Scarcity and Choice Economics

Task 1

a) A definition of economics that includes the problems of scarcity and choice.

Scarcity is a concept of the tension between the limited resources and the unlimited wants and needs of individuals or countries. For an individual, limited resources are time, money and skills; and for a country, they are natural resources, capital, labor force and technology. Because resources are limited comparing with the wants and needs, either individuals or countries have to make decisions regarding what goods and services they can buy and which ones they have to give up. (Investopedia,) Lionel Robbins (1939) believes that scarcity exists as the available resources are insufficient to satisfy all wants and needs. If there is no scarcity or has alternative use of other available resources, there is no economic problem. So that “economics can be seen as the science that studies human behavior as a relationship between given ends and scarce means which have alternative uses” (p.16). P. Samuelson (1948) further proposes that “economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people.”

It may note that different individuals or countries have different values because of their different levels of scarce resources they face, so that they have to make decisions for how to allocate their resources. Economists try to evaluate the well-being of rich and poor in order to find a way to increase this well-being to some extent. From this perspective, economics can be seen as a study of how supply and demand forces allocate scarce resources (InvestorWords.com,), which explains why people make these decisions and how they allocate their resources efficiently.

“The definition of economic is the social science that studies the production, distribution, and consumption of goods and services.”

www.en.wikipedia.org/wiki/Economics

This is a common definition of economics however, it is not good enough as it does not include scarcity and choice. A better definition would include the “economic problem”:

In 1935 Lionel Robbins . defined economics as “the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.”

www.britannica.com

b) An explanation of what is meant by the concept of opportunity cost.

Base on the definition of economics about scarcity of resources, opportunity cost can be considered as a result of scarce resources as scarcity necessitates trade-offs and trade-offs caused an opportunity cost. (NetMBA.com,) In specific, the cost of a good or service is usually measured by monetary terms, and then the opportunity cost can be seen as a result of a “giving up choice” (if there are two or more options for people to decide). For example, a person who has £20 can either buy a cloth or pay for a dinner. If she buys a cloth, the opportunity cost is a dinner. In contrast, if she pays for a dinner the opportunity cost is the cloth. It may note that if there are more than two options, the opportunity cost should be still only one item rather than all of them.

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Keat and Young provide a definition of opportunity cost that is ‘an amount or subjective value that is forgone in choosing one activity over the next best alternative’. They explain that opportunity cost is not only in monetary or material terms but also in terms of anything else with values. For example, a person who desires to watch two television programs simultaneously, and then the opportunity cost of watching ‘24 Hours’ should be giving up enjoying ‘Prison Break’.

Opportunity cost: It is the value of the next-best choice available to someone who has picked between several mutually exclusive choices.

www.answers.com

c) An explanation of the difference between micro and macro economics.

“[Macroeconomics] is field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product and inflation and price levels.”

www.answer.com

Again, the term of economics can be considered as the study of choice and decision-making in a world with limited resources (Mcwdn.org,) and can be divided into microeconomics and macroeconomics. Either one is essential to understand most economic phenomena. In specific, microeconomics is the study of the individual parts in an economy such as how prices are determined and how prices determine the production, distribution and use of goods and services. Macroeconomics is the study of the total output of a country, dealing with the issues of growth, inflation and unemployment and with national economic policies relating to these issues (Mcwdn.org,) in order to maximize production levels and promote trade and growth for future generations.

Task 2

a) Show how an individual demand curve (schedule) is derived and how market demand is derived.

The demand schedule described graphically as the demand curve, which is defined as the relationship between the price of the good and the amount or quantity the consumer is willing and able to purchase in a specified time period, given constant levels of the other determinants–tastes, income, prices of related goods, expectations, and number of buyers (Sosin, K.). Based on the demand law, there is an inverse relationship between the price of a good and the quantity of the good demanded per time period (Brooker,). As shown in Figure 2.1

Price (£)

3 £

6 £

9 $

12 £

Quantity (c)

60

30

15

6

For example, In fact, I was smoked 30 cigarettes by each day that I must pay 6 £. Then decrease the price to 3 £, I will happy to buy more cigarettes to smoke. However if the price increase higher, I think much more people will not buy more.

b) Using diagrams provide a clear explanation of what is a firm’s output decision in the short-run.

