Economics

Economics

Stage 2

Contents

Part 1:Introduction to Economics

202

Chapter 1 : Microeconomics 2

Chapter 2: Macroeconomics 34

Chapter 3, Theory, Data and Forecasting 46

Part 2, National Income and Demography

Chapter 1:Concepts of National Income 58

Part 3: Inflation 82

Part 4: Unemployment 99 Part 5, Trade Balance and Exchange Rate

Chapter 1 : Trade Balance 113

Chapter 2, Exchange Rate 127

Part 6: Money

Chapter 1 : Evolution of Money 140

Part 7: Demand and Supply of Money 145 Part 8: Monetary Policy

Chapter 1 : Objectives of Monetary Policy 158 Part 9, Fiscal Policy

Chapter 1 : Objectives of Fiscal policy 165

Part 10: Transmission mechanism of Monetary Policy and the Impact of

Banking Sector Credit

Chapter 1 : Monetary Policy Transmission Channels ' 74

Part 11 : Central Banks and Monetary Policy Regimes 181

Part 12: Impact of Fiscal and Monetary Policies on Equilibrium 192

Part 13: The World Economy:

International Monetary Institutions

Economics I Reference Book 15

Chapter 1

Learning Outcome

Introduction

The meaning

and nature of

economics

By the end

___ Introduction to Economics of chapter Microeconomics

you should be

able to: Recall the importance of studying economics _ Differentiate between microeconomics and macroeconomics j- Identify and explain the basic concepts of microeconomics, i.e. supply^ demand, elasticity and inelasticity, consumer preferences, supply demand curve and equilibrium Discuss the production function 0 Discuss the terms opportunity cost, sunk cost, marginal cost, average cost, production cost

Economics is the study of the way in which societies use and develop the scarce resources at their

disposal. Scarcity is the key to the entire study of economics, the concept which underlies all economic

thought and activity, due to mankinds constant search for ways of overcoming scarcity. What

economists mean by scarcity, however, is quite different to the normal interpretation of the word.

An accepted definition of economics is perhaps a useful way to begin. Lord Robbins provided the

following widely quoted definition of what he called the basic economic problem" :

y Economics is the science which studies human behavior as a relationship between ends and scarce means

which have alternative uses.

Economics is as old as civilization itself, derived from two Greek words oikos- a house - and nemo-1 manage.

The first practical economists were probably stewards or estate managers concerned with managing the business

affairs of a private individual or nobleman. Gradually over time, economics expanded into managing the

business and finances of the state as a whole. One of the earliest treatises on the subject ^Economicd9 (300 BC) ^

was concerned with raising revenue from taxation.

In Britain, the foundations of modern economics were laid by a Scottish economist Adam Smith, when he

published The Wealth of Nations in 1776. Other early economists were David Ricardo who published Principles

of Political Economy and Taxation in 1817 and John Stuart Mill with Principles of Political Economy, , n 1847. The

use of the title PoliticalEconomy'shows the emphasis of the subject at that time and it is a title still used in some of

the older universities.

In the definition stated above, the economic problem has been identified that of ends, means and alternative

resources. We all have our own basic economic problem that of trying to live within our income. In

everyday speech the word means is used instead of income, so if we partially rewrite the definition and

substitute inadequate income for scarce means and, instead of using the word ends, , , think instead of all

the consumer goods which are always temptingly on offer but which we are unable to afford because our

incomes are limited, then we can identify more closely with the formal definition.

We can say then, that economics is about living within our income. So far we have assumed that resources were

scarce in relation to the needs and wants of individuals or households, but this problem afflicts the whole of

society at every level.

Scarcity at an individual level is only ourselves experiencing the dilemma that all people, firms, organizations and

governments experience. A chancellor or a company director trying to balance the national or company accounts

is acting in the same way as a household trying to satisfy all its wants from its limited income. They are both

allocating limited resources as best they can, deciding which ends have to be met first as priorities and

relegating those which must, as a consequence, remain unsatisfied. Disputes about the relative levels of wages

and profits are essentially disputes about the distribution of a limited national income.

Our incomes are limited in relation to all those products which we wish to own and enjoy. One must choose

between them, deciding which wants to satisfy and which to reluctantly ignore. Those choices, however, are only

possible because our incomes have alternative uses and can be spent as we wish. The general term ends in the

definition should be broken down into two separate and distinct component parts needs and wants.

Needs

These are the primary essentials necessary for survival such as food, shelter, and clothing and heating. With these

basic requirements met, life can be sustained and, for most people in our society, these needs are adequately

satisfied. For the majority, only one house can be lived in at a time and only three meals eaten per day.

Improvements in quality are constantly sought, but the quantity demanded is limited once adequacy has been

achieved. In economics it is said that the demand for human needs is limited or finite, i.e. they have a definite

quantitative limit.

Wants

Human wants are believed to be limitless or infinite. These are the commodities which enhance life and bestow it

with a sense of fullness. Certainly our capacity to yearn for and ultimately acquire goods and services such as

cars, foreign holidays, computers arid fitted kitchens seems endless and inexhaustible. Wants are not necessary to

ensure survival-

4

Economics I Reference Book 2

Microeconomics and

macroeconomics

Opportunity cost

The production

possibility curve

they do not sustain life. They are the motor force which drives us to a more complete and satisfactory enjoyment

of it.

The key to our understanding of economic man is that wants must be limitless. If they were not, then with a

given level of income, we could satiate all our consumer desires. We would no longer have to practice choice

because our incomes could afford us to demand all that we wanted. Income is only limited because it is not

and never is, enough, to allow us to demand all that we want.

This problem of scarcity, choice and limited income seems to remain constant,

irrespective of which society we study, of its relative level of economic

development or its place in time. Our desire for wants is relative _ we never have

enough, our income is therefore limited and everything we want is scarce.

Microeconomics is concerned with the individual parts of the economy, for example how prices of

individual goods are determined.

Macroeconomics is concerned with the economy as a whole, for example what determines the

general level of prices.

A man living alone living on a desert island has little use for money, but he still has to deal with the

problems of scarcity and choice. His scarce means are the physical resources he finds on and around

his island, including his own skills and knowledge. Even time is a scarce resource since there are only twenty-

four hours in a day - an hour spent building a shelter is an hour not spent gathering food.

Each opportunity taken implies some alternative foregone. Every choice involves a cost. The real cost is not

the price we pay. In the simple one- man economy, money serves no purpose. The real cost of taking one

option is the alternatives foregone, or, to be more accurate, the most attractive alternative foregone.

Economists call this ^ opportunity cost. So it could be, for example, that if the government decides that it wants

to hire 1000 extra police it will have to reduce spending on education and 900 fewer teachers can be afforded.

So the opportunity cost of 1000 police would be 900 teachers.

Companies choose between one expansion programme and another because investment funds are limited, as

are the necessary resources available. For the same reason, governments cannot cut taxes, employ more nurses

and re-equip the army all at the same time - ministers must choose. All economic problems are really just the

same problem set in a different context.

Opportunity cost can be illustrated by means of a table called a pi^ duction possibility schedule where we

assume a country with given resources and a given level of technology. Let us also assume that the

country can produce two products

- food and guns. The more resources the country puts into the production of food, the fewer are available for

the production

1 hich tdi

/\/\COme We could

' U S to I

ms to remain

relative levej of isreJative !and ev m^hin

0

A

but

Hs scarce

fs island. P

to o o

iMpffwoiiiks

of guns. Once all resources are being used, the only way the output of one good can be increased is by reducing

the output of the other. There is a trade off between the production of food and the production of guns which can

be seen in the following table.

Table 1-1: Production Possibility Schedule

10 m toy

Production Possibility Schedule showing possible combinations of food

and guns production per month

Food(Thousands of tons) Guns(Thousands) 30

5

Figure 1-1: Production Possibility Curve

resource

u

Gildig

t choice

one

- h one

'most w

cost.

Food {'000 tons)

The horizontal axis measures the quantity of food while the vertical axis measures the quantity of guns. The

curve on the figure shows all those combinations that can be produced if all the nations resources are fully

employed. It is called a production-possibility curve. Points outside the curve are those that cannot be

obtained because there are not enough resources to produce them.

