Author Archive
Economics Basics – Elasticity
Posted by: | CommentsThe term elasticity in economic analysis means responsiveness to a change. In the case of price elasticity of demand it is the response of consumers to a change in the price of the product. A change in the supply conditions in a market can cause a new equilibrium price to be made. If the change in quantity demanded is less than the price change, it illustrates low price elasticity or a relatively price inelastic demand curve. Products with low price elasticity make ideal targets for indirect taxation if the government wants to raise revenue.
A lack of close substitutes and high priority given to the product by consumers will lead to a low price elasticity. A firm facing low price elasticity can increase its total revenue by raising the price; and when demand is price elastic, a price reduction will increase sales revenue. The demand for one product can be sensitive to a change in the price of a related one, known as cross price elasticity of demand. If there is a relationship between two products, it is either that they are substitutes or rival products, or complements – where one is required for the other one to work and give consumer satisfaction.
Income elasticity of demand is where sales are sensitive to income changes. Growth products in the economy have high income elasticity of demand. The high income elasticity of demand for imports creates potential balance of payments problems when there is economic growth.
If the demand conditions cause a new equilibrium market price to be established, the price elasticity of supply shows how producers respond to this new information. For some products, there is a fixed supply in the short run and the supply is perfectly inelastic. The easier it is to adjust production, the more elastic the supply curve will be.
Economics Basics – Efficiency
Posted by: | CommentsThe objective of any economic system is to maximize the use of scarce resources and to allocate them to different uses in an efficient way. All the production units should operate at their lowest unit cost. This would be a suitable definition of productive efficiency tor firms. Of course, dynamic firms will be investing in production methods that reduce the unit cost over time, in order to boost their total profit. It follows from this, that the most efficient output will be where the firm produces at the minimum point of the long run average cost curve. In terms of the whole economy, productive efficiency would be where there is no unemployment of resources and production possibilities are maximized. Allocative efficiency is where the market price reflects the producer’s marginal cost, giving an acceptable profit, while also reflecting the marginal utility or the satisfaction the consumer receives from purchasing the last unit. Any firm selling at a price higher than marginal cost would be described as allocatively inefficient.
If there were perfect competition in all markets then the whole economy would be economically’ efficient. Productive efficiency would coincide with allocative efficiency. Market imperfections mean that allocative and productive efficiency are not always achieved and the resulting market failure involves a loss of welfare. An additional problem is that there may be a conflict between equity and efficiency. This means that although an economy may be economically efficient, it is not necessarily equitable or fair to different groups of people. Any attempt to improve the welfare of one group, by changing the allocation of resources in an efficient economy, will automatically be at the expense of another group. This is often called Pareto efficiency after the Italian economist Vilfredo Pareto (1848-1923) who pioneered the study of efficiency. In assessing how well an economy works, it is inevitable that economists will make value judgements; this branch of economic study is called welfare economics.
Economics Basics – Economies of Scale
Posted by: | CommentsIn the short run, a firm may try to be productively efficient by producing at the lowest point of its average cost curve. In the long run it may choose to operate on a larger scale. If the output increases by more than the inputs, the firm will experience increasing returns to scale. An economy of scale is the benefit a firm receives in the form of a reduction in long run unit cost as a result of its increased size. An internal economy is a benefit that each firm gets as a result of its own growth. When a firm has exploited all the internal economies and is operating at the minimum efficient scale where long run unit cost is lowest, it can still get benefit from external economies. An external economy benefits all firms in an expanding industry, particularly where it is highly localized. Examples may be improvements in transport infrastructure, a pool of specialized labour, cooperation in research and development and local training programmes.
In manufacturing, technical economies can occur because the growth in output beyond a certain point makes new production techniques economic. Fuller use can be made of expensive fixed capital. There may be managerial economies through the employment of specialist staff and cost savings based on accumulated experience of organizing production. Marketing economies can occur through the bulk buying of materials or in the distribution of the finished product. Large firms can get greater access to loans at a lower cost because lenders see them as a lower risk. Diversification can be an economy of scale because it allows the firm to spread business risks. Widening the product range is sometimes called an economy of scope. It is possible for a firm to grow too big, managerial diseconomies can result from coordination problems within complex organizations. External diseconomies can arise out of the clustering of growth activities in a particular location.