Basically, firms are used to conduct cost curves to find the optimal point of production where can help them make the most profits and allow their productivities to be more efficient. In the short-run, assuming the firm operates in perfectly competitive markets and must pay for its inputs at a given market rate for producing a single product. It owns a fixed level of technology and produces in the most efficient way at every level of output. Two inputs are employed: labor (L is variable) and capital (K is fixed). The firm is a ‘price taker’ in the input markets. Hence, the average total cost (AC) curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. (Pindyck, & Rubinfeld, 2001, p.212)

Therefore,

AC = AFC + AVC = TC/Q

where AFC and AVC refers to the average per-unit cost of using the fixed input K and the variable input L respectively; TC is the total cost of using inputs; Q is the amount of output that a firm can produce in the short run.

Marginal cost (MC) is the change in a firm’s total cost (or total variable cost) resulting from a unit change in output:

MC = dTC/dQ = dTVC/dQ

As shown in Figure 2.2, MC curve determines the shape of the AVC functions as follows and the same three rules also apply for AC:

â–ª If MC > AVC, AVC is rising.

â–ª If MC < AVC, AVC is falling.

â–ª If MC = AVC, AVC is at a minimum value.

As the shape of the AVC curve is affected by diminishing marginal returns (MR) to the variable input (the input of labor). Therefore, the firm is used to made the optimum output decision at MC=AC in the short-run.

c) Using diagrams provide a clear explanation of what is a firm’s output decision in the long-run.

As illustrated in Figure 2.3, the LRAC curve is an envelope of SRAC curves, and outlines the lowest per-unit costs the firm will incur over a range of output. The firm can choose any level of capacity, but the firm experiences diseconomies of scale when it produces more than 40 thousands units. It is because large scale of production affects the total market demand for inputs, so input prices rise.

Due to increased input flexibility, MC curve tends to be flatter than in short-run. It intersects with the LRAC curve at its minimum point (see figure 2.4). Then the optimum output decision of firms should be at MC=MR (Perloff, J. 2009, p.208)

Task 3

a) How an equilibrium price and equilibrium quantity is achieved.

Demand curve is amount of some good consumers are willing to buy at various prices, while supply curve refers to amount of some good sellers are willing to offer at various prices. As shown in figure 3.1, the interaction of supply and demand yields an equilibrium price P* and equilibrium quantity Q* At this point, the allocation of goods seems to be the most efficient as the amount of goods being supplied is exactly the same as the amount of goods being demanded. So that each participate (firms or consumers) is satisfied with the current economic condition. The triangle area above P* is consumer surplus and the triangle area below P* is producer surplus.

However, some scholars may argue that the market equilibrium can only exist in theory. In the real world, prices of goods/services change constantly against the fluctuations in demand and supply.

b) The effects of excess supply on market equilibrium.

If the price is set too high, excess supply will be created within the economy, which will result in an inefficient allocation.

The higher pirce, the lower demand, look at that two point this diagram. As shown in Figure 3.2.1, at price P1, the quantity of goods that the producers wish to supply is at Q2 for more profits, but the quantity that the consumers want to consume is at Q1 because the product becomes less attractive as price is too high. Then, Q2 > Q1 indicates that too many products are produced but too little is consumed, so that there is a surplus of products in the market.

Brickley explains if using wages and demand for labour: “when the minimum wage ($5.15) is higher than the market equilibrium wage ($4), more people would like to find a job, and then the numbers of labour supply will exceed the equilibrium amount because Qs > QD, which will result in the unemployment in the labour market.”

c) The effects of excess demand on market equilibrium.

Similarly, when price is set below the equilibrium price at P1, excess demand will be created in the market place, as more and more consumers want to purchase the good with the lower price but producers are unlikely to do more on it. As shown in Figure 3.3.1, at price P1, the quantity of goods demanded by consumers is Q2 but the quantity of goods that producers are willing to produce is only Q1. As the result, Q2 > Q1 indicates that too many products are demanded by consumers but few goods are produced to satisfy their demand, so that there is a shortage of products in the market. 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 (Investopedia, 2003).

Task 4

a) Explain clearly what is meant by perfect competition.

