(originally published to Helium writing site, now gone)
The main thing to know about economics is that we need to study it due to scarcity, that is, because our wants exceed the finite supply of resources. We therefore need to determine the best way to allocate those resources. The major concepts within economics can be divided into two groups: microeconomics, which examines how individuals, households and firms allocate scarce resources, and macroeconomics, which studies the structure, behavior and performance of the economy as a whole.
Economics is about the production, distribution and consumption of goods and services. The concept of scarcity is perhaps the most important thing to know about economics. If all resources and means of production were infinite or abundant, we’d have all the goods and services we could ever want and we wouldn’t need to study economics.
But resources are finite or scarce and people want more than what is available. This gives rise to the concept of scarcity and is the reason we study economics. Scarcity means there are insufficient resources to satisfy our abundant wants, so we have to find some way of rationing the allocation of resources.
Much has been written on post-scarcity economies where people can have as much of anything and everything as they want. This situation usually assumes that technology has advanced to such a stage where we can have as much of any good or service as we want for free or very low cost. Such utopian societies are often the settings of science fiction, as are dystopian societies where all incentive to lead a normal life disappears.
Allocation of resources in a normally functioning society is determined by price and this will be the focus of the next article on economic fundamentals.
2 Supply and demand
This section examines how economics copes with scarcity, and that is through the pricing mechanism. This is what microeconomics is all about.
Supply and demand is used to determine prices of goods and services. Producers are willing to supply varying quantities of a good or service depending on the price they can obtain for it. Consumers will demand different amounts of the good or service based on the price they have to pay. At the price where the volume produced equals the quantity purchased, with neither a surplus nor any unmet demand, this is the equilibrium price paid and quantity produced for that good or service.
Supply and demand curves
Economists show the relationship between supply and demand on a graph. Price is shown on the vertical axis while quantity is on the horizontal axis. The supply curve for a good or service always slopes upward from left to right. This is because producers will want to supply more of a product the higher the price. By contrast, the demand curve nearly always slopes downward from left to right. The lower the price of the product, the more of it will be demanded by consumers.
Thus the supply curve and the demand curve will form a cross on the graph. Where they intersect will be the price at which all units of the good or service will be sold. In other words, the market is cleared at that price. The model assumes perfect competition with no firm or consumer having an influence on the price.
Changes in demand and supply
For just about any good or service, the quantity demanded by consumers is likely to change over time. Factors leading to a change in the quantity demanded include changes in income, prices of related products, tastes and preferences, and expectations of future prices. An increase in income levels due to a wage rise or tax cuts will usually result in consumers demanding a greater quantity of goods and services.
If the price of a particular good comes down, consumers are likely to demand a greater quantity of any complementary goods. For example, if computer prices fall, not only will demand for computers increase but so too will demand for goods such as computer accessories, printers, and electronic games. Conversely, if two products are clear substitutes, such as butter and margarine, a fall in the price of one will lead to a decrease in demand for the other.
Changes in tastes and preferences will result in shifts in the quantity demanded of various goods over time, for example, different styles of clothing. Expectations of price changes will play a role too. If people feel that the price of a product will soon rise, they might demand extra units at the lower price while it lasts.
Where demand for a product increases, producers will usually move to satisfy that extra demand by increasing supply. This may involve resources flowing to the production of goods and services with high demand and away from those that have lost popularity. Technological advances and economies of scale often push the price down, resulting in further increases in demand. Other determinants of supply will include input costs and expectations of price changes, as well as market expansion through population growth.
In these situations, both demand and supply curves will shift to the right, to reflect larger quantities, and will intersect at a different point on the chart. The new equilibrium price may be lower than before. This is typical of electronic goods. Sometimes the new price might be higher, such as for certain fashion items. This might occur if consumers are convinced that a particular product has become more prestigious and is highly desirable.
3 Price elasticity
Price elasticity is the extent of changes in the quantity of a product demanded and supplied for a given change in its price and how this can vary between different goods and services.