28 _ B 1

2

C

economy det m^ined.

for example

24 .

D 3

E __

18

10 4

6

Economics I Reference Book 2

Economic Systems

custom and habit.

The market economy %

lapit' or I _ : XXriceh4cS/xS. ArttTo

A ..

Smith called this the invisib ^hand .

What is produced depends on

they are willmg ' 'Afferent methods. Who is going to

their willingness to exercise it. =====f==' closest to the market economy.

.private property - the resources needed for production belong to private iXST are Fe

atures

of a free to use and dispose of them as they see fit. market system

Freedom of choice - consumers are'ree== hire'hTresources wealth as they choose. Producers are to buy or hxr the re

they need to produce the goods and services mey price. sellers interact to produce the market price.

Public goods

Public goods are goods and services which cannot be provided through the market and, if we are to enjoy them, they

must be j'ovided by government. These include such servicers public health, law and order, public service

broadcasting and national defense.

Features of public goods are:

Non-rivalry the fact that one individual is enjoying a public good does not mean there is any less for anyone else

Non-excludability it is not possible to exclude non-payers from enjoying the benefits of public goods.

Merit goods

Merit goods can be provided through the market, but the likelihood is that people could not afford or would not be

willing to spend on'hem as much money as is judged appropriate. goods include education, personaMfiealth care and

cultural and recreational facilities such as parks, sports grounds and theatres.

Externalities

Market prices reflect costs and benefits accruing to individual buyers and sellers. They do not reflect social costs and

benefits which accrue to society as a whole. A producer whose factory is heated by a coal fired furnace will include the

cost of the coal in the price of the product. This will not include the eost of the pollution caused by burning the coal.

The command

Command, centrally planned or socialist economies are the opp6site pf market economies. In a command economy,

the questions what, how and for whom, are decided by a central planning authority appointed by the government.

Examples of command economies are China and the former Soviet J'nion. Most command economies contain some

element of private enterprise such as private food production and small-scale trading.

Features of command

Public ownership - the means of production are owned and controlled by the community as a whol'and decisions

about their use are made through the central planning authority.

Limited freedom of choice individuals are free to choose the goods and services they wish, but this freedom is

limited not just by their funds but also by the range of goods and services available. This range is decided by the

planning authority. Prices are used, but they are set by the planning authority and so do not reflect the underlying

forces of supply and aemand.

Motivation - the underlying motivation is the common good rather than personal self interest.

Co-operation command economies tend to stress the attractions of co-operation rather than competition.

'Planning mechanism - at the core of the command economy is the /central planning authority.

The mixed economy

The mixed economy lies between the market and the command economies and contains elements of both to get the

best of both systems. Britain is an example of a mixed economy. Most goods and services are produced by private

enterprise in response to

market forces. In recent years this has been extended by the govemmenfs privatization programme -the sale of state-

owned industries such as telecommunications, gas and electricity companies. Despite this, there remains a substantial

public sector.

Production

Production is the creation of goods and services which people want and for which they are willing to pay. Production

can also apply to unpaid work as carried out in the home, such as cooking, cleaning, gardening and general

maintenance, which are important for the well-being of any family, but are usually not marketable. Productive

workers are not only those who make things but also those who provide services such as shop assistants, teachers,

bankers and doctors. Production produces output which can be classified as goods and services or according to the

type of industry involved, such as:

Consumer goods wanted for their own sakes and satisfy wants directly. Nondurable goods, such as food and

heating, are used up immediately, but durable goods provide a flow of utility over a period or time.

Capital or producer goods not wanted for their own sakes but for the consumer goods they can produce. The

demand for them is a derived demand depending on the demand for the consumer goods which they make.

Services as a society becomes more mature and specialized, the demand for services increases. Similarly as

living standards rise, so an increasing proportion of income is spent on services such as entertainment, education,

health care and education.

Prunary or extractive industries - include agriculture, forestry, fishing, mining and the production of oil.

Secondary industries include construction, manufacturing and the production and processing of electricity, gas

and water.

Tertiary industries transport, distribution and services in general. The factors of production

The factors of production are the scarce resources that firms use to produce the goods and services we demand. We,

ll look at these factors under four headings:

Land

Capital

Labor

Enterprise

Land

Land refers to all natural resources and not just the land itself and includes rivers, lakes and seas, mineral deposits,

fisheries, the climate; in fact any free gift of nature. The total supply of land is fixed, if we ignore land reclamation

and the effects of erosion. The amount of land available for one particular purpose is not fixed since it is possible to

switch land from one use to another.

The land used for farming could be used instead for housing, but at any given location,

such as a busy city centre, there is a fixed amount of land available and while it is possible

to switch the land from one use to another, it is not possible to increase the actual amount

of land. In a country such as Britain where the land has been worked for thousands of

Economics I Reference Book 9

years, there can be very little land which has not been modified in some way by human effort. The income earned from the ownership of land is

called rent.

Capital

Capital consists of those man-made assets such as buildings, tools, machines and equipment which are used in the production of other goods and

services. Capital items are not wanted for their own sake but for the part they play in production. Notice that there is no reference here to money.

Capital, as a factor of production, means the physical resources needed to make other products; it does not mean the money required to purchase

them. In this sense, the capital of a firm is its buildings and equipment and not the money subscribed by its shareholders.

Working capital consists of completed goods, partly finished goods and stocks of raw

materials held by producers. Fixed capital consists of the actual buildings and machines

used in the productive process. Production covers services as well as goods, so the

nation' fixed capital would include hospitals, schools, bank buildings, insurance offices,

railways, airports and so on, including the furnishings and equipment they use. A feature

of capital is that it wears out and has to be replaced. Allowance has to be made for

maintenance and declining value. This is called depreciation. The income earned from the

ownership of capital is interest.

Labor

Labor is the human effort that goes into producing goods and services, including mental effort as well as physical effort. A bank manager is working

and supplying labor when interviewing a customer or deciding whether or not to make a loan; so too is a teller when answering a customers query.

Because labor is provided by people and cannot be bought and sold in the same way as land and capital, it must be treated separately.

The supply of labor depends on a number of factors:

Size of the population this places an upper limit on the supply of labor.

Composition of the population the make-up of the population will affect the number of people available for work. Children and senior citizens

are much less likely to seek employment than people between the ages of 18 and 65.

Migration - emigration and immigration can affect both the size of the ponulation and its composition.

Employment legislation can affect the number of people available for work and how long they may work. A rise in the legal school leaving

age would reduce the supply of workers. A rise in the age of retirement would increase it. Laws governing the length of the working day and

holiday entitlement would also affect the supply of labor.

Pay - apart from voluntary workers, most people work to earn their living. Their willingness to work is therefore influenced by the rate of Dav

offered. If pay rates are generally low, a rise in the rate of pay is likely to encourage more people to work or existing workers to work longer. As

incomes rise and people become better off, there comes a point where they might prefer leisure to extra income. At this point, a rise in pay rates

could lead to less work being offered.

The efficiency of labor

The demand for labor is a derived demand. Employers hire workers for the work they can do and the goods and services they can produce. Output

is determined not just by the number of workers employed but by how effectively they work. If efficiency can be

improved, the same level of output can be produced by fewer workers, or alternatively, the same, number of workers

can produce a higher level of output.

Efficiency depends on a number of factors:

Education and training- modern business requires a well-educated and well-trained labor force. Many employers run

their own training schemes and encourage their staff to improve their qualifications.

Working conditions a well-organized workplace can increase the efficiency of workers and a pleasant working

environment can improve workers5 motivation. This applies to social as well as physical environment and is one of the

reasons why some employers encourage social and sporting activities for their staff.

Health and welfare nobody gives of their best when they are ill. The National Health Service in Britain was set up

for social reasons, but one of its consequences is a healthier workforce.

Motivation- people work better if they are properly motivated which may be done by financial incentives such as

bonuses, commission and work-related pay. It can also be helped by providing a pleasant working atmosphere,

recognition of effort and good career prospects. The income earned from labor is called wages.

Enterprise

Land, capital and labor must be combined together if production is to be undertaken.