Perfect competition is a market structure based on five assumptions:

1. All firms sell homogeneous products that can be perfect substitutes for each other.

2. All firms are price takers.

3. All firms are assumed to have equal access to resources (technology and other factor inputs) and improvements in production technologies;

4. Consumers have perfect information about the prices, so that if one firm decides to charge a higher price than the market charge, it will loss its consumers.

5. The industry is characterized by no barriers to entry and exit in long run.

In the short run the equilibrium market price is determined by the interaction between market demand and supply. As illustrated in Figure 4.1.1, The average revenue (AR) curve is equal to the Marginal Revenue (MR) curve. Market price P1 is located at MC=MR for firms in order to maximises profits. P1 assumes to be constant for each unit sold. Then, the firm sells the profit-maximising output Q1 at P1. As P1 is greater than AC, the shaded area can be the supernormal profit made by firms.

However, some firms may be experiencing economic loss or sub-normal profits if their average total costs exceed the current market price, as illustrated in figure 4.1.2. Besides, some firms may be making normal profits if their total revenue equals total cost (that is to say they are at the break-even output). From this perspective, it can conclude that firms’ profits depend on the position of their short run cost curves.

b) Explain clearly what is meant by oligopoly.

Oligopoly is market form which is dominated by few numbers of sellers. It is a non-price competition and has strong barriers to entry. Pure oligopoly produces homogeneous products and differentiated oligopoly produces differentiated products. (Brooker, 2001) It can help firms to achieve economies of scale. But large capital investment is required, and sometimes it also needs to control of a raw material or resource and limit pricing (e.g. OPEC countries regarding oil issues).

Moreover, oligopolistic markets are characterized by interactivity. That is to say the decisions of one firm influence, and are influenced by, the decisions of other firms. For example, the supermarket industry in the UK with a four-firm[1] concentration ratio controlled over 70% market shares. The price of 1L semi-milk in Tesco can affect and be affected by Sainsbury’s one or ASDA’s one.

Actually, there is no single model describing the operation of an oligopolistic market (Colander, 2008, p.288). Some of the well-known models such as Cournot-Nash model, Bertrand model and kinked demand model try to explain this market behaviour under certain conditions. Take kinked demand model (see Figure 4.2) for example, assuming that:

1). If an oligopolist raises its price above the existing price, other firms will not follow, then the acting firm will lose market share; demand seems to be elastic.

2). If an oligopolist lowers its price, other firms will follow to preserve their market share, then the acting firm’s output will increase slightly; demand seems to be inelastic.

Based on these assumptions, demand curve (ABC) will be kinked and MR curve will be discontinuous. The gap (between point G and H) on the MR curve means that marginal costs can fluctuate without changing equilibrium price and quantity (Pindyck & Rubinfeld, 2001, p. 446). However, there are three main harmful effects of oligopoly. First, price is usually greater than the LRAC as well as the LRMC. Second, quantity produced usually does not correspond to minimum LRAC. Third, when a differentiated product is produced, too much may be spent on advertising and model changes. (Brooker, 2001)

Task 5

a) An explanation and evaluation of what is meant by Keynesian economics.

Keynesian economics is an economic theory, which states that the active government intervention in the marketplace and monetary policy is the best method of ensuring economic growth and stability (Investopedia, 2009).

Consumption depends on the level of disposable personal income, which equals to income minus taxes (= Y – T). Then the consumption function proposed by Keynes is:

C = C0 + Cy (Y – T)

Where C0 is autonomous consumption and Cy is marginal propensity to consume;

As the National income is Y = C +I + G + NX, where I is planned investment, G is government spending, and NX is net export = exports – imports, the Keynesian model is:

Y = C0 + Cy (Y – T) + I + G + NX

There an implications of Keynes’ model for government policy—i.e. the introduction of the multiplier effect. It argues that an increase in government spending will result in a multiple increase in output. For example, increase. a ten-billion-dollar increase in government spending could cause total output to rise by sixteen billion dollars (a multiplier of 1.6)

Moreover, this theory based on the beliefs of (I) macroeconomic fluctuations significantly reduce economic well-being and (II) the government is knowledgeable and capable enough to improve on the free market (Blinder, 2008). There are four principal main point as the central of Keynesianism.

1). Keynesian believes that aggregate demand (AD) is affected by both monetary and fiscal policies (i.e. spending and tax). (Blinder, 2008).

