Economics 101 Part 1


Economics

This topic is a brief introduction to economic concepts.

Three Questions
Economists focus on three fundamental questions:
1. What should we produce and how much?
2. How should we produce these goods and with what resources?
3. Who are our customers/purchasers of these goods?

A Few Economic Concepts:

  • Economics is about choosing resources and making choices between different goods and services for distribution and consumption in an environment where you have scarcity of resources.
  • Economics is the study of how societies produce and distribute goods and services amongst its members in an attempt to satisfy the wants and needs of its members.
  • Efficiency means that society gets the most out of its scarce resources.
  • Equity means that the benefits of those resources are shared fairly among those in society.
  • The cost of something is what you give up to get it.
  • When people specialize and do what they do best to produce a product or service, they can trade with another person who is also specializing at what they do best and both will be better off.
  • A market economy is an economy that allocates resources through the decentralized decisions of many households and companies as they interact in markets for goods and services.
  • The overall economic standard of living is typically measured by how much a society produces and can be measured by household incomes or total market value of a nation’s production. Some people are arguing that we should be focusing on “quality of life”, not GDP.
  • Factors of production are the inputs needed to produce and are traditionally divided into three categories: land (land, water, plants, animals, energy metals and so on), labor (human effort) and capital (man-made machines, tools, factories, roads, water and electric systems and so on) that are used by people to produce things. Two other factors of production are information resources and entrepreneurship.
  • Diminishing returns refers to the fact that for everything you can produce, the amount of additional output you get from each additional input decreases as you use more and more of the input.

Economic Systems
An economic system is a set of laws, institutions, and activities that guide decision making.
Traditional economic system Economies that are based on hunting, gathering, farming and barter are referred to as traditional economies.
Pure market system This system is based on supply and demand with little or no government control. An Internet public auction is an example of this.
Command economy This system is run by a strong central government that focuses on industrial goods over consumer goods. The former Soviet Union had a command economy.
Free enterprise This is also called capitalism or a market economy. Individuals are free to set up their own enterprises and compete in the marketplace. The marketplace is comprised of individuals whom are free to buy and sell. There are four types of competition in a free enterprise system: perfect competition, monopolistic competition, monopoly and oligopoly. Perfect competition is where you have a lot of buyers and sellers and no one company is large enough to dominate the market and affect the price. Monopolistic competition has many sellers producing similar but differentiated products in order to dominate a niche in the market. A monopoly exists when a particular commodity has only one seller who controls supply and prices. Oligopolies have a few competitors that dominate the industry. An example of this is the automobile industry.

Mixed economies
When the principles of the command economy and free enterprise are combined, you have an economy that is mixed. Mixed economies have capitalism and some form of government intervention. The government intervenes in an attempt to smooth out the worst features and inequities of the economy to create a mixed economy. Canada, the United States and the European Union have mixed economies.

Adam Smith
In 1776 Adam Smith wrote An Inquiry into the Nature and Causes of the Wealth of Nations. He developed the capitalist theory. Smith said that all companies would function best with minimal government involvement. His invisible hand would make the economy work well. Wealth creation would be accomplished by entrepreneurs (owner/managers) who would invest their own money to create businesses that would employ workers and produce goods and services. A portion of the profits would be reinvested back into the business allowing them to grow and increase wealth. Adam Smith is called the father of economics. Adam Smith, in the An Inquiry into the Nature and Causes of the Wealth of Nations, also wrote that the needs of producers should only be considered with regard to meeting the needs of consumers. This philosophy is consistent with the marketing concept. Adam Smith recognized that the usefulness of an item cannot be determined by the price of an item. Useful things can have very low prices and unnecessary luxury items can be very expensive. Adam Smith was the first person to define capitalist as an owner-manager that brought together land, labour and capital to form a business that made profits.