Somebody has to decide what to produce and how to produce it. This somebody is the entrepreneur, the person who

organizes the other factors of production. The entrepreneur is the risk taker. Nobody can know for sure whether a

business will succeed. Future demand and potential costs can be estimated, but there is always an element of

uncertainty. The entrepreneur must hire or buy the factors of production needed before the goods can be made and

sold. Only when all payments have been made or received can it be known for certain if his or her judgment has been

correct.

Some argue that enterprise is merely a specialized form of labor. Professional managers can be hired to direct a

business. The people who run major banks would come into this category. They manage the businesses on behalf of

the owners, the shareholders. It is the owners of the business who carry the ultimate risk. They have a claim over the

profits and it is their money which is at risk should the business fail.

The reward for enterprise is profits. One difference between enterprise and the other factors of production is that the

rewards for land, capital and labor are contractual; rent, interest and wages can all be fixed by agreement or legal

contract.

The reward for enterprise is residual; profits cannot be fixed by contract, they are simply what is left from income or

revenue after all costs have been met.

Production and time

The factors of production may be combined together in a variety of different ways to

produce the same end product. One method may require more capital and less

labor, another more labor and less capital. For example, a Dank can decide to operate

with more equipment, computers and automated tellers, or it can decide to do the same

work with less equipment, but more staff. The options open to a producer depend on the time available:

The very short term the period in which supply is fixed and nothing can be done to vary it.

The short term the period during which some factors can be varied but there

Economics I Reference Book 11

14

is at least one which is fixed and cannot be changed. For example, a bank branch which suddenly increases its volume

of business can take on more staff to deal with the extra work, but in the short run it cannot increase the size of its

premises. The short term in this instance would be the time it would take to extend or enlarge the branch.

The long term in the long temi, all factors can be changed. All that is fixed is the technology and methods of

operating. For example, a bank which finds its business has grown can move to larger premises or redevelop the

existing building.

The very long term not only can all factors be varied, but so also can the technology used. The banks have already

introduced many examples of new technology in recent years, including automated teller machines, debit cards and

telephone/internet banking. This process is likely to continue and could lead to major changes in the way those banks

operate.

In the long run everything can change, and in the very long run, even technology. In the short term, however, one

factor (usually land or capital) remains fixed, so output can only be increased by using more of the variable factors.

This changes the proportions in which the fixed and variable factors are used.

Production Function The production function links input to the output. It explains the

technological relationship between the inputs firms use and the output produced. Mathematically, the production

function can be expressed as follows:

q=0 ( fm)

Where,

q is the quantity of goods or services produced,

are the quantities of m different inputs used, and 0 tells us that q is a function of/i.e./determines q

Costs in the Short Run

The length of short run is influenced by technological considerations such as how quickly equipment can be

manufactured and installed.

Short Run Variations in Input

In the short run we are primarily concerned with the effect of variable input on output and costs with a given auantity

of the fixed input. The underlying assumption for a simplified production function is tnat the capital is fixed, whereas

the labor is variable. Therefore, the scenario here is that the firm starts with a fixed amount of capital equipment and

then contemplates using various amounts of labor to work with it.

Table 1-2 in the case study shows how output can vary if input is changed. The change in output can be

interpreted in three different ways.

Total Product =the total amount produced during some period of time by all the inputs the firm uses. If all but one of the inputs is held

constant, the product will change as input of the variable factor is changed.

Marginal Product = the addition to total product resulting from the use of one more (marginal) unit of the variable factor Change in Total product Change in Number of units of variable factor.

Average Product = total product per unit of the variable input Total product Number of units of variable factor

As shown in the case study, as more of the variable input is used, average product first rises and then falls. The point where average product

reaches a maximum is called the point of diminishing average returns. For example, in Figure 1-2, average product reaches a maximum when 7

units of labor are employed.

Ahmed & Sons is a specialist manufacturer of office furniture. It produces one standard product, the Executive desk. The firm has a well

equipped factory and is able to vary its output by varying the number of workers it employs. Each worker is of equal skill and makes the same

effort as the rest of the team.

The following table shows how the number of desks produced each month varies with the number of workers employed.

14

From the table and the diagram we can see that production falls into three phases:

1.Increasing returns up to and including the employment of the third worker, total output is growing at an increasing rate.

Marginal product is increasing and so too is average product.

2. Diminishing returns with the employment of the fourth worker, total output continues to increase but at a

reducing rate. Marginal product is positive but getting smaller. Average product is also declining.

3. Total output starts to decline - with the addition of the eighth worker, marginal product becomes negative and

total product falls. There would be no point in employing the eighth worker.

The law of diminishing returns assumes that at least one factor of production is fixed and applies to the short run. Underlying the law of

diminishing returns are other assumptions:

All units of factors employed are of equal efficiency

Diminishing returns cannot be explained by using the best workers first and poorer workers

later

Technology remains unchanged Short Run Variations in Cost

We have now seen how output varies with changes in just one of the inputs in the short run. By costing these inputs, we can discover

how the cost of production changes as output varies. For the time being we consider firms that are not in a position to influence the

prices of their inputs, so they take the prices of these inputs as given.

We now define cost concepts that are closely related to the product concepts introduced earlier.

Total Cost (TC) is the entire cost of producing any given rate of output. Total cost is divided into two parts: Total fixed costs (TFC) and

total variable costs (TVC). Fixed costs are those costs that do not vary with output; they will be the same if output is 1 unit or 1 million

units. These costs are also often referred to as overhead costs or unavoidable costs. All of those costs that vary positively with output,

rising as more are produced and falling as less is produced, are called variable costs.

In previous examples, we kept changing the number of labor as labor is variable input. Therefore the cost o|>labor would be a variable

cost. Variable costs are also called direct costs or avoidable costs.

These costs can be cut down or avoided, for example using machinery instead of labor; therefore this can also be referred to as avoidable

cost.

Average Total Cost (ATC) is the total cost of production per the number of units produced. ATC

may be divided into average fixed costs and average variable costs.

Marginal Cost (MC) is defined as the increase in total cost resulting from raising the rate of production

by one unit. The marginal cost of the tenth unit, for example, is the change in total cost when the rate of

production is increased from nine to ten units per period.

Sunk Cost (also called retrospective cost) is defined as a cost that, once incurred, cannot be reversed. For

example, a worn-out piece of equipment bought several years ago is a sunk cost because the cost of buying it

Table 1-2: Total, average and marginal products in the short run

Quantity of

Labor(L)

Total Output (TP) Average Product (AP) Marginal Product (MP)

2 v- 3 4

43 43 43'

2 160 80 11.7

3 351 117 191

4 600 150 249

r 875 175 275 6 1152 192 277 7' 1372 196 220

8 1536 192 164 9 1656 184 120

10 1750 175 94

11 1815 165 65

12 1860 155 45

18

cannot be reversed.

Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is

taken. Both retrospective and prospective costs may be either fixed (i.e. they are not dependent on the volume of economic activity,

however measured) or variable (dependent on volume).

Short Run Cost Curves

The three different types of cost defined above are mathematically interrelated. Considering the output numbers used in Table 1-1

in case study 1, we assume that the price of labor is PKR 20 per unit and the price of capital is PKR 10 per unit. Figure 1-3 shows

the computed values.

Since total fixed cost does not vary with output, average fixed cost is negatively related to output, while marginal fixed cost is zero. In contrast, variable cost

Table 1-4: Variation of costs with fixed capital and variable labor Pl.. Output Total Cost (PKR) Average Cost (PKR) Marginal Cost

(PKR)

1ST Fixed

(TFC)

Variabl

e

(TVC)

Tota

l

(TC)

Fixed

(AFC)

Variable

(AVC)

Total

(ATC)

3 4 5 6 7 8 9 10

ft 100 20 120 2.326 0.465 2.791 0.465

160 100 40 140 0.625 0.250 0.875 0.171

351 100 60 160 0.285 0.171 0.456 0.105

600 100 80 180 0.167 0.133 0.300 0.080

875 100 100 200 0.114 0.114 0.229 0,073

1152 100 120 220 0.087 0.104 0.191 0.072

1372 100 140 240 0.073 0.102 0.175 0.091

1536 100 160 260 0.065 0.104 0.169 0.122

1556 100 180 280 0.060 0.109 0.169 0.167

1750 100 200 300 0.057 0.114 0.171 0.213

1815 100 220 320 0.055 0.121 0.176 0.308

1860

Wc

100 240 340 0.054 0.129 0.183 0.444

1 / TC. A- i

Economics | Reference I

is positively related to output, since to produce more requires more of the variable input. Average variable cost may, however, be negatively related to

output at some levels of output and positively related at others. Marginal variable cost is always positive, indicating that it always costs something to increase

output; but, as we will soon see, marginal cost may rise or fall as output rises.

