Economics is a field of study that has become increasingly relevant in our globalized, financialized society. The economy is part of our collective conscious and a buzzword that links personal finances to big business and international trade deals. Economics deals with individual choice, but also with money and borrowing, production and consumption, trade and markets, employment and occupations, asset pricing, taxes and much more. What then is the definition of economics? One way to think of it is the study of what constitutes rational human behavior in the endeavor to fulfill needs and wants given a world with scarce resources. In other words, economics tries to explain how and why we get the stuff we want or need to live. How much of it do we get? Who gets to have more? Who makes all this stuff? How is it made? These are the questions and decisions that economics concerns itself with.
As an individual, for example, you constantly face the problem of having limited resources with which to fulfill your wants and needs. As a result, you must make certain choices with your money – what to spend it on, what not to spend it on, and how much to save for the future. You'll probably spend part of your paycheck on relative necessities such as rent, electricity, clothing and food. Then you might use the rest to go to the movies, dine out or buy a smartphone. Economists are interested in the choices you make, and investigate why, for instance, you might choose to spend your money on a new Xbox instead of replacing your old pair of shoes. They would want to know whether you would still buy a carton of cigarettes if prices increased by $2 per pack. The underlying essence of economics is trying to understand how individuals, companies, and nations as a whole behave in response to certain material constraints.
Adam Smith (1723 - 1790), is often considered the "father of modern economics." His book "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776) was the first fully elaborated attempt to understand why some nations prospered while others suffered widespread poverty. He famously argued that individuals working for their own self-interest could nonetheless create a stable and well-provisioned society through a mechanism he called the invisible hand of the market. (See also: 'Adam Smith and 'The Wealth Of Nations.')
Smith, however, was not the first to write on economic matters. Other scholars of what was then known as political economy wrote prior to "The Wealth of Nations," but Adam Smith was one of the first to identify the unique economic changes that accompanied the birth of industrialization and capitalist production. Smith’s work was followed by David Ricardo’s "Principles of Political Economy and Taxation" (1817) and later by Karl Marx in "Capital" (1867). Each of these authors sought to explain how capitalism worked and what it meant for producers and workers in the capitalist system. (See also: What is the difference between Communism and Socialism?)
In the late 19th century, the discipline of economics became its own distinct field of study. Alfred Marshall, author of "The Principles Of Economics" (1890) defined economics as a social science that examines people's behavior according to their individual self-interests. He wrote, "Thus it is on one side the study of wealth; and on the other, and more important side, a part of the study of man." In the early 20th century, however, there was a push toward legitimizing economics as a rigorous science alongside the physical sciences like chemistry and physics. As a result, mathematical models and statistical methods were brought to the forefront along with a number of strong assumptions that are needed to make those models work. For example, modern mainstream economics makes the assumption that human beings will always aim to fulfill their individual self-interests. It also assumes that individuals are rational actors in their efforts to fulfill their unlimited wants and needs. It also makes the claims that firms exist to maximize profit and that markets are efficient. This school of economics, which has come to dominate both the academic field of economics as well as the practical application of economic theory in policy and business, is known as neoclassical economics. (See also: The Difference Between Finance And Economics.)
The bulk of this tutorial will concern itself with this line of neoclassical economic theory. Other strands of so-called “heterodox” economics have sprung up to challenge the mainstream model, and other social sciences such as psychology and sociology have added valuable insight to the mechanical models of pure economics. Sometimes rejected as fringe elements, mainstream economics is today increasingly tolerant of some these ideas and even go so far as try to incorporate alternative theory into its own. Some of these will be examined briefly at the end of this tutorial.
First, we start our tutorial with a brief overview of what economics is and go over some basic concepts before proceeding.
What Is Economics?
In order to begin our discussion of economics, we first need to understand some important concepts. For instance, what is the economy anyway? When we hear that “the economy is growing” or that “the economy is doing poorly,” what does that mean? At the most abstract level, the economy is a system that exists to produce and provide people in a society with the goods and services they need to live and do what they want. The size of this system can grow as the population gets larger or as the existing population gets wealthier. Economists often measure the size of the economy with metrics such as gross domestic product (GDP), which measures the value of all the goods and services produced by a country in a year.