The term price elasticity is used to describe the relative steepness of supply and demand curves for different goods and services and is fundamental to understanding the principles of supply and demand. Economists and business managers need to know how much the quantity of a product demanded and supplied will change when its price changes.
The price elasticity of demand measures the change in demand for a good or service for a given price change and may vary at different places along the demand curve. If the price of a product rises 5% and demand falls by 5%, price elasticity equals -1 or unity. However, if demand falls 10%, elasticity is -2. If it drops by only 2%, elasticity is -0.4. Price elasticity of demand will vary for different products, depending on whether the good or service is a necessity or luxury, the extent of substitute products, the percentage of income spent on the product, and whether price changes are perceived as long or short term.
If, for example, bus fares rise 5%, demand may only fall by 1% (elasticity of -0.2) as there might be few alternatives for those without their own transport, so very few of these consumers will stop taking the bus, which to them is a necessity. This is an example of inelastic demand. Other examples include basic food items, beer, cigarettes, oil and medicines. Conversely, if the price of a particular brand of automobile rises 5%, demand might fall 15% (elasticity of -3) because there are many substitutes and consumers will buy a different brand. Other examples of elastic demand include spirits, many luxuries, and most brand items.
Price elasticity of supply is the change in the amount of a good or service producers are willing to provide for a given change in price and is always a positive number. If the price of a good or service rises 5% and businesses increase their supply by 10%, elasticity equals 2. If companies are only willing to lift supply by 3%, elasticity is 0.6.
There are several determinants of price elasticity of supply. An important factor is availability of inputs and this includes raw materials and suitable labor. Another is how much time and effort it takes producers to adjust their processes to a new level of supply. If there is spare capacity, firms can increase their supply quickly. But if extra machinery is required and new staff need to be recruited and trained, it will take longer. Response time will also depend on how easy or difficult it is to shift resources between industries.
4 Applied microeconomics
This section looks at various areas where the principles of microeconomics are applied, including pricing and supply and demand.
Applied microeconomics has many specialized areas that utilize microeconomic theory and come up with policies appropriate to those areas. Some of the more important ones are as follows:
– Agricultural economics looks at crop and livestock farming, land use, yields, and agribusiness in general.
– Environmental economics examines pollution and environmental degradation, how these lead to market failure, and the policies to address the failure.
– Financial economics examines financial markets, company financing, the stock market, budgeting, investing and saving.
– Health economics studies the supply of and demand for health care, patient outcomes, financial issues, health workers and health insurance.
– Industrial organization and regulation looks at the structure of markets, the strategy of firms, innovation, technological progress, privatization, trademarks, and antitrust policy, and can involve any industry.
– Labor economics analyzes the labor market, employment, the supply and demand for labor, and wages.
– Law and economics uses economic concepts and theories to look at the effects of laws and which ones are economically efficient.
– Managerial economics examines the decisions of firms and other units and makes use of operations research and regression analysis.
– Public finance looks at government spending and revenue policies and their effects.
– Regional economics compares economic activity across geographical areas of a nation, and analyzes issues such as why some regions grow faster than others.
– Urban economics studies city issues such as pollution, traffic, urban sprawl, and poverty.
– Welfare economics looks at resource allocation and income distribution together.
5 Market failure
There are a number of areas where the market, through supply and demand and the pricing mechanism, isn’t the best allocator of resources, and government steps in to rectify or ease the situation. Market failure is thus another important concept in economics. There are several reasons why markets can fail to allocate resources efficiently and easily in the manner described in previous sections.
If one firm is dominant or has a monopoly in a particular market, this can unduly influence price and output, which can result in an inefficient allocation of resources. For example, in the US, antitrust regulations reduce monopoly power.
A second way a market can fail is if there are outside influences or externalities operating, for example, a firm might be polluting the environment or producing unsafe products. Government regulation aims to reduce or eliminate such externalities. An issue we’re hearing more and more about these days is global warming and carbon emissions. Governments take various measures to try and reduce the amount of carbon emitted, such as carbon pricing, emissions trading schemes, and direct regulation.