If we look closely at the graph, we will see that the marginal cost curve cuts the ATC and AVC curves at their lowest points. This is another example of the

relation between a marginal and an average value. The ATC curve, for example, slopes downwards as long as the marginal cost curve is below it; it makes

no difference whether the marginal cost curve is itself sloping upwards or downwards.

Going back to Figure 1-3 we can see that the average variable cost curve reaches a minimum and then rises. With fixed input prices, when average product

per worker is at a maximum, average variable cost is at a minimunL The common sense is that each new worker adds the same amount to cost but a

different amount to output, and when output per worker is rising, the cost per unit of output must be falling, and vice versa.

The short-run curves for AVC are often U-shaped. This is primarily dur to the following assumptions:

The average productivity is increasing when output is low, but the ave productivity eventually begins to fall fast enough to cause average ti cost to

increase.

The least cost combination of factors of production

The law of diminishing returns does not tell us which combination inputs and which level of output a producer will choose. We assume businesses

are run to maximize profits and are keen to keep their to a minimum.

20 Economics | Refere

Profit is the difference between total revenue and total costs, but the law of diminishing returns deals in physical inputs and gives no

indication of cost; nor does it show at what price output will be sold.

Using the data in the case study, if we assume that the fixed factor is free, then the lowest per unit of output will be where average

product per worker is highest. This would be when three workers are employed. On the other hand, if the workers are unpaid

volunteers, perhaps working for a charity, then the optimum level of output will be the maximum that can be achieved.(lhis is where

marginal output is zero and corresponds with seven workers being employed.)

In practice, firms have to pay for both their fixed factors and their variable factors. The mix they choose of these will depend on

relative costs.

The cost structure of firms in the long run

In the short run, with only one input variable, there is only one way to produce a given output: by adjusting the input of the variable

factor until the optimal rate of output is achieved. Thus, once the firm has decided on a rate of output, there is only one technically

possible way of achieving it.

By contrast, in the long run all inputs can be varied. The firm must decide both on a level of output and on the best input mix to

produce that output. Specifically, in our two input example this means that firms must choose the nature and amount of plant and

equipment, as well as the size of their labor force. So long run in this context means that the capital stock can be changed, while very

long run means that the technology can change too.

Cost curves in the long run

When all inputs can be varied, there is a least cost method of producing each possible level of output. Thus with given input prices,

there is a minimum achievable cost for each level of output; if this cost is expressed as a quantity per unit of output, we obtain the

long-run average cost of producing each level of output. When this least cost method of producing each output is plotted on a graph,

the result is called a long run average cost curve (LRAC). Figure 1-4 shows one such curve.

This cost curve is determined by the industrys current technology and by the prices of the inputs. It is a boundary in a sense that

points below i are unattainable;points on the curve, however, are attainable in sufficient time elapses for all inputs to be adjusted. To

move from one point on the LRAC curve to another requires an adjustment in all inputs, which may, for example, require building a

larger, more elaborate factory. The RAC curve is the boundary between cost levels that are attainable, with Smown technology

and given input prices, and those that are unattainable.

r jst as the short-run curves discussed earlier in this chapter are derived frcfn the production function describing the physical

relationship between uniputs and output, so is the LRAC curve. The difference is that in deriving tie LRAC curve there are no fixed

factors, so all inputs are treated

as variable. Because all input costs are variable in the long run, we do not need to distinguish between AVC, AFC,

and AT/as we did in the short run. In the long run there is only one long-run average cost (LRAC) for any given

set of inputs.

qo 1

(|m

Output per period Figure 1-6 : The shape of the long-run average cost curve

The long-run average cost (LRAC) curve is the boundary between attainable and unattainable levels of cost. Since the lowest of

producing qo is co per unit, the point Eo is on the LRAC curve. Suppose a firm producing at Eo desires to increase output ql.In the

short run it will not be able to vary all inputs, and thus unit costs above cl, say c2, must be accepted. In the long run a plant that is

the optimal size for producing output qi can be built and costs of cl can be attained. At output qm the firm attains its lowest possible

per-unit cost of production for the given technology and input prices.

As the firm varies its output in the long run, average cost may vary for two distinct reasons. First, the prices of its inputs may

change. Second, the physical relation between inputs and outputs may change. To separate these two effects, we assume for the

moment that all the input prices remain constant.

This LRAC curve is often described as U-shaped, although empirical studies suggest it is often saucer-shaped.

Demand, Supply In this section we will be examining the forces of demand and supply, the relationships and the between them, and

how the price mechanism operates in the market economy.

Price Mechanism

Demand

Demand is the quantity of a good or service which would be purchased at a particular price over a period of time. Demand is

always related to price. The quantity demanded depends on the price asked. As price changes, so usually does the quantity

demanded. Demand is measured over a period of time such as a week, a month or a year.

20 Economics | Refere

Figure 1-7, Market demand curve

What we are concerned with is effective demand, that is, the willingness and the ability to purchase the product. This should not be confused with

desire, want or need. Typically, the higher the price, the lower the quantity of a product people will purchase and the lower the price, the higher the

quantity. If we look at the purchases of a particular product we might make as individuals during a month, we can draw up what is called an

Individual Demand Schedule. By combining the individual demand schedules of all the people in an economy, we obtain the Market Demand

Schedule.

1-5: *" jemand Schedule M QuantityDemanded i )per month

10,000

8,000

5.000

2.000

1,000

Demand curve

A demand curve shows the relationship between price and

quantity demanded, assuming all other market conditions

remain constant. A demand curve normally slopes downward

to the right. As price falls, there is a movement down the

curve to the right. As price rises, there is a movement up the curve to the left. Other things being equal,a change in

price leads to movement along the demand curve. The demand curve slopes downward to the right because as

price falls, people tend to bov more.

This is due to the operation of two factors:

The substitution effect The income effect

Sabstitution effect

As the price of a product falls, it becomes relatively cheaper compared d alternative goods and services. Some

consumers are likely to '~tch their purchases to the cheaper product and so the quantity lem-anded increases.

Economics I Reference I

Income effect

A fall in the price of a product increases the purchaser's real income. He or she is able to buy the same

quantity as before and have some money left over which can be used to finance additional purchases,

althoug it may not all be spent on the same product. The lower price may now place the product within the

reach of people who could not previously afford it. This could further increase the quantity demanded.

Exceptions to the general law of demand

There are three exceptions to the general rule that, as the price of a good falls, more of it is demanded and

as the price rises, less is demanded:

Inferior goods

Expected price rises

Goods of conspicuous consumption

Inferior goods

Usually the substitution and income effects work m the same direction.

As price falls, both the substitution and income effects lead to an increase in the quantity demanded. This is

true for normal goods, but there are some products known as inferior goods where this is not the case.

Inferior goods are low quality products bought by people who can afford nothing j better. As incomes rise,

people switch from inferior goods to more expensive, but more attractive, alternatives. The substitution

effect j continues to operate as for a normal good.

A fall in price encourages the substitution of an inferior good for a mor= j expensive alternative. The income

effect is the opposite of that normal1 good The fall in price increases the purchasers real income and allows I

them to switch part of their expenditure away from the inferior good to alternatives. This partially offsets the

increase in quantity demanded due to the substitution effect.

An extreme form of inferior good is a giffen good where the incomcj effect is so great that it completely

wipes out the substitution so that a fall in price results in a decrease in quantity demandedLi

Expected Price rises

A rise in price may sometimes lead to a rise in quantity demanded! purchasers believe this is part of a series

of price rises and more are to expected. People hoping to buy a house by means of a fixed inter mortgage

might interpret one rise in interest rates as an indication f further increases are imminent. This could result

in a surge in den1 for fixed interest loans to beat future rate increases. On the Stock Excl a rise in the price

of a particular share might increase demand for investors anticipated further rises in price.