Types of Economic Systems
Types of economic systems are defined either by the way that stuff is produced or by how that stuff is allocated to people. For example, in primitive agrarian societies, people tend to self-produce all of their needs and wants at the level of the household or tribe. Family members would build their own dwellings, grow their own crops, hunt their own game, fashion their own clothes, bake their own bread, etc. This self-sufficient economic system is defined by very little division of labor and is also based on reciprocal exchange with other family or tribe members. In such a primitive society, the concept of private property didn’t typically exist as the needs of the community were produced by all for the sake of all.
Later, as society developed, economies based on production by social class emerged such as feudalism and slavery. Slavery involved production by enslaved individuals who lacked personal freedom or rights and existed as the property of their owner. Feudalism was a system where a class of nobility, known as lords, owned all of the land and leased out small parcels to peasants to farm, with peasants handing over much of their production to the lord. In return, the lord offered the peasants relative safety and security including a place to live and food to eat.
Capitalism emerged with the advent of industrialization. Capitalism is defined as a system of production whereby business owners (capitalists) produce goods for sale in order to make a profit and not for personal consumption. In capitalism, capitalists own the business including the tools used for production as well as the finished product. Workers are hired in return for wages, and the worker owns neither the tools he uses in the production process nor the finished product when it’s complete. If you work at a shoe factory and you take home a pair of shoes at the end of the day, that’s stealing even though you made them with your own hands. This is because capitalist economies rely on the concept of private property to distinguish who legally owns what.
Capitalist production relies on the market for the allocation and distribution of the goods that are produced for sale. A market is a venue that brings together buyers and sellers, and where prices are established that determine who gets what and how much of it. The United States and much of the developed world today can be described as capitalist market economies.
Two alternatives to capitalist production are worth noting.
Socialism is a system of production whereby workers collectively own the business, the tools of production, the finished product, and share the profits – instead of having business owners who retain private ownership of all of the business and simply hire workers in return for wages. Socialist production often does produce for profits and utilizes the market to distribute goods and services. In the U.S., worker coops are an example of socialist production organized under a broader capitalist system.
Communism is a system of production where private property ceases to exist and the people of a society collectively own the tools of production. Communism does not use a market system, but instead relies on a central planner who organizes production (tells people who will work in what job) and distributes goods and services to consumers based on need. Sometimes this is called a command economy.
Scarcity
Scarcity, a concept we already implicitly discussed in the introduction to this tutorial, refers to the tension between our limited resources and our unlimited wants and needs. For an individual, resources include time, money and skill. For a country, limited resources include natural resources, capital, its labor force and its level of technology. If scarcity didn’t exist, economics wouldn’t matter since everybody would be able to provision all of their needs and wants at all times, and for free.
Because, however, our resources are limited in comparison to all of our wants and needs, individuals, firms, and nations have to make decisions regarding what goods and services they buy or produce and which ones they must forgo. For example, if you choose to buy one new video game as opposed to two old games, you must give up owning a second game of inferior technology in exchange for the higher quality of the newer one. Likewise, a company that produces video games must decide how to allocate its workforce, time, and money to produce a small number of high quality games or a large number of lower quality products. Because of scarcity, people, firms, and nations must all make decisions over how to allocate their individual resources. Economics, in turn, aims to study why we make these decisions and how we allocate our resources most efficiently.
Macro and Microeconomics
Macro- and microeconomics are the two main vantage points from which the economy is studied. Macroeconomics looks at the economy on a national and international level. It examines total output of a nation (GDP) and the way the nation allocates its limited resources of land, labor supply and capital. Macroeconomics is concerned with international trade, a nation’s fiscal and monetary policy, the level of inflation and interest rates, national unemployment, and more.
Microeconomics studies the level of the individual and the firms within the economy. Analyzing certain aspects of human behavior, microeconomics shows us how individuals and firms respond to changes in price and why they demand what they do at particular price levels. Microeconomics tries to explain how and why different goods command different values, how individuals make financial decisions, and how individuals best coordinate and cooperate with one another.
Micro- and macroeconomics are intertwined; as economists gain understanding of certain phenomena, they can help us make more informed decisions when allocating resources. Many people believe that the micro foundations of individuals and firms acting in aggregate constitute macroeconomic phenomena.