2). Keynesian theory emphasizes that changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices.

3). Keynesians believe that prices, especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor. (Blinder, 2008)

4). Keynesians do not think that the typical level of unemployment is ideal, partially because unemployment is subject to the caprice of aggregate demand, and partially because they believe that prices adjust only gradually.

b) An explanation and evaluation of what is meant by Monetarist economics.

Monetary economics attempts to provide a micro-based formulation of the demand for money and distinguish the relationships of nominal and real monetary in micro and macro contexts, involving the influence on the aggregate demand for output (Tobin, 1958).

Monrtarist believe that inflation is the main problem and can be controlled using interest rather to change money supply. There are too much money change too few goods that is inflation going up. There is one solution that which is reduce consumers disposable income. However , how to make many people spend their money faster? Company can increase their interset or bonus. Because it can keep the price and more spent on mortgage and loan repayments, what is more, less spent on discretionary goods.

However, Rt Hon Dennis Healy MP, Chancellor of the Exchequer (1974 – 1979), once said ‘most of the theories on which economics is based are bunkum’ (The Sunday Times, 15th March 1992). J. M. Keynes (1883 – 1946) believes that ‘the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’

References

Brooker, Robert F., 2001, PowerPoint Slides of Oligopoly, Harcourt Inc. Cited in Ingham, H., 2004, Economics Lecture-notes, [Online] Lancaster University, UK. Available at: http://www.lancs.ac.uk/staff/ingham/ [Assessed 10th Dec. 2009]

Brooker, Robert F., 2001a, Law of Demand, Harcourt Inc., Cited in Ingham, H., 2004, Economics Lecture-notes, [Online] Lancaster University, UK. Available at: http://www.lancaster.ac.uk/staff/ingham/mba/23oct-02.ppt [Assessed 10th Dec. 2009]

Blinder, Alan S., 2008, Keynesian Economics, [Online] Princeton University Available at: http://www.econlib.org/library/Enc/KeynesianEconomics.html [Assessed 10th Dec. 2009]

Brickley & Smith & Zimmerman, 2007, Chapter 3 Markets, Organizations, and the Role of Knowledge, Managerial Economics and Organizational Architecture, 4th edition, McGraw-Hill,. [Online] Available at: http://www.uwlax.edu/faculty/knowles/eco310/chap003.ppt [Assessed 9th Jan. 2010]

Colander, David C., 2008, Microeconomics, 7th edition, McGraw-Hill, p.288

Keat & Young, 2006, Managerial Economics 5/e, Prentice Hall Business Publishing [Online] Available at: http://www.nhu.edu.tw/~cyhuang/teach/manageco/pwt/5edCh07.ppt [Assessed 9th Jan. 2010]

Keynes, 1883–1946, quotation, [Online] Available at: http://thinkexist.com/quotation/the_ideas_of_economists_and_political/295379.html [Assessed 9th Jan. 2010]

InvestorWords.com, 2010, Definition of Economics [Online] Available at: http://www.investorwords.com/1648/economics.html [Assessed 9th Jan. 2010]

Investopedia, 2003, Economics Basics: Demand and Supply [Online] Available at:

http://www.investopedia.com/university/economics/economics3.asp [Assessed 9th Jan. 2010]

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Pindyck, R., & Rubinfeld, D, 2001, Microeconomics, 5th ed. Prentice-Hall, pp. 212-229 and p. 446

Perloff, J: 2008 Microeconomics Theory & Applications with Calculus, Pearson.

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Robbins, L., 1945. An Essay on the Nature and Significance of Economic Science, London: Macmillan and Co., Limited, [Online] p. 16, Available at: http://www.mises.org/books/robbinsessay2.pdf [Assessed 9th Jan. 2010]

Samuelson, Paul A., 1948, Economics, New York: McGraw-Hill,

Sosin, Kim, 2007, Explorations in Economic Demand, Part II. [Online] Available at: http://ecedweb.unomaha.edu/DEM_SUP/analysis.htm [Assessed 9th Jan. 2010]

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Tobin, James, 1958, Liquidity Preference as Behavior Towards Risk, Review of Economic Studies 25(1), pp. 65–86

[1] Four big supermarkets in the UK include: Tesco, Sainsbury, ASDA and Morrison.