Economics Basics – Economic Systems
Posted by: | CommentsThe fundamental objective of any economic system is to get the maximum use from scarce resources. Economists use the term optimum allocation of resources to describe an efficient outcome. An economic system is simply the organization that is chosen to achieve the ends. The basic decisions which must be made by any economic system are:
- what goods and services will be produced;
- how will the output be made;
- how will the output be distributed.
The choice of economic systems is political and involves value judgements. They exist in a spectrum ranging from socialism at one extreme to capitalism at the other. In a socialist system there would be state ownership of all the resources and the questions would be answered by state administration. In a capitalist system, there would be privately owned property which individuals could choose to use in the production system. Resources in this model are allocated by the free interaction of the market forces of demand and supply with a minimal amount of government intervention in the way the economy functions. All economic systems in the world are now described as mixed, in that they have elements of both systems. Disadvantages exist in the form of inefficiences in the socialist system; inequality and unacceptable products in the capitalist system.
Mixed economies differ in the degree of state intervention, measured by the proportion of total resources accounted for by government and the type of intervention. The choice here is basically between physical rationing of resources through legislation and regulation, or intervening in the price mechanism via economic incentives such as taxation and subsidies.
Economics Basics – Economic Growth
Posted by: | CommentsEconomic growth is the process where there is an increase in the aggregate supply or the productive potential of an economy. It is measured by the annual change in the GDP or the output of the domestic economy. A rise in GDP can be a reflection of the state of the business cycle, in that it rises during recovery and falls during a recession. True growth is therefore best measured from peak to peak in the business cycle, to show that the increase in GDP is due to an economy shifting to new production possibilities. The basic sources of economic growth are an increase in the quantity of factors of production or a rise in their productivity. Economic growth is a cumulative process. A 3% annual growth rate will raise GDP by 10% in three years, double it in 24 years, and quadruple it in 48 years. It is easier for countries with a lower base level of GDP to raise its growth rate than it is for rich countries, but the truth is that a lot of countries face severe barriers in their quest for it.
The exact causes of growth are controversial and there are numerous growth theories offering explanations. Any country wishing to raise its growth rate will have to increase capital accumulation and investment. Human capital and an increase in the stock of knowledge through education and training, is now seen as a much more important factor in growth than previously, because of the importance of technology in the fortunes of business enterprise. In government economic policy there has been increasing emphasis on what is called supply side economics. Some people see intervention as a positive force for growth while others prefer supply side policies which involve less government intervention. One of the difficulties with any policy aimed at promoting growth is that it might damage the other macroeconomic objectives in the short term.
Economics Basics – Economic Activity Rates
Posted by: | CommentsThis term refers to the proportion of any age group which participates in the labour market, and is therefore economically active. The age limits chosen for the working population are between 16 and 65. Within this group however are people who are not economically active, through personal choice or circumstances. A proportion of people in the younger section are in full-time education and training. There are individuals unable to participate because of illness and disability or because they are full-time careers of dependants. There will be a relatively small number of individuals with no economic incentive to seek economic activity. The picture of economic activity is complicated by those who are economically active on a part-time basis, both inside and outside the 16-65 age group.
The post-war model of economic activity assumed an activity rate for adult males to be close to 100%. The trend has been for the rate to fall over time because of structural changes in the economy which have affected employment. Redundancies and early retirement are the main causes.
Another major change has been the rise in the economic activity of females. This has coincided with a huge increase in part-time employment, with the services sector of the economy providing the bulk of new employment opportunities. Explanations for higher female economic activity rates emphasize the progress in education together with a change in social attitudes and wage levels.
The government can increase the economic activity rate by:
- encouraging more employment opportunities for people who have previously been labelled as non-workers;
- reducing the problem of long-term unemployment;
- improving the caring services for the dependant groups;
- encouraging greater flexibility in the conditions of employment.
Economics Basics – Direct Taxation
Posted by: | CommentsThe Government has a choice of taxing income, wealth or consumption to finance its expenditure. A direct tax is a compulsory contribution imposed on the person who is intended to pay. The main forms of direct tax are income tax on individuals and corporation tax on businesses. Although there is no general tax on the ownership of personal wealth, when property changes hands for more money than it cost the seller, a capital gains tax may be incurred, and when property changes hands on the death of the owner, an inheritance tax may be incurred.