Supply and Demand
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply.
A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.)
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena:
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.
Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.
Utility
We have already seen that a primary focus of economics is to understand behavior given the problem of scarcity: the problem of fulfilling the unlimited wants of humankind with limited or scarce resources. Because of scarcity, economies need to allocate their resources in such a way that everything ends up where it ought to. Underlying the laws of demand and supply is the concept of utility, which represents the advantage, pleasure, or fulfillment a person gains from obtaining or consuming a good or service.
Utility, then, is used to explain how and why individuals and economies aim to gain optimal satisfaction in dealing with scarcity. The idea of utility as a guiding force of human action is not new, and was established in economic theory in the 1700’s and 1800’s in Europe and especially in England thanks to thinkers such as Adam Smith, John Stuart Mill, and Jeremy Bentham who believed that people are driven to find pleasure and avoid pain. The viewpoint that people maximize utility, known as utilitarianism, has been taken up by the field of economics, but also criticized by some who claim that pleasure and freedom from pain are not the only goals that matter in life.
Utility is an abstract theoretical concept rather than a concrete, observable quantity. The units to which we assign an amount of utility (known as utils), therefore, are arbitrary, representing a relative value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility thus corresponds to the person's level of consumption. Usually, the more that a person consumes, the larger his or her total utility will be. Marginal utility is the additional bit of satisfaction, or amount of utility, gained from each extra unit of consumption. For example, from eating just one more cookie.
Although the total amount of utility gained usually increases as more of a good is consumed, the marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain maximum threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed. For example, the pleasure of eating the first cookie is much greater than the pleasure received from eating the tenth or eleventh cookie in a sitting.
Moving on from cookies, let us now consider a chocolate bar. Say that after eating one chocolate bar your sweet tooth has been completely satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day. In fact, if you were to eat 5 or more chocolates, you may begin to experience pain and not pleasure.
This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units.
The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more.
In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.
Elasticity
We’ve seen that the demand and supply of goods react to changes in price, and that prices in turn move along with changes in quantity. We’ve also seen that the utility, or satisfaction received from consuming or acquiring goods diminishes with each additional unit consumed. The degree to which demand or supply reacts to a change in price is called elasticity.
Elasticity varies from product to product because some products may be more essential to the consumer than others. Demand for products that are considered necessities is less sensitive to price changes because consumers will still continue buying these products despite price increases. On the other hand, an increase in price of a good or service that is far less of a necessity will deter consumers because the opportunity cost of buying the product will become too high.
A good or service is considered highly elastic if even a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life, or if there are good substitutes. For example, if the price of Coke rises, people may readily switch over to Pepsi. On the other hand, an inelastic good or service is one in which large changes in price produce only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life, such as gasoline.
| Elasticity = (% change in quantity / % change in price) |
If the elasticity is greater than or equal to 1, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.
As we saw previously, the demand curve has a negative slope. If a large drop in the quantity demanded is accompanied by only a small increase in price, the demand curve will appear looks flatter, or more horizontal. People would rather stop consuming this product or switch to some alternative rather than pay a higher price. A flatter curve means that the good or service in question is quite elastic.
Meanwhile, inelastic demand can be represented with a much steeper curve: large changes in price barely affect the quantity demanded.
Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.The elasticity of supply works similarly to that of demand. Remember that the supply curve is upward sloping. If a small change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one. The good in question is inelastic with regard to supply.
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand:
1. Availability of Substitutes In general, the more good substitutes there are, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.
However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people in this case might not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
2. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to get to work or drive for any number of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.
3. Time The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.
Income Elasticity of Demand
Income elasticity of demand is the amount of income available to spend on goods and services. This also affects demand since it regulates how much people can spend in general. Thus, if the price of a car goes up from $25,000 to $30,000 and income stays the same, the consumer is forced to reduce his or her demand for that car. If there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand: demand will be sensitive to a change in price if there is no change in income. It follows, then, that if there is an increase in income, demand in general tends to increase as well. The degree to which an increase in income will cause an increase in demand is called the “income elasticity of demand,” which can be expressed in the following equation:
If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less than 1, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. As an example, consider what some consider a luxury good: vacation travel. Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new higher purchasing power, he decides that he can now afford to go on vacation twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is 7, which is highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These cases often involve goods and services considered of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the decrease in going out to fast food restaurants as income increases, which are generally considered to be of lower quality that other dining alternatives. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero. These goods and services are considered necessities and are sometimes referred to as Giffin Goods.