Utility
Utility maximization is the theory in economics that all economic actions that a person takes (buying, selling, getting a job and so on) is the result of a rational decision that results in their own maximization of their happiness, or utility. It follows then that all financial transactions must be good for both parties otherwise they wouldn’t have occurred. This utility’s source could be from pleasure, security or self-satisfaction. Self-satisfaction could be the good felling one gets from giving generously to another. Are all decisions rational? If so, then all you have to do is sum up all of these transactions to determine a gross domestic product (GDP) and use this number to gage the overall health of the economy. However, not all economic decisions are rational.

Perfectly Competitive Markets of the Free Enterprise System
In perfectly competitive market theory, the entrepreneur is ignored and the focus is on an abundance of buyers and sellers all interacting efficiently. Negotiations are made between these buyers and sellers and prices are agreed upon. Equilibrium in economic terms means that the supply of goods produced equals the demand by consumers. This is the Neoclassic theory. In order for this equilibrium to be achieved, both buyers and sellers need to have perfectly accurate and complete information about the market, prices and the goods themselves. Since no single buyer can influence the market, the market determines price. Also, in order for this to exist, products and services in the market need to be fundamentally alike such that the only real difference between them is price. These types of products are called commodities. Many economists criticized this view because it ignored entrepreneurship. Entrepreneurs create chaos in markets like the one described above because they introduce new and different products that some people in the marketplace do not yet understand and thereby ignore, while other consumers will buy this product creating new demand, and other consumers will switch from one product to the new product. Today, with the ever-increasing advancements in technology, entrepreneurs and small businesses have become a large part of the economy. In order to understand economics, these entrepreneurs cannot be ignored. The only thing close to a perfectly competitive market happening today is perhaps in some of large commodity markets where buyers and sellers meet and are aware of the products being bought and sold.

Free Market
A free market system is one in which decisions about which goods and services to produce, in what quantities and what prices is determined by buyers and sellers making free choices.  When someone buys something it sends a signal back to the seller that at that given price, there is a demand for that goods or service. Sellers respond to that call and work to replace that good or service in the marketplace so that another buyer may purchase it. Overall this works quite well however there are certain inequities in the system. The wealth benefits created by this system do not not flow to everybody evenly. Some are wealthy and others do not have their basic needs met, such as food, shelter and clothing.

Joseph Schumpeter
Classical economists, around the end of the 19th century, began to speak about the importance of the entrepreneur. Joseph Schumpeter, a classical economist, said that there is no such thing as equilibrium between supply and demand and that markets are chaotic. The innovations of entrepreneurs destroy old markets and create new ones. Schumpeter said that innovation is the practical implementation of knowledge, ideas or discoveries and rely therefore not simply on inventiveness but on entrepreneurial abilities. These entrepreneurs create businesses that are profitable enough to survive and pay the interest expenses on their debts. Consequently, interest rates are an indicator of economic progress. Profit and interest are outcomes of economic dynamics.

John Maynard Keynes
Keynes developed theories around the time of the Depression that later came to be known as Keynesian economics. Keynes suggested ways that governments could get their countries out of the Depression. He advocated interventionist government policy, by which the government would use fiscal and monetary measures to mitigate the adverse effects of economic recessions, depressions and booms.

Full Employment
Economists use the term full employment to represent a situation in which everyone who wants a full time job can get one. Full employment output is how much output is produced in the economy when there is full employment in the labour market. Full employment is not the same thing as having a zero unemployment rate. This is because there will always be some people who want a full time job but have quit their job to search for a better job. This is called frictional unemployment.

Inflation
Inflation is the general rise in the prices of goods and services over time. Not all prices of goods may rise, but as long as the general price of goods and services are rising, there is a period of inflation. There are two types of inflation. Demand-pull inflation occurs when there the supply of goods cannot meet the demand. Cost-push inflation occurs when the costs of production rise. Manufacturers will often pass the costs of rising prices of raw materials on to the consumer, causing prices to rise. Once workers realize that prices are on the rise, they demand higher wages. What can happen in this situation is that companies put a hiring freeze on to compensate for the higher wages they have to pay. Unemployment will often rise during these times.