23

Goods of cdAs|>icu|)us consumption

The appeal of some goods is the very fact that they are expensive and beyond the reach of most people. Their high

price adds to their exclusiveness and their attraction. Jewelry, expensive cars and up market branded goods may

all come under this heading.

Determinants of demand

The demand for a good or service, that is, the quantity bought over a period of time, is determined by a number of

factors:

Price factors, the price of the product - as we have seen from the demand schedule and

demand curve, the quantity purchased of a product depends on the price. Economists often say

it is a function of price.

Non-price factors, The prices of other products ^buyers have a choice of competing products

on wmch to spend their limited income. Buyers will take account of the prices or alternative products

when deciding which to purchase. A customer considering whether or not to apply to a bank for a

credit card is likely to compare that banks fee and interest rates with those charged by other banks.

Buyers7 incomes ^the more people earn, the more they are able to spend and the greater

is likely to be the general level of demand.

Buyers7 tastes and preferences - each person has his or her

own set of tastes and preferences.

Market size ^the number of potential customers will influence the demand for a product. A bank

branch located at the centre of a busy city is likely to face a greater demand for its services than one

located in a rural area.

Demand and utility

Goods and services are desired for utility- in this context meaning 'satisfaction rather than usefulness. As we

get more of a good or service, we increase our satisfaction or add to the total utility we derive from it. However,

the extra or marginal utility we gain from each extra unit of the product becomes progressively less, the more units

we have. This is not as complicated as it sounds. Imagine how you would feel after a long

ilk on a hot summers day if you were offered a cool, refreshing drink. The tirst glass would be very welcoming

indeed. So too might a second s'ss. but not quite as much as the first. In other words, the utility from tbe second

glass is not as great as that from the first. That from a third be even less. This is sometimes referred to as the Law

of Diminishing Mirsinal Utility which states that:

the quantity of a commodity consumed by an individual increases, tine

marginal utility decreases.

Economics | Reference 1

Put another way, the more we have of a good, the less satisfaction we gain from consuming one more unit of

it. It would be helpful if we could measure utility or satisfaction. Unfortunately, nobody has yet invented a

device which can actually measure satisfaction. An alternative approach might be to ask how much a person

would be willing to pay for each extra unit of a good. As more of a product is consumed, each extra unit

becomes less attractive and worth less to the consumer. The amount a person is willing to pay for each extra

unit indicates how much he or she values that unit and reflects the utility or satisfaction derived from it.

Measuring satisfaction or utility is fraught with problems. Using money as a measure of satisfaction is not a

perfect alternative since the satisfaction derived from holding money may change. The satisfaction you would

derive from receiving an extra 100 rupees per week would be much greater than that derived by a millionaire

receiving the same increase. In other words, money is also subject to diminishing marginal utility. A way

around this problem is to accept that we cannot measure utility and instead place our choices in order of

preference. Demand, however, is only half the story and we must now turn to supply.

Supply

Supply is the quantity of a good or service which would be offered for | sale at a particular price over a period of

time. As in the case of demand, j supply is always related to price. Supply is measured over a period of time such

as a week, a month, or a year. Each supplier will have in mind the I quantity he or she would be willing to supply

at each price. Typically, as price rises, the supplier will increase the quantity on offer. As with demand, j this

information can be set out in a table known as a supply schedule. By I combining the supply schedules for each

individual supplier, it is possiW to produce a market supply schedule.

Table 1-6: Market Supply Schedule

Price per Product (PKR)

Quantity Supplied per month

5 1,000

10 2,000

15 5,000

20 8,000

25 10,000 a .

Economics | Reference 1

25

A supply curve slopes upwards from left to right which implies felt producers will increase their output if

they are offered higher prices, kirfier price gives producers an incentive to produce more and also ~7 es them the

means to produce more since the higher price gives them the income they need to bid for extra resources and can

offset

any nsng costs.

Demand and supply relationships Interrelated

demand Joint or complementary

demand

Sometimes demand for one product is closely linked to demand for another, such as strawberries and cream, cars

and petrol, or possibly bricks and mortar. In each case, the two joint products are used or consumed together. A

change in the demand for one of these products is likely to lead to a change in demand for the other.

Two financial services which have joint demand are mortgages and insurance. A person taking out mortgage to

buy a house will probably think it wise to insure their own life and the lender will no doubt insist that the house

which serves as security for the loan is also insured. Home contents and personal possessions may also be

included. Given that mortgages are long-term loans, often for 25 years, it can be seen that home loans can generate

considerably more business than just the original loan. Hence there is a competition between banks for this type of

business.

Derived demand

In some cases a product is demanded because it is used in the production of some other product. This is known as

derived depa: and. The demand for bank staff is derived from the demand for financial services. As the demand

for financial services increases, other things being equal, the demand for bank staff is likely to increase.

Composite demand

Some products have a number of different uses; for example, steel can be used in the manufacture of ships, cars,

domestic appliances and many other products. Composite demand is the total demand for a product in all its

different uses.

Competitive demand

Two commodities may be close substitutes for each other, so an increase in the sales of one might reduce the

demand for the other. Life assurance policies and personal pension plans are both forms of long-term saving,

although they each have their own distinctive features. If bank customers were persuaded to increase their

Davments into their pension plans, they might decide they haa less need for life assurance or that they had less

money available for life assurance. Any form of holding wealth could be said to compete with these two products

^bank accounts, shares, unit trusts, personal equity plans. Physical assets such as property, works of art and

jewelry, are all ways of holding wealth.

Economics | Reference I

For most people, the most important form of wealth they hold is their own home. In a sense, all products are in

competitive demand since consumers have limited incomes and must therefore make choices.

Inter-related supply Joint supply

In soixTcases, tw '^ products are produced together; an example would be wdol and mutton. An increase in the

supply of one leads to a similar increase in the supply of the other.

Competitive supply

Where two products are produced together, it may be that output of one can only be increased at the expense of

the other. A farmer who wishes to keep more livestock on his farm may only be able to do so by cutting back

on arable farming.

The price mechanism

At the heart of the market economy is the price mechanism. Price carries out three important functions:

Rations

S

ignals

Allocates

Rations

Price rations out the existing supply of a product among those who wish i to buy it. If at a given price, the

demand for a product exceeds the supply, j the price will rise. As the price rises, some would-be purchasers

decide it is now too expensive and drop out of the market. Eventually a price is j reached where the quantity

purchasers are willing to buy just matches 1 the quantity suppliers wish to sell.

Signals

Prices provide important information for buyers and sellers in a market which allows them to make informed

decisions and to co-ordinate their activities.

Allocates

Price allocates scarce resources towards the production of goods services that people are willing to buy

and away from the production < those that people reject. If the demand for a product increases then,

('things being equal, its price will rise. This higher price is an incentive 1 the producer to expand output of

the product. It also provides the ] for expanding output. The producer can use the extra money gained i

the price rise to bid for the extra resources needed to increase produc If demand for a product decreases,

the opposite happens. Price falls i the producers income is reduced. With less money, the producer is j to

command fewer resources. Determining price

by to miction of demand and supply. We can curves iJe M ' '

30

25

20

15

10

5

0

0 2,000 4,000 6,000 8,000 10,000 12,000 Figure 1-9,

Equilibrium price

IA h a diagf > ! can see that there is only one price at which TO ZTL rSh i lS qUal to the 9 f^[

Producers wish

ab0V the equilibrium price, producers would wish to sell more "Uk ers Wlsh t0 buy. Supply

would exceed demand and producers

:===tlh rf St,Ck-Ther Wud be no p m maintaining r jduction at this level and so production

would be cut back. To clear Mstlng

s,uiplus> producers would need to reduce their price This ?r

cess wuid conn ^^ | i the equilibrium price was reached

'producers underestimated the strength of demand and produced less ^ ^n .he equilibrium level of output, at

below the equilibrium price they X uld soon find themselves sold out. Some customers would be willing LZricclT A P?e AtWs WOuld Producers to rais* ^ UtpUt * * the Pra'ss

would continue

TSreated', adjU5tments * to to work, % P ce emg charged and paid, the market price,

may not be -'equilibrium price. However, provided the market forces of demand

t0 E , ' ' PiC tend the

n0t almyS allWed t0 feely. Sometimes for y of motives, governments decide

to interfere with the free operation

f. ihc market and controi a particular price or group of prices Tbere are two types of price controls: P or pnees.