Another anomaly in elasticity occurs when the demand for something increases as its price rises. We’ve learned that if the price of something goes up, people will demand less – but certain luxury or status items may be demanded because they are expensive. For example, designer label clothing or accessories or luxury car brands signal status and prestige. A work of art, a personal chef, or a diamond ring all may be in high demand precisely because they are expensive. These types of goods are referred to as Veblen Goods.
Competition, Monopoly and Oligopoly
Economists make the assumption that there are a large number of different buyers and sellers in the marketplace for each good or service available. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. For example, if the price of a good is very high and some firms are making extra profits in that sector, other firms will be induced to start producing that same good – in competition with the others – which will increase supply and reduce the selling price. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead (recall the section on elasticity). In a market with many buyers and sellers, both the consumer and the supplier have equal ability to compete on price.
Adam Smith in the 18th century recognized that competition between producers is crucial for the invisible hand to keep an economy efficient. Smith imagined a primitive society with only two products: beaver and deer. A hunter can produce only one type of game and therefore must choose whether to hunt for beaver or deer each day. If given the same effort, a deer sells for twice as much as a beaver, people will switch from beaver production to hunt deer instead. The result is more deer and less beaver, so the profit rates for deer begin to decline as beaver increases. Smith predicted that in a world of competition, the profit rates for all industries will converge to the same rate of profit, since if it becomes more profitable to be in a certain line of business, new companies will pop up to exploit that difference – pushing it back in line in the process.
Economists call this assumption about competitive producers perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits. Take for example corn farmers. Many hundreds of farmers all produce an identical product: corn. Buyers do not care which farmer sells them their corn, and so buyers’ only concern is the price of corn. Therefore, the lowest priced corn seller will sell the majority of corn. If a corn seller cannot compete because his cost of production is too high, he will be forced to find ways to lower his costs or risk going out of business.
Monopoly and Oligopoly
In some industries, however, we find that there are no good substitutes and there little competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control price. Consequently, consumers do not have much choice.
A monopoly is a market structure in which there is only one producer and seller for a product. In other words, the single business is the entire producer in the industry. Entry into such a market can be restricted due to high costs or other impediments, which may be economic, social or political that keep potential competitors out. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. Most economists agree that monopolies are inefficient since without competition, they can keep prices artificially high.
In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry to keep out potential competitors. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. In certain cases, types of oligopolies (for example cartels) are illegal.
Production Possibility Frontier, Growth, Opportunity Cost and Trade
So far, we have gone over key topics of economics that have focused generally on microeconomic phenomena. Here, we turn to more macroeconomic matters that occur on the level of national economies.
Production Possibility Frontier (PPF)
In the field of macroeconomics, the production possibility frontier (PPF) represents the point at which a country’s economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. There are just enough apple orchards producing apples, just enough car factories making cars, and just enough accountants offering tax services. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the stability of the economy will dwindle. The production possibility frontier shows us that there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can and should be produced.
Let's turn to an example and consider the chart below. Imagine an economy that can produce only two things: wine and cotton. According to the PPF, points A, B and C – all appearing on the PPF curve – represent the most efficient use of resources by the economy. For instance, producing 5 units of wine and 5 units of cotton (point B) is just as desirable as producing 3 units of wine and 7 units of cotton. Point X represents an inefficient use of resources, while point Y represents the goals that the economy simply cannot attain with its present levels of resources.
As we can see, in order for this economy to produce more wine, it must give up some of the resources it is currently using to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would need to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the figure shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production. Markets play an important role in telling the economy what the PPF ought to look like.
Consider point X on the figure above. Being at point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. On the other hand, point Y, as we mentioned above, represents an output level that is currently unattainable by this economy. But, if there were a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, represented in the figure below on which Y would fall, would then represent the new efficient allocation of resources.
When the PPF shifts outwards, we can imply that there has been growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking due to a failure in its allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.
