costs of production, firms offer more forsale. In this way, the price acts as a signal to firms that scarce resources should bereallocated from markets where profits are low to markets where profits are high. Theprice mechanism is often referred to as the 'invisible hand' since it is the result of freemarket forces.

Have you ever considered why baked beans only cost 25p when they enjoy so muchpopularity? Why do firms not cash in on this demand by charging 99p? Why does a pintof beer cost f2.25 in your local pub compared to f3.50 in a nightclub? Why does thegovernment tax cigarettes and beer but not apples? Why does the accountant working atyour firnr earn more than the cleaner? The answers to all these questions can be found byanalysing how demand and supply interact in the market place.In this unit you will begin to develop your understanding of how markets behave. First,you will concentrate on the demand side of the market. What affects the level of demand,how do consufilers react to price chan-ges, how can firms set prices which will maxinrisetheir revenues; and why do finns set different prices for different market segments? Onceyou feel cornfortable with this knowled-ee, unrt 3 will then introduce concepts related tothe supply side of the market. Unit 4 will then combine the ideas frorn units 2 and 3 intoan intecrated understanding of rnarkets. Hopefully. you can see that economics is a subjectwhich builds upon itself and it is, therefore, irrrportant to gain confidence in the ideas andissues of each unit before rnovinq onto the next.Key reading: Begg and Ward, Chapter 2

OBJECTIVESBy the end of this unit, you should be able to:. explain the theory of demando understand the determinants of demandBradford MBA 35


11/15


o explain the concept of consumer and producer surplusexplain the concept of elasticity and to appreciate its importance when managers aredeveloping pricin g strategies

o explain the relationship between elasticity and revenueTHE DEMAND CURVERead: Begg and Ward, Chapter 2, pages 22-32

The demand curve demonstrates the relationship between the quantity demanded andprice. Demand is considered as effective demand. which means dernand backed up by theability to pay. Much of the demand curve is hypothetical in that it states what consurnerswould denrand at relative prices. The dernund curve is sornetirres drawn as a straight lineor ils ir curve. It doesn't really martter since botlr are examples of how the econornistattempts to develop theory through making assumptions to sirnplify the process.

Figure 2.1: The demand curve

Quantit-y

If we exarnine the demand curve in Figure 2.1, consider how dernand is higher at lowprices and how this demand changes as prices increase. Look art how the demand changesas price drops from ptto pz. There is an extension of demand from q, to q.. What wouldcause a contraction of demand? The only factor that causes either an extension orcontraction of demand is a change in the price of the product itself. Anything other than achange in price causes a shift in the demand curve itself. These other factors are referred to

36 Bradford MBA


12/15

Unit 2: lssues relating to Demand

as the determinants of demand and include:

price of substitute and cornplementary goodschanges in consumer incomesconsumers'tastes and preferences and how these may be affected by advertising,fashion. etc.

o expectations of future price changeso time period.A change in any of these determinants of demand causes a shift in the demand curve. InFigure 2.2, aslttft from D, to D2 means more of the product is demanded at every price. Ashift from D1 to Dj is a reduction in demand at every prrceFigure 2.2: Demand curt,es

Quunlity

If the original price is p,,, at successful advertisirrg campaign may increase the dernanclfrom D,to D.. We have shifted from point a to point b on Figure 2.3 below. The quantitydemanded at this price has increased from Qtto 4y

Bradford MBA 37


13/15


Figure 2.3: Change in the demand curvePlice

\

ACTIVITY 2.1For each of the following scenarios, construct a diagram to show the efiect on your firm's demand.

1. An increase in the price of a complementary good.2. A decrease in the price of a substitute good.3. An increase in consumer incomes.

A brilliant advertising campaign by your main competitor.A decrease in the price of your product.

Answers to Activity 2.1If there is an increase in the price of a cornplementary good, then thedemand curve will shift to the left. This is because the complementary goodwill be demanded less al the higher price and. since the products are jointlydemanded, our product will face a reduction in dernand as a result.

2. If there is a decrease in the price of a substitute good, then the demandcurve for our product will shift to the left since consumers will purchase thecheaper substitute product instead.

38 Bradford MBA


14/15

Unit 2: lssues relating to Demand

3. If there is an increase in consumer income, then we would expect thedemand curve to shift to the right since consumers can afford to purchasemore of our product at every price.4. If there is a brilliant advertising campaign by our main competitor. then ourdemand will shift to the left.5. If our product is decreased in price, then we will experience an extension of

demand. This means there will be a movement along the orisinal demandcurve itself.Of course, at this stage we are only focusing upon demand. You should goback to our definition of a market. We now need to examine the role of thesellers who supply the products if we are to establish how the marketdetermines price and output.

PRICE ELASTICITY OF DEMANDRead: Begg and Ward, Chapter 2, pages 32-43Price elastic of demand is a crucial concept for businesses to grasp if they are to besuccessful in the market place. It is worthwhile reflecting on the material at each stage thatfollows and taking stock of the ideas covered before tackling the activities to be coveredlater in the unit.

The price elasticity of demand measures the responsiveness of the change in demand for achange in price. If a firm has control over its own pricing policies. the concept allows thefirm to establish the effects of a change in price on its revenue and, hence. its profits. Itallows firrns to answer the questions such as what will happen to revenue if we increaseour prices by 2 per cent or reduce price by 7-5p.Elasticity of dernand can be calculatecl usir.rp. lhe 1'orrnula:

E,=

Different demand elasticitieso If the E,, is > 0 but less than I the denrand is price inelastic.o If the E,, is >l the demand is price elasticExceptional cases are:o If the E 7 is = I the demand has unit elasticity.o If the E,, is infinity the demand is perfectly elastic.o If the E7 is = 0 the dernand is perfectly inelastic.Bradford MBA 39


15/15


Elastic and inelastic demandElastic demand means that a relatively small change in pricechange in the quantity demanded. This is shown in Figure 2.4.Figure 2.42 Ehsrtc demand

leads to a relatively large

Price

')pl

QuantityInelastic demand means that a relatively large change in price leads to a relatively smallchange in the quantity demanded. This is shown in Figure 2.5.

Figure 2.52 Inelastic demand

Quantity

If we examine Figures 2.4 and 2.5, we can show the relationships between the relativechanges in price and quantity demanded. Strictly speaking this approach should be usedto simplify the idea only, since the validity of the diagrams is dependent upon the scale ofthe axes.40 Bradford MBA

Bradford Mba

Documents