29

Price ceilings

In the case of price ceilings, government fixes the maximum price which can be charged for a particular product.

Producers can charge less than this if they wish; they cannot charge more. The aim is to keep prices low so that

poorer people can afford to buy the product. If the maximum permitted price is set above or at the equilibrium price,

it will have no effect, as market forces will move the market price to the equilibrium price.

If the maximum permitted price is set below the equilibrium price, the quantity people wish to buy at the official

price is greater than the quantity producers wish to supply. The result is that, at the official controlled price, demand

exceeds supply and there is a shortage.

2. Price floors

In the case of price floors, the government fixes a minimum price whichJ can be paid for a particular good.

Consumers can pay more than this minimum, if they wish, but not less. If the minimum price is set at or below the

equilibrium price, it will have no effect, as once again market forces will move the market price to the equilibrium. If

the minimuil price is set above equilibrium, suppliers will offer more than customeia wish to buy. The result will

be a surplus.

In a free market, if supply exceeds demand at any given price, price fall until the quantity supplied just equals the

quantity demanded. Tlfl would also happen with a controlled price unless there is some mechaniJ to enforce the

governments minimum price.

Elasticity

When a firm considers changing the price of one of its products, it muJ see what effect this will have on sales. In the

case of a normal good, a in price will lead to a fall in quantity sold; a fall in price will lead toaiM in sales. So far so

good, but the firm would probably like somethin|H little more precise than this. For example, if a bank raised the

anmfl charge on its credit card by 20%, it could expect to lose some cardhoIdaH The important question is, how

many? Will it lose just 1% or 2% offll customers, or will it lose a much more substantial number sucftH 30% or

40%? In other words, just how sensitive will customers change in price? I

In economics this is known as price elasticity of demand. I

Price elasticity of demand is defined as the responsiveness of demanded to a change in

price. Price elasticity of demand is saiduAA

Elastic if a small percentage change in price leads to a larger perce'H change in quantity demanded

Inelastic if H large percentage change in price leads to a smaller

J Unitary or unit elasticity if a given percentage change in price is matched by the same percentage change in

quantity demanded. Price elasticity of demand can be calculated using the equation:

% change in quantity demanded % change in price

Let's use this equation in the example of the bank raising its credit card annual charge.

EXAMPLE

A bank raises the annual charge on its credit card from PKR 1000 to PKR 1200 and finds the number of

cardholders drops from one million to '00,000. To calculate the price elasticity of demand, we calculate first that

the increase from PKR 1000 to PKR 1200 is a 20% rise in price, while the decrease in the number of

cardholders from one million to 900,000 is a Call of 10%.

Inserting these figures into the equation, we get:

-10% =-0.5

+20%

Notice that the answer is negative. This is because price and quantity iemanded normally change in opposite

directions. Usually people find it convenient to ignore the minus sign, but in an examination it is a : .3od idea to

say that this is what you have done. In other forms of : isticity which we will meet shortly, the sign is important,

so we cannot A ways ignore it.

Interpreting the result is straightforward. If we ignore the sign, ibe value can be anything between zero and

infinity.

_ If the value is greater than 1, price elasticity of demand is elastic _ If the value is less than 1, price elasticity of demand is inelastic

.f ine value is 1, price elasticity of demand is unitary

Bllastkity in practice

Jin rr'ctice, when suppliers consider changing price, they are unlikely to iisaass whether demand is elastic or

inelastic, or whether it is greater titoi1 or less than l.What they are interested in is how the price change _ i:! rect

their sales and whether it will increase or decrease their total However, the effect of a price change on total

revenue depends thtprice elasticity of demand:

_ Siaestk demand ^price and total revenue change in opposite directions. A -sc in price leads to a fall in total

revenue. A fall in price leads to a rise mictil revenue.

Imrilastk demand - price and total revenue change in the same direction. A in price leads to a rise in total

revenue. A fall in price leads to a fall

rev enue.

Unit elasticity of demand total revenue remains the same when price is changed. Any revenue

lost by a fall in price is just matched by the revenue gained from extra units sold. Similarly, any revenue gained by

raising price is matched by revenue lost because fewer units are sold.

Factors influencing price elasticity of demand Availability

of close substitutes

Price elasticity of demand is much more elastic for products for which close substitutes are readily available at a

similar price. In Britain there is considerable competition between banks for mortgage business and house buyers

are well aware of the going market rate. Any bank which tried to raise its rate significantly above that of its

competitors would find the demand for mortgages very elastic as would-be borrowers turned to other, lower priced

lenders.

Proportion of income spent on a product

If people spend only a very small proportion of their income on a product, they are not very sensitive to changes in

its price. Most people spend very little on items such as pins or nails and would not notice even a 100% increase in

their price.

For these, price elasticity of demand is fairly inelastic. Mortgages are a different matter. For most house buyers,

mortgage interest and repayments represent a significant part of their income and they are very sensitive j to changes

in interest rates. This would make the interest elasticity ofl demand for mortgages fairly elastic.

People seem less sensitive to interest charges when borrowing money 1 for fairly small purchases. Here the interest

elasticity of demand can bd said to be inelastic. Where this is the case, it would take relatively higfcj interest rates to

discourage people from borrowing and spendiiid | This weakens interest rate policy as a weapon for managing the

econoiJ

_ J

Some goods such as tobacco, alcohol and drugs are strongly habit formiB and have no close substitutes. Users of

these substances are not e'W discouraged by price rises and so demand for them is inelastic government may take

advantage of this to raise revenue knowing if high taxes are put on tobacco and alcohol, although there a small fall in

consumption, the total tax revenue will incie'''

Even non-addictve goods may become habit forming. People

the habit of reading a particular newspaper, shopping at a particula''J

or even using a particular bank. This is why banks are so keen to enooi'H

students and young people to open accounts. The hope is to

new customers for life. Once the habit is established and beconid"!

of the daily routine, people are less sensitive to price increases and becomes more inelastic.

Durable and non-durable goods

Demand for durable goods such as cars, televisions and domestic electrical goods tend to be sensitive to price

changes and therefore elastic. These are goods which should last for years and so it is easy if prices rise to postpone

purchases of new models and extend the working life of existing units. Demand for non-durables such as fuel, food

and clothing is more inelastic since, even if prices rise, purchases cannot easily be delayed.

Time

Time can have a major effect on price elasticity of demand. The longer -u) ers have to adjust to a price change, the

more elastic demand becomes.

Width Of Definition

The wider a product is defined, the less elastic is its demand. If a finance rjouse, acting on its own, raises its interest

charges on loans, it can expect to lose business to its competitors. It will find demand for its loans sensitive to

interest rates and therefore elastic. If all banks and finance houses raise their charges simultaneously, the demand

for loans will be j ore interest inelastic.

Necessities And Luxuries

^' needs to be treated with caution. It is often assumed that the demand i'r necessities will be inelastic and the

demand for luxuries will be elastic.

>1 is a necessity, yet the demand for individual types of food may be .2 < .:y elastic. If potatoes become dearer,

consumers can switch to bread, rxx and pasta. The key factor is the availability of acceptable substitutes ace not

whether the product is a necessity or a luxury good. Many luxury fece inelastic demand as purchasers are not

very sensitive to price.

.taicoroe elasticity of demand iiiai*me elasticity of demand is the responsiveness of demand for a pni to a change in incomes.

pe e already seen that changes in income can lead to changes in H&2 for a product. Income elasticity of demand

can be calculated g me equation:

% change in quantity demanded % change in income

elasticity of demand is said to be:

3 :.he value is greater than 1 v Ae value is less than 1

This is an occasion when the sign is important. For a normal good, the 'signis positive, indicating that income and

demand move in the same direction. As incoijief increases, so more of the good is bought. For an inferior good,

th'sign is negative. Income and demand move in opposite directions. As incomes increase, consumers can afford

to buy dearer, better quality goods and so buy less of the inferior product.