An economy can only be producing on the PPF curve in theory; in reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo some choice in favor of others, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly.
Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy may be able to produce for itself all of the goods and services it needs to function using the PPF as a guide, but this may actually lead to an overall inefficient allocation of resources and hinder future growth – when considering the benefits of trade. Through specialization, a country can concentrate on the production of just a few things that it can do best, rather than dividing up its resources among everything.
Let us consider a hypothetical world that has just two countries (Country A and Country B) and only two products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country A has very little fertile land and an abundance of steel available for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources, and since it requires a great deal of effort to produce cotton by irrigating its land, Country A would have to sacrifice producing cars – which it is much more capable of doing. The opportunity cost of producing both cars and cotton is high for Country A, as it will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is far greater than that of producing cotton.
Each country in our example can produce one of these products more efficiently (at a lower cost) than the other. We can say that Country A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) decide to specialize in producing the goods with which they have a comparative advantage. If they then trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce so quality improves. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B.
Determining how countries exchange goods produced by a comparative advantage ("the best for the best") is the backbone of international trade theory. This method of exchange via trade is considered an optimal allocation of resources, whereby national economies, in theory, will no longer be lacking anything that they need. Like opportunity cost, specialization and comparative advantage also apply to the way in which individuals interact within an economy.
Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though countries both have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs (good land, steel, labor), enables the country to easily manufacture more of both cars and cotton than Country B. A country that can produce more of both goods is said to have an absolute advantage. Better access to quality resources can give a country an absolute advantage as can a higher level of education, skilled labor, and overall technological advancement. It is not possible, however, for a country to have an absolute advantage in everything that it produces, so it will always be able to benefit from trade.
Measuring Economic Activity
One important part of macroeconomics is measuring the economy. Knowing if the economy is growing and by how much is an important metric for policy makers, financial professionals, corporate strategy and everyday citizens. Here we will bring up just a few of the most important measures of economic activity at the national level.
Gross Domestic Product (GDP)
Gross domestic product, or GDP, is one of the main indicators used to measure a country's economic activity. It represents the total aggregate dollar value of all goods and services produced in a country each year, and is often equated with the size of the economy. GDP is often measured quarterly, but expressed as an annualized figure. For example, if 3rd quarter GDP is reported to be up 3%, this tells us that economy has grown by 3% over the last year starting from the 3rd quarter.
GDP is tabulated either by adding up what everyone working within a county (citizens or non-citizens) earned over the course of a year (the income approach), or else by adding up what everyone spent (expenditure method). In theory, both measures should arrive at roughly the same total since your spending is somebody else’s income.
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non-incorporated firms, and taxes less any subsidies and government transfers (such as welfare checks). The expenditure method is the more common approach and it is calculated by adding up total consumption (C), investment (I), government spending (G), and the net difference between imports and exports (X-M). Sometimes economists express this as the GDP equation, where Y is the national income, or GDP.
Y = C + I + G + (X - M)
Consumption is typically the largest GDP component in the economy, consisting of private expenditures on the wants and needs of a nation’s citizens. Investment is what businesses spend on things like equipment purchases or new construction of factories. Government spending includes items such as salaries of civil servants and government contractors, purchase of weapons for the military, and any investment expenditure by a government. Exports are the goods produced in a country but sold abroad, and imports are goods produced abroad but purchased here.
When the economy is healthy and growing, you will typically see steady increases in a county’s GDP. If GDP falls, the economy is contracting. Investors worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession. The rule of thumb is that two consecutive quarters of shrinking GDP is the signal for a recession.
Unemployment
The unemployment rate measures how many people in a country are out of work. It is the share of the labor force that is jobless, expressed as a percentage. Unemployment generally rises or falls in response to changing economic conditions, making it a lagging indicator. When the economy is in poor shape and jobs are scarce, the unemployment rate will rise. When the economy is growing at a healthy rate and jobs are relatively plentiful, it can be expected to fall.
