Economists divide economics into two broad categories: microeconomics and macroeconomics. Microeconomics is the study of decision-making behavior of individual people and individual firms. Individuals make decisions in an attempt to maximize happiness and firms make decisions in an attempt to maximize profits. In the presence of competitive markets, society’s limited resources get used efficiently. An optimal combination of goods and combination of services is produced from those limited resources. Markets are never perfect and at times they can fail. The discussion that follows is just a very brief introduction to a few microeconomic concepts.
Supply and Demand Model
This is a model of how markets function. This model helps to explain why prices change and why sometimes it may be difficult to find what you are looking for.
Markets A market is where buyers and sellers meet and trade money for goods and services. The meeting place could be in a retail store, on the Internet, through a computer transaction, business to business or some other means.
Demand People want to purchase things. This is quantity demanded. This want is what people are both willing and able to pay for. People have wants, preferences and a given amount of money that they have to spend. The quantity demanded by an individual is therefore how much they are willing and able to buy something at a given price. The economists definition of demand is not your wish list of things if you won the lottery.
The Demand Curve The demand curve is graphed using a vertical axis for price and a horizontal axis for quantity demanded, on the two-dimensional Cartesian plane. As the price for a product increases, the quantity decreases. Non-price factors determine where the demand curve is placed on the graph. If for some reason a product becomes more desirable, perhaps because it’s perceived value has increased, there is a shift in demand and the demand curve shifts to the right. People are now willing to pay more for it.
Supply It costs money to supply things. Producers of things must put forth effort to make goods and supply services. They also may need to purchase goods and services from others to do so. As the quantity of production of units increases, the price that buyers need to pay will increase. This is because each addition unit of production increases costs.
The Supply Curve Price is on the vertical axis and quantity produced is on the horizontal axis on the two-dimensional Cartesian plane. As the quantity increases, price increases. Suppliers look at the price being offered by consumers and make as many units as is profitable and no more. There’s no point to making more units when each additional unit produced costs more than what she can sell it for. The supply curve can shift if there is a change in production costs or methods. If production costs increase, the supply curve would shift to the left.
Economists use the word elasticity to describe how changes in one thing affect another. Demand elasticity refers to how much the quantity demanded changes when the price changes. If a consumer of a particular product is said to have a low demand elasticity, then that consumer’s change in quantity demanded is low, when the price changes. In other words, for this person, price is not very “important”. For example, if the price were to double, this person may only reduce their demand for that item by only a small percentage.
How do markets determine the amounts and prices of goods and services sold? If we put the supply and demand curves on the same graph, they will intersect at an equilibrium point. This equilibrium point is the market price and the market quantity of the item in question. Both consumers and producers are happy. Markets always eventually tend toward this intersection point even when they are not there now. Suppose the actual price the good is selling for is above the equilibrium price (also called the market price). The quantity supplied by suppliers is greater than the quantity demanded by buyers. There is an excess supply. Producers will want to produce more but they will not sell all of it because some consumers will not pay the price. Producers will then be forced to reduce their prices to sell off the excess supply that they have built up in inventories. On the other hand, if the price starts out lower than the equilibrium price, there is an excess demand and a shortage of the good. Consumers will bid up the price until it is pushed back to the market price.
Firms operate to maximize profit. They have other goals as well, but they still have a profit motive. If a firm faces no competition in its market, it is a monopoly. At the other extreme is what economists call perfect competition. With perfect competition, the firm competes with many other firms in an industry in which they all produce an identical good. An oligopoly is where there are about two or three firms competing in an industry. Imperfect competition has many competitors that all produce a slightly unique good.
Fixed and Variable Costs
Total costs of a firm are often separated between fixed costs and variable costs. Fixed costs are costs that are incurred even when the firm isn’t engaged in business activity. From a retail perspective, fixed costs would be those costs incurred even if you don’t sell anything. An example of a fixed cost would be rent paid to the landlord, depreciation on equipment or interest payments on your debt. As your business activity level increases, total fixed costs increases but unit fixed costs decrease. Variable costs are costs that vary with the amount of business activity. In a retail store, the cost of your goods sold, and the cost of bags are examples of variable costs.