Price elasticity of supply

Price elasticity of supply is the responsiveness of supply to a change in I price. An awareness of price elasticity of

supply helps people to under the consequences for price of a change in the conditions of demanA |

Price elasticity of supply can be calculated as:

% change in quantity supplied

% change in price

Price elasticity of supply is:

Elastic if the value of the equation is greater than 1 which implies 1 supply is flexible and changes at a greater

rate than pi

Inelastic if the value of the equation is less than 1 which implies i supply is less flexible and changes

proportionately less than

33 Economics | Reference

Factors influencing price elasticity of supply

Elasticity of supply depends on the ease with which output can adji changes in price. This is influenced by a

number of fac

Time

The longer the time period involved, the greater the opportunity to s output and so the greater the elasticity of

supply.

Time required for production

If the production process takes only a short time, it is relatively < adjust output to take account of price

changes. A fast food oi change its output relatively quickly and so its supply is fairly ( farmer may have to

wait a whole year before he can make sig changes in output, so his supply will be much more ii

Number of producers

THe more producers of a good, the more elastic is supply like Available capacity If firms are already

working to full capacity, it will be harder to i output and supply will be inelastic. If firms have spare capacity, iti

easier to increase output

and supply is more elastic. SlQCdge potential

: a : dUCt T1 bf m fr stored, surPius output can be put into stock r; J mand and pnces are low offered for sale when demand is

Substitutability of factors of production

Inhere is a range of factors of production suitable for making a good and these are interchangeable, producers

are more able to meet any increase m 'emand and supply will be more elastic.

Chapter 2

Learning Outcome

Introduction to Economics Macroeconomics

By the end of this chapter you should be able to: n Discuss the basic

framework of macroeconomics, i.e. National Income, Inflation,

Unemployment, Exchange Rate and Trade Imbalances B Discuss the

macroeconomic goals of achieving full employment, economic growth and

stability H Discuss marginal benefit and marginal cost and the relationship

between the two n Discuss consumer and producer surplus a Explain

deadweight loss, overproduction, underproduction a Explain the concept of

trade offs a Describe the characteristics of perfect competition, oligopoly,

monopoly, monopolistic competition * Recall the principles of

macroeconomic policies for a sustainable economy

Identify the importance of theory, data and forecasting i Recall the

controversies in modern macroeconomics

33 Economics | Reference

-- i! llimi 41+ III IIIWI

Introduction

Framework of

Macroeconomics

We need macroeconomics due to the fact that there are forces that affect the economy as a whole that cannot be

fully or simply understood by analyzing individual markets and individual products. Macroeconomics is study of

dealing with economic activities as a whole with respect to the national output, national income, price levels,

international trade, balance of payments, unemployment, and inflation, among other aggregate economic

variables.

1. Economic Growth

Per capita output has been facing ups and downs for many decades in most industrial countries, alon'jAdth total

output. These long-term trends also impact on average living standards. For instance, in Pakistan the per capita

income has increased to USD 1250 in 2010 from USD 920 in 2008.

EcoAomic growth is the predominant determinant of living standards and the material constraints facing a

society from decade to decade and generation to generation. Macroeconomics has traditionally taken the trend in

output as given and looked at how to minimize deviations from that trend. However, in recent years there has

been discussion of whether the policies used to stabilize activity may also influence the long-term trend. Among

the most important issues in macroeconomics is ldentfyir'

mus a clear objective of macroeconomic policy.

2. Business Cycles

:he economy is not 'Ways stable and goes through a series of um and jowns, called business cycles. When the

business cycle is in an upward . __ d __ 0m; WhCreaS Whn is a d th.6

1= jery important for economists, entrepreneurs and managers of firms velop an understanding of business

cycles. During recessions most businesses incur heavy

losses, while the survivors face falling profits. On

* oth] r hand, dumg a period of boom, businesses do well due to high 'mand fr p r o d u c t s , r esu l t s in higher

profits. It is easier for usmesses to expand during boom times while during recession acquisitions, and hostile

take-over and even worse, shutting down of busmesses, are likely to happen. Understanding the business cycle is

thus important for successful businesses. Decisions on whether to expand ra prices, lay ofFsome of the labor

force, introduce new products need n 0,1 the 'asis of economic situations; therefore it is important or companies to closely

observe the business cycle and try to foresee

right bUSineSS dedSi nS

Inflation

Econ'imc growth and inflation go hand in hand. Swings in economic =ty are us.ufy accompanied by fluctuating inflation. Therefore it thp

CmeSjfiy data* fa- ta government to maintain a balance between rt U' attmptS of government ^ control high inflation generally suit m recessions. Therefore an important policy problem that arises

1 m governments is how to stimulate economic activity without T usi'g inflation. The policy makers, during a time

of boom, are often

H ffi ' thdr ro^s t0 brlng Mata 'der control. When flat on falls after a recession, policy makers often feel that they have

so: leeway to stimulate the economy again. Controlling inflation alone =keepmg the economy stable, is not a simple matter and polio

4. Unemployment

Slowdown in the economy results in unemployment. Unemployment is ery critical matter for the government.

Indeed, it was the high unemployment of the 1930s that led to the establishment of the subject

anLo'al5 maCrfeCnmlcs -------------- ngly, analysis of the causes of, d potential cures for,

unemployment is still very high on the agenda of macroeconomics. A new bout of high unemployment can never be ruled out, even for those countries where it

has been low for some time.

r Governmentscan reduce unemployment by increasing their spending ta"xe"

e' irnflTeS' th era e o g _____________ ent spending and axes to influence the economy is known as fiscal policy.

conomics

35

The price

together to coordinate their macroeconomic goals and policies.

Income policies are government attempts to moderate inflation by direct steps, whether by verbal persuasion or

official wage and price controls.

Characteristics of market competition Perfect Competition

The following assumptions should be taken into account relating to perfect competition:

Identical goods are produced by all the firms in the market

There is a large number of independent firms

Each seller is small relative to the size of the total market

Entry or exit is barred from any barriers to entry or exit

When it comes to perfect competition, all firms are price takers. Thr demand curve in this situation is horizontal

to the x-axis due to th** perfectly elastic demand of the products. The firms can sell all of the* output at the

prevailing market price, but if they set their output piioc higher than the market price, they would sell nothing.

Due to the thaf _ .^ ey ' , i w n - - - ^ . i ^ n . ,

knnneer tn--tdrrrte * * * resources to discovering the best price at wl QPII *r Proc^uct- A price-

taker market is equivalent to a perfe competiti

There is ] !i> ^ h i e e . . , e, I : i , . - : n . i r | A i . |v , !> ,_ n : , , h u , . , -

is based on market supply and demand. The individual fir chedule is

perfectly elastic.

Monopol istk

Competitjon

Monopol o>mp eUia.>n I i a> (ho fo l low in ; ; market eha I \K t c -> : .

A large number of independent sellers: The market share for every fii relatvely ; - l ! i i i i i 1 ! ) n r : i iMi I :> -hr , Ih l i h mai l ,n \ i - - - power ove ! pi Xn, - , I I , , ! V , j v ; i ( | v , price rathier than the price of ind ividual competitors. Collusion ([ fixing) is ' i ' l ' - ' 1 1 h . ' l v- .1 i h I I I I I h , I . .

Different pPducts

\ Prducts produced by each producer are slightly ^ Se

f r o m i t s c c ' 1

" 1 : 1

i ' i ' > 11

- - ! ' a i e a - a ! i i ! u ; ! 1 I ! I i h " . n n , , a a . i I I u , competir 1

' 1 1 1

' ' 1

1 . H e h ' . ' ! } ' . . ! I ! ] I i ^ - 1 , > | m i , ' : - -

Frms conm^ te on price, quality and marketing as a result ofyffro different' a t ion . Qu al i t y acts as an

in tegral product-differentia

characters - a. I >i !e I - a . , , , 1 A , , j . l , ,pp ,m: Jemma! , m , i he . . output can he -e' h\

i ia- , . i . )u ai i i \ ana [Mi , : ; hai L. .n i !e .. ha earn .

usually have a strong correlation between them. To inform or coituthl the products characteristics to the

market , marke t in g is of ut importanc -.