A third way relates to goods and services that people want but are unable or unwilling to pay for, or private firms might be unwilling to provide, or a product might be unsuitable for them to provide. The best example is public goods such as defense, law and order, health, education, and transport infrastructure, where governments step in and provide them, or provides a large proportion of them.
Macroeconomics is about the overall economy whereas microeconomics is about the individual players.
Macroeconomics examines the structure, behavior and performance of the whole economy rather than the actions of individuals and firms. It includes things like national income, consumption, investment, exports and imports, employment and unemployment, and inflation.
The two most important areas of macroeconomic research are finding the causes and effects of short-term fluctuations in the economy (the business cycle) and how to achieve long-term growth. This involves analyzing data on things like gross domestic product and its components, as well as inflation, unemployment, retail sales and consumer sentiment. These data can be fed into a macroeconomic model to try and forecast turning points and future growth levels. The findings will influence government economic policy.
The macroeconomic policies of government are fiscal policy and monetary policy and these are examined below. Both aim to stabilize the economy and promote long-term sustainable growth and are often used in tandem.
7 Fiscal policy
Fiscal policy influences the economy through changing the levels of government income and spending. Basically, if the government wants to stimulate a sluggish economy, it can spend more money than it receives (running a budget deficit). Economist John Maynard Keynes first suggested this in the 1930s as a way of beating the economic depression that engulfed the world at that time. Until then, governments had traditionally aimed to balance the budget, but Keynes argued that this caused the economy to shrink even more.
Conversely, if an economy is overheating, the government can increase taxes or reduce spending or both (and run a budget surplus) to reduce inflation and slow down growth, thereby putting money aside to perhaps use in the next downturn and ease its effects.
The effectiveness of government boosting the economy through spending more than it receives is reduced when inflation is high and when government already has a large debt. We have seen this in a number of countries since the 1970s during economic downturns. This was particularly so during the global financial crisis and worst economic downturn since the 1930s.
For these reasons, monetary policy has been used increasingly since the 1970s and this policy is the subject of the next section.
8 Monetary policy
In recent decades, monetary policy has been favored over fiscal policy, because expansionary fiscal policy (where the government spends more than it receives) tends to “crowd out” the private sector by reducing the resources available to it and putting upward pressure on interest rates.
Monetary policy is where government controls the supply of money in the economy. Monetarists, led by Milton Friedman, contend that inflation depends largely on the amount of money in the economy rather than on government spending and revenue decisions. Under monetary policy, a government will increase the rate of growth in the money supply if it wants to stimulate the economy, and decrease the growth rate if it wants to slow the economy (for example, if inflation is pushing up growth to unsustainable levels). The government does this by lowering or raising interest rates.
Since 2008 and the global financial crisis, governments of most economies have cut interest rates, or in other words have made money cheaper, to try and increase the money supply, boost employment, stimulate growth, and prevent a recession or prevent a worse recession as the case may be. However, low interest rates have meant cheap credit, which has led to high debt in both the private and government sectors. Many economies are now treading a fine line between a further escalation of debt if interest rates are kept low, but lower growth and a possible return to recession if rates are increased. There are no easy answers as we’ve seen in recent years in the US, Europe and elsewhere.
9 Economic systems
The way a society organizes itself to produce, distribute and consume good and services is another important thing to know about economics. Two main economic systems are capitalism and socialism.
Capitalism is where the factors of production (land, labor and capital) are owned mainly by the private sector, and where the market determines price. This system has been favored in most places and at most times since the industrial revolution.
Socialism is where there is common or government ownership of the factors of production, and where there is no division of labor and capital.
In practice, most economies are what we call mixed economies, though leaning towards capitalism, with a sizeable government sector but larger private sector.
Since the 19th century, capitalist systems have tended to have an ever growing government sector as economies become more mature and people want goods and services that can’t always be provided by firms and individuals, such as roads, health, education, the arts, social security, and so on. Just about any Western economy is a good example of this.
At the same time, socialist systems have tended to allow more and more goods and services to be provided by the non-government sector. Russia and China are good examples.