The National Debt
Governments borrow money. The total of what they owe is called the national debt. Each year governments spend money and collect money in taxes. When spending exceeds collection, the result is called a deficit. When collection exceeds spending it is called a surplus. If a country has a large national debt, it pays a significant portion of it’s collected taxes on interest charges on the national debt. Also, a large debt load means that when times are tough, the government is unable to follow Keynes’s suggestion to reduce taxes and borrow to spend more to help stimulate the economy out of a recession.

International Trade
International trade is the buying and selling of goods and services between countries. When a country sells domestically made goods or services to an entity outside of the country, the sale is called an export. When an entity in a country purchases a good or service that was produced abroad, that purchase is known as an import. Net exports is the total value of all exports minus all imports in a given period of time. If your exports exceed your imports you have a trade surplus. If your imports exceed your exports, it is called a trade deficit. Economists like to encourage international trade without the government subsidies and trade restrictions. Economists like to see products move freely between countries because, assuming that the trade is voluntary, it makes both sides better off because if it didn’t make them better off, they wouldn’t trade in the first place. Also, opening a country up to international trade opens a country up to new ideas and new innovations. Therefore, economists do not necessarily think of trade deficits as bad.

International trade can be a significant portion of a country’s GDP and can have great impact on an economy. For example, Canada’s dollar value is heavily influenced by world demand for commodities that Canada exports to other countries. Why? Canada is a net exporter of oil and wheat, for example. Since Canada produces more oil than it can consume internally, it exports it. In exchange for this oil, people outside of Canada will convert their own currency to Canadian dollars to pay for the oil. This creates more demand for Canadian dollars, causing the value of the Canadian dollar to increase, as the law of supply and demand explains.

Balance of Trade
Countries export goods and services they produce and and import other goods and services. If a country brings in more money from exporting than it spends on importing, it has a positive balance of trade. This is called a trade surplus. If a country spends more for imports than it receives from exports, it has a negative balance of trade, which is called a trade deficit.

A Firm’s Operating Environment
Economics is just one of many factors that influences a firm. The PEST analysis includes the following four factors: Political, Economic, Social and Technological factors. An extended framework that is also used is the STEEPLE analysis that includes the following: Social/demographic, Technological, Economic, Environmental (natural environment), Political, Legal and Ethical. The table below lists a few examples.

Social/Demographic Income distribution, demographics, age distribution, education, fashion trends, labor, lifestyle and so on
Technological New inventions in materials, energy use and costs, product life cycle and so on
Economic Economic growth and recession, interest rates and monetary policies, inflation rates, consumer confidence and so on
Environmental (natural) Environmental impact of activities, recycling, energy use and conservation and so on
Political Political stability, safety regulations, political party agendas and so on
Legal Employment laws, contract laws, laws regulating landlords and tenants, bankruptcy laws, tax laws and regulations and so on
Ethical Bargaining in good faith with suppliers, representing honestly the products you are selling and so on


Productivity
Productivity is measured by dividing the total output of goods and services of a given period of time by the total hours of labour required to produce those goods. To increase overall productivity requires either the production of more output with the same number of hours worked, or the production of the same output with fewer hours worked. How do you increase productivity? Educated people are more productive, get paid higher salaries and produce more innovative new technologies. Sustained economic growth is possible if you educate your citizens well. New technologies and new innovations can also come from increased international trade. When countries open themselves up to international trade, competition from foreign competitors causes local businesses to innovate to match offerings from companies around the world. Economists will often use this argument when they are promoting the concept of free trade and opposing trade restrictions and government subsidies.

Knowledge Economy
The knowledge economy is a concept that identifies the fact that much of the economic focus is on the production of knowledge assets. Knowledge assets are intangible assets, not physical assets. As many firms strive to be more competitive in the market, they strive to add more value to the products and services they sell, by more effectively creating and managing knowledge assets. The service economy relies on these knowledge assets to be competitive. The explosion of computer technology in recent years has fueled the explosion of knowledge assets. Information can flow easily and quickly over the Internet in electronic form and can be easily replicated at almost zero cost. Knowledge assets don’t follow the traditional principle of scarcity. When a good, such as some food, is consumed it is used up. When a piece of clothing is worn it eventually wears out. Not so with knowledge assets.

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