To calculate the unemployment rate, the number of unemployed people is divided by the number of people in the labor force, where the labor force consists of all employed and unemployed people. The ratio is expressed as a percentage. This represents the so-called headline unemployment figure, or U3 unemployment. Some have criticized this measure for not accurately reflecting the employment picture of a country. This is because it includes people who are working part time but would rather work full time, and more importantly because it excludes people who are no longer looking for work – and therefore are no longer considered in the labor force. Some discouraged workers that have given up looking for work would probably like to work but have lost hope. A more inclusive unemployment measure that includes discouraged and part time workers is the U6 unemployment figure, and this is typically quite a bit higher than the headline rate.
Unemployment in a growing economy is never actually zero percent. This is because some people choose not to work (voluntary unemployment), some are in between jobs (frictional unemployment), or some skilled workers find their skills are no longer in demand (structural unemployment). Full employment is a situation where all available workers in the labor force are being used in the most efficient way possible. Full employment embodies the highest amount of skilled and unskilled labor that can be employed within an economy at any given time. Any remaining unemployment is considered to be frictional, structural, or voluntary. In the contemporary United States, the headline unemployment rate associated with full employment has been around four to six percent.
Inflation
Inflation measures the change in the price levels of goods and services in an economy over time. Inflation is defined as a sustained increase in the general level of prices for goods and services in a country, and is measured as an annual percentage change. Under conditions of inflation, the prices of things rise over time. Put differently, as inflation rises, every dollar you own buys a smaller percentage of a good or service. When prices rise, and alternatively when the value of money falls you have inflation.
Inflation can be caused for a number of reasons, but what is important to understand is that a rate of inflation that is too high or too low is bad for economic stability. Typically an inflation rate between one and four percent annually is ideal. If inflation rises too high, the prices of things in an economy can surge even if wages don’t catch up. In extreme cases, hyperinflation can wreck a nation’s economy. At the same time, if price levels decline, in what is known as deflation, people may stop spending money and companies may halt investments. They anticipate that things will be cheaper tomorrow, so why spend today? This mindset can lead to a dangerous deflationary spiral that can also wreck an economy.
Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a market basket. The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year. These measures are commonly the consumer price index (CPI) and the producer price index (PPI).
Alternatives to Neoclassical Economics
While mainstream neoclassical economic theory has been dominant over the past century, some criticisms have been leveled at this school of thought. Some argue that the strong assumptions made that people are all hyper-rational, all-knowing, utility-maximizing beings is simply wrong. Critics have referred to these hypothetical rational individuals as a different species altogether, homo economicus. Other critics claim that the assumptions about efficient markets and equilibrium given supply and demand do not reflect reality either. Here we briefly give an overview of some alternative or supplementary ways that people theorize about the economy and economic activity.
Imperfect markets
An imperfect market refers to any economic market that does not meet the rigorous standards of a hypothetical perfectly (or "purely") competitive market, as established by equilibrium models. An imperfect market arises whenever individual buyers and sellers can influence prices and production, or otherwise when perfect information is not known to all market actors. Situations can arise in which too few sellers control too much of a single market, or when prices fail to adequately adjust to material changes in market conditions. It is from these instances that the majority of economic debate originates. For example, when there is too much stuff for sale and not enough demand, we experience a recession as price levels must decline.
Imperfect markets also exist when there are information assymetries. Neoclassical economics assumes that all buyers and sellers have perfect information – that they know everything that there is to know about the items in the market and about the intentions of all other market participants. In reality, however, producers of goods or other sellers tend to have much more information than buyers. For example, a company selling shoes might cut costs and use cheap materials that cause them to be of inferior quality. Unless they inform consumers, buyers probably do not know about these potential defects. Similarly, the seller of a used car will know that it is likely to be a pile of junk sooner than later, while a buyer must trust the word of the seller.
One proposed solution to imperfect markets has been government intervention to prop up prices and stimulate demand. Free market economists believe there is no role for governments in the market, but some schools of thought such as the Keynesians believe that government spending is not only important but necessary during economic crises.
Behavioral Economics
Behavioral economics was developed in the late 1970’s by psychologists who understood that people often fail to behave rationally in financial situations, although in predictable ways. They found that people were not always utility maximizing and that their economic behavior could be manipulated. One key finding by the social psychologists Amos Tversky and Daniel Kahneman (who later won the Nobel prize in economics), for example, showed that rather than being risk averse as neoclassical assumptions would predict, people are instead loss averse. In other words, people are more hurt by a loss than the utility they receive from an equivalent gain – losing $100 hurts more than the pleasure of finding $100. They recognized that human emotions play a role in economic behavior.