Economies of Scale
With a large market that allows for mass production, large and efficient machines and plants can be used; the costs of which can be spread over many units of production. The fixed cost per unit of production becomes less and less the more you produce, up to a certain point. This concept is known as economies of scale. The per unit becomes less and less until the costs of coordinating the complex organization begin to rise. To achieve economies of scale you need a large enough market to warrant the large plants and machines required and you need enough capital available to purchase the large plants and machines.
Direct and Indirect Costs
Many companies are organized into departments. Responsibility accounting is concerned with the tracing of costs to departments. A direct cost is a cost that can be traced to a particular department. A cost that is not directly traceable to a particular department is called an indirect cost of the department. For example, the salary of the store manager of a large department store cannot be directed traced to a particular department of the store, but his services benefit each department. The department store’s sales and marketing expenses cannot be directly traced to any one department of the store, since all departments benefit.
Costs are classified into the functional areas of a business. Functional areas include manufacturing, merchandise, administration, marketing, research and development and others. Once these costs have been classified, managers can make better plans and they can control cost more effectively. Manufacturing costs are further classified into the following three categories: direct material, direct labour and manufacturing overhead. Manufacturing overhead costs are further broken down into three types of costs: indirect material, indirect labour and other manufacturing costs. Direct material is raw material that is consumed in the manufacturing process, is physically incorporated in the finished product and can be easily traced to products. An example would be cotton and buttons used to make a shirt. Before material is entered into the production process it is called raw material. After it enters production it becomes direct material. Therefore, the cost of raw material used is equal to the direct-material cost. Direct labour is the cost of salaries, wages and benefits for personnel who work directly on the manufactured products. Indirect material is the cost of material that are required for the production process but do not become an integral part of the finished product. An example of this would be the needles required to stitch the garments together. These would eventually wear out and need to be replaced. Indirect labour is the costs of personnel who do not directly work on the product but whose services are required in the manufacturing process. Such personnel include supervisors, security guards and custodial employees. All of the manufacturing costs that are neither material nor labour costs are classified as manufacturing overhead. These costs include depreciation of plant and equipment, property taxes, insurance and utilities such as electricity, and service departments. Service departments include equipment maintenance departments and computer-aided design (CAD) departments. Also, the costs of an employee’s idle time is classified as overhead. Idle time is time that a worker is not working, but still need to be paid. It can be caused by equipment breakdown or a power failure. It would be unfair to assign idle time costs to the particular product that the workers were working on at the time. As mentioned, idle time costs should be classified as manufacturing overhead.
Four of the most important types of non-manufacturing costs are merchandise costs, marketing costs, administrative costs and research and development (R&D) costs. Merchandise costs are the costs incurred by retailers and wholesalers to acquire merchandise for resale. Merchandise costs include the purchase costs of the goods and the shipping costs. In the simulator, shipping costs are not allocated across the cost of goods sold, but are simply recorded separately. Marketing costs include all costs related to selling goods and services and the costs of distribution to the customers. These costs would include all wages and company travel costs of sales personnel, the costs of advertising and promotion. Administrative costs refer to the costs of running the organization as a whole. Examples of these costs include the salaries of top personnel, the costs of accounting, legal and public relations functions. Research and development costs include all costs of developing new goods and services. These costs include the costs of running laboratories, building prototypes of new products and testing the new products.
Opportunity cost is the value of a resource measured against the best alternative use for that resource. The opportunity cost is potential benefit given up when the choice of one action precludes the selection of another action. For example as a retailer, if you have the choice of purchasing dress shirts from A or designer B, the opportunity cost of choosing A is the forgone potential profit associated from selling designer B’s shirts.