UJW tamers to entry so that firms are free to enter and exit the i New firms can enter the industry if the

existing firms in the indus

earning ec( amnia mmm-. demand s Economics I Reference I

X? monopolistic competition the demand curve is highly elastic because tKlnk

of competing products as close substitutes.

Oligopoly is a form of market competition characterized by:

A small number of sellers

'ff?je?hnd'enCe (d made by one firm ect the demand, price and profit of

others in the industry)

Significant barriers to entry that often include large economies of scale ,Prc)ducts that may be similar or

differentiated

Monopoly

Jherejs a monopoly when there is only one seller of a specific well- product. This

product has no good substitutes. If a firm has to ^ hS^noroisc p

----------------------------- ^ to market entry

stotedeTSr1? ' SingIe,Prke are the two Possible pricing strategiesnfthe customers are unable to resell the product to eachother

pr= can be maximized by the monopoly by charging different prices erent fouPs of customers. In the absence of price discrimination the monopoly

will charge a single price. 5

Aggregate Supply and Aggregate Demand

Aggregate supply is the total amount of goods and services that are irelThtefLTthCOhT ^ ply (AS) is a Action of price s_y= a=f XX A K'* u

Wg Will be ~ 0f

Economics I Reference Book 15

Benefit amwi

Marginal Cost

Aggregate demand refers to the total amounts of goods and services that

_Jng toHbu/iii a _+H^_

a~ de=

Figure 1.2-2: Aggregate demand curve

Price index for commodities Real GDP

(trillions)

Aggregate Supply and

ihe supply and demand curves are often used to help analyze macroeconomic equilibrium. Recall that in the

previous chapter we used' , s~T y and demand curves to analyze the prices and quantities of individual products.

Figure 1.2-3 shows the aggregate supply and

=g=es fOT A Utj ntire j^e 31

A

Demand Curves

See =hf=sd m a - _ Wh-as the

7 he downward sloping curve is the aggregate demand curve (AD curve) t represents what all entities in the

economy - consumers, businesles frdgners and governments - would buy at different aggregate price levek From

the curve we see that at an overall price level of 150, total

; -J riding SdMto

roeconomics

41

Macroeconomic equilibrium

Consumer Surplus

The upward sloping curve is the aggregate supply curve (AS curve) This cu've represents the quantity of goods and

services that businesses are willing to produce and sell at each price level (with other determinants ofaggregate

supply held constant). According to this curve, businesses

r nanK ?se PKR 3000 bmcin at a price level of 150; they will want to sell a higher quantity, PKR 3300 billion, if the price rises

to 200. As the

i ? output demanded ns ^businesses will want to sell more goods and services at the higher price level.

A macroeconomic equilibrium is a combination of overall price and quantity at which neither consumers nor

producers wish to change purchases, sales or prices.

Can the real GDP and the price level that would satisfy

buyers and sellers using AS-AD equilibrium. At point E in Figure 1.2-3

q _and p=15 *e economy is said to be in equilibrium. This is the only point where AS cuts AD, hence at this

point consumers and prod= are satisfied. If the price level were higher than equilibrium, say p=200, then businesses

would want to sell more than purchasers would want to buy. Goods would accumulate on the shelves as firms

produced JT consumers As the goods continue to pile up, firms would ~Ut productlon and bem to curtail the prices. As the price

level declines ~m JflnaI hgh level of200, the gap between desired spending and desired sales would narrow until the

equilibrium at p=150 and q=3000 is reached. Once the equilibrium is reached, neither buyers nor sellers wish to

change their quantities demanded or supplied and there is no pressure on the price level to change.

The diminishing marginal utility is the basis for consumer surplus. When there is a gap between total utility of a good

and its total market value,

If receive more than we pay then that results in surplus. According to the law of diminishing marginal utility, the first

units satisfaction is

f ta to last U"* gamed, although the amount paid for each unit of commodity we buy (from the first to the last unit) is

the same.

amount paid for the 3000 tons ot steel, by an amount represented by the shaded triangle. Figurel.2-4, Consumer Surplus

s ofsteel15 more tha

L2tt 4 /hoWS the consu

7* 'n the total mer surplus. The total value to society of t=

42 Economics I Reference Book

2

43

Production

We can also refer to the consumer surplus for an individual. Assume that the price of a fresh glass of juice is PKR 50. The consumer considers how

many gallons to buy at this price. Since the consumer is very thirsty, he is willing to pay PKR 100 for it. However it would cost him only PKR 50,

therefore the cost for the consumer for the fresh juice will be less than what he is willing to pay, therefore he will enjoy the surplus of PKR 50.

Now consider the second gallon of juice which is worth PKR 90, yet again the customer will be paying only PKR 50, therefore the surplus at this

price will be PKR 40. Thus, the more glasses of juice the consumer buys, the worth of each glass will keep declining until a point where the

consumers need is satisfied and the worth of the glass will be less than the actual cost.

Here is one interesting observation about consumer surplus. The consumer paid PKR 100 for two glasses of juice; however the total worth of juice

for him was PKR 190. Thus the consumer has gained a surplus of PKR 90 against the amount he paid. The consumer will consume the good until

its worth is more than the actual amount.

Producer Surplus

The industry supply curve, under certain assumptions (perfect markets), is also the marginal societal (opportunity) cost curve. The surplus of the

market price above the opportunity cost of production is the producer surplus. Take for example in Figure 1.25, steel producers are willing to

supply the 2500 tons of steel at a price of PKR 400. The produce surplus is increased by PKR 100 from producing and selling the 2500 tons of

steel for PKR 500. The difference between the total (opportunity) cost of producing steel and the total amount the buyers pay for it (producer

surplus) is at a maximum when 3000 tons are manufactured and sold. This is illustrated in the following figure:

Figure 1.2-5: Producer Surplus

44 Economics I Reference Book

2

The allocation of resources, goods, and services by market price, from an economic point of view, has important advantages. When markets are

functioning well, competition and allocation by price lead to an efficient allocation of resources, so that the marginal benefit to society just equals the

marginal cost for the last unit of each good and service produced.

The marginal in marginal benefit and marginal cost refers to an additional unit, so the marginal benefit and cost comparison compares the benefit

of one additional unit to the cost of producing the unit. We shall see that the efficient allocation of a societys resources, and therefore the production

to the efficient quantity of each good or service, is achieved when the benefit to society of producing one more unit just equals the cost to society of

producing that additional unit. We measure the benefit to society as the value that a user places on the additional unit produced. We measure the cost

to society as the opportunity cost of production (i.e., the value of other goods and services we must forego to produce the additional unit).

A good or services demand curve shows the decreasing value to customers of additional units of a good or service when markets function well and,

as a result, the opportunity cost of production of additional units of a good or service is illustrated by the supply curve. To show that the fact that each

successive unit consumed will be less highly valued by the consumers, downward sloping demand curves are drawn. To show the fact that the

opportunity cost of producing additional units of goods increases as more and more resources are drawn away from other productive uses to produce

additional units of the good, upward sloping supply curves are drawn.

Based on the above interpretations of demand and supply curves, it can be said that the efficient quantity of any good or service is the quantity where

the demand curve and the supply curve intersect. If the economy produces less than 3000 tons of steel, we have not maximized the benefit to society

of steel production. The value that consumers place on additional units of steel is greater than the value consumers place on the other goods and

services foregone to produce those units. Conversely, if the economy produces more than 3000 tons of steel, each unit above 3000 units requires that

society give up other goods and services more highly valued by consumers than the additional units of steel above 3000 tons. As long as the demand

curve represents the marginal benefit to the society and the supply curve represents marginal cost to society, the benefit to society derived from

producing steel is maximized at 3000 tons.

We have so far discussed that the marginal benefit is depicted by the demand curve and the marginal cost is depicted by the supply curve.

Competition leads us to supply/demand equilibrium. We will now consider how deviations from the i^deal conditions can result in an inefficient

allocation of resources'' the quantity