Behavioral economics has been a hot area of research over the past few decades by psychologists and economists alike, and has established a set of dozens of cognitive and emotional biases and heuristics that are surprisingly common and predictable.
Economic Sociology
While behavioral economics seeks to explain deviations from rational behavior by studying the phenomena that occurs within individual human minds, economic sociology seeks to explain this by shifting the level of analysis up to the role that social norms, expectations, values and beliefs play on economic action. For example, neoclassical economics states that as utility maximizers, if we know that we could get away with stealing something and would never get caught that we will. However, we are socialized to recognize that theft is immoral, and therefore the majority of people will never steal even if they know they won’t ever get caught.
Another key theory to emerge from economic sociology is the concept of embeddedness, which suggests that economic activity is embedded in a network of social relationships, both weak and strong. For example, you might do business with somebody because you like them as a person instead of searching for the best possible service at the best possible price. Or, people may prefer to do business with people of similar ethnic, racial, religious, or cultural backgrounds. Embeddedness also tells us that depending on the composition of a social network, the social norms and rules of behavior can change with regard to economic transactions. For example, it may be considered taboo to haggle on a price with a close friend, but perfectly acceptable with a stranger. Tastes and preferences can be influenced by friends as well as acquaintances and are not entirely developed on one’s own.
Heterodox Economics
In addition to the above theories, there are strands of economic thought that are considered heterodox, or that challenge mainstream beliefs within the discipline of economics. While this tutorial is not the place to elaborate on these, it is worth noting some of the dominant schools of heterodoxy.
- Marxism Adherents of this theory argue that the ideas developed by Karl Marx about capitalism as a system are correct – that capitalism is doomed to fail due to a number of structural contradictions and that socialism is one solution to these problems.
- Institutional economics asserts that people and organizations are not rational, but subject to bounded rationality, whereby people simply do not have the time or brain power to find out all the information they need to make economic decisions. Therefore, they accumulate the best information at hand and make a best effort to achieve a satisfactory outcome.
- Austrian economics believes in completely free markets without any government intervention. Individuals each function according to their own self-interest, but that these individuals need not be utility maximizers and each have their own tastes and preferences. Importantly, macroeconomic phenomena cannot be explained by aggregating these individual actions.
- Post-Keynesian economics developed from the work of the economist John Maynard Keynes believe in the importance of aggregate demand and effective demand. These economists also believe that money is endogenous, meaning that it is created from within the commercial banking system and is not simply created by central banks externally.
Conclusion
We hope that this tutorial has given you some insight to the economy and the. Let's recap what we've learned in this tutorial:
- Economics is best described as the study of humans behaving in response to having only limited resources to fulfill unlimited wants and needs.
- Scarcity refers to the limited resources in an economy. Macroeconomics is the study of the economy as a whole. Microeconomics analyzes the individual people and companies that make up the greater economy.
- The Production Possibility Frontier (PPF) allows us to determine how an economy can allocate its resources in order to achieve optimal output. Knowing this will lead countries to specialize and trade products amongst each other rather than each producing all the products it needs.
- Demand and supply refer to the relationship price has with the quantity consumers demand and the quantity supplied by producers. As price increases, quantity demanded decreases and quantity supplied increases.
- Elasticity tells us how much quantity demanded or supplied changes when there is a change in price. The more the quantity changes, the more elastic the good or service. Products whose quantity supplied or demanded does not change much with a change in price are considered inelastic.
- Utility is the amount of benefit a consumer receives from a given good or service. Economists use utility to determine how an individual can get the most satisfaction out of his or her available resources.
- Market economies are assumed to have many buyers and sellers, high competition and many substitutes. Monopolies characterize industries in which the supplier determines prices and high barriers prevent any competitors from entering the market. Oligopolies are industries with a few interdependent companies. Perfect competition represents an economy with many businesses competing with one another for consumer interest and profits.
- Economists measure economic activity in a nation using gross domestic product (GDP), the rate of unemployment, and inflation.
- Alternatives to the mainstream theory of economics includes imperfect markets, behavioral economics, heterodox economics, and economic sociology.