Income tax dates from the 1790s, and has until recently been the major source of tax revenue. It can be designed to be progressive, proportional or regressive. The idea of a progressive tax is to take an increasing proportion in tax as the level of the taxpayers’ income rises. This is done by increasing the marginal tax rates. There has been a move away from this idea because it was argued that there were serious disincentive effects on work and risk taking if the economic rewards were highly taxed. There was an idea that a cut in the high marginal rates would actually bring in more revenue from income tax because the incentive to avoid and evade tax would be less. One of the principles of a tax system is that it should be equitable. This means treating people with equal means in the same way. It explains why income generated from any source should be taxed and why gains from the transfer of wealth are taxed. Not all income is taxed however, individuals receive personal allowances and companies can offset some expenditure against tax. Economists see national insurance contributions raised to finance pension and sickness benefit as a direct tax. The burden of the tax is shared between employees, employers and the government.
Economics Basics – Development Economics
Posted by: | CommentsOver 75% of the world’s population live in what have been pessimistically called less developed, or optimistically, developing economies.
The study of developing economies or underdevelopment recognizes a fundamental difference between the ideas of economic growth and economic development. Economic growth is to do with the rate at which GDP is increasing per head of population. Economic development refers to the growth in the welfare of the population. Growth is not a sufficient condition for development because the distribution of the income is a critical factor in welfare. The trickle down theory, suggesting that rapid economic growth would eliminate poverty, has proved to be a poor explanation of real world events. Some countries show signs of dualism, where a prosperous modern sector exists alongside an agricultural system with people at, or close to, subsistence level.
Development is about the quality of life and the choices that people have. It therefore involves value judgments about what is acceptable. The basic needs approach to development identifies simple targets that must be reached including:
- adequate food, clothing, shelter and health care;
- universal access to education and employment;
- adequate leisure time;
- political and religious freedom.
Development economics tends to describe the characteristics of developing economies and identifies the obstacles to achieving development. The problem is that developing economies are not all the same, e.g. there is a sub-group that has experienced rapid growth, based in exports, whilst others burdened with debt have seen GDP stagnate.
Economics Basics – Demerit Goods
Posted by: | CommentsThese are goods which impose costs on people who are not direct consumers of the product, as well as those who are. In this sense, demerit goods are regarded as being socially harmful. The problem is that free markets will produce anything for which there is an effective demand. The degree of harm done by consuming products is not easily measured and therefore our definition of what makes something a demerit good involves opinion or a value judgment.
The example usually given of a socially harmful product is tobacco. It can cause health damage to users and non-users and there are economic costs associated with these effects. The economic case against smoking is that the market price does not include these costs, with the result that the product is underpriced; this encourages overconsumption. Governments have tried to reduce consumption by raising the supply costs through taxation. This is not very successful in conditions of low price elasticity of demand.
The government is acting in a paternalistic manner, trying to protect users and non-users from the consequences of consumption. It is making the judgment that the social cost is greater than the social benefit. The economic case put forward by consumers is that it interferes with freedom of choice; the contribution in tax revenue more than outweighs the economic cost of the negative effects. If this is true, it could be argued that the activity has net social benefit. Consumption can be reduced by making the product illegal and preventing imports from countries where it is still legal. Alternatively, the government can artificially raise production costs or control the output through a licensing system. The best solution would be to try and shift tastes away from a demerit good, but this is particularly difficult where it has addictive qualities.
Economics Basics – Demand Pull Inflation
Posted by: | CommentsIf there is unused capacity in the economy, a rise in total expenditure or aggregate demand will lead to a rise in output. As the economy gets closer to capacity, there may be some shortages and upward pressure on wage levels in the labour market. This will lead to prices as well as output, beginning to rise. Whenever aggregate demand rises faster than the aggregate supply, there will be what is known as demand pull inflation. One important idea was the so-called Phillips relationship. This predicted that the closer to full employment the government chose to run the economy, the faster the rate of inflation would accelerate. There was therefore a trade-off between full employment and the control of inflation.
An increase in aggregate demand can be caused by a rise in consumer expenditure, business investment, government expenditure, or a net injection resulting from export revenue exceeding import expenditure. Monetarists believe that the cause can be traced back to an increase in the money supply in the economy.
For inflation to persist, there must be a continuous rise in aggregate demand. Demand pull inflation is therefore associated with a booming economy where government fiscal and monetary policies are expansionary. It can set off inflationary expectations and workers keen to protect real income can exert wage pressure leading to cost push inflation.
The solution to demand pull inflation is to operate a deflationary policy. Appropriate fiscal policies could be a cut in government expenditure or a rise in taxation. A reduction in the money supply or a rise in interest rates would be the preferred monetarist solution. The difficulty is not just finding a solution, but in correctly identifying the cause.