The Basic Economic Problem
-Things that humans require that are important for our existence are called needs. E.g: Water, food, shelters, air, clothes.
- Humans also want things but they can live without it. It is not important for survival. These are called wants. E.g: iPod, TV, computer, vacations
- People always want more and more things
- Wants are continuously increasing
- Hence, wants are unlimited.
-We have limited resources to produce goods and services that we want.
-Everything has limits (except our wants)
-Scarcity is when unlimited wants meet limited resources
-All resources have alternatives are put to many uses. E.g: Use land for factories or land for a small school.
-So, we have to choose what we want to use them for, "optimum use of resources available"
-This is when you choose a resource, causing the next best alternative to foregone. This means that we give up something else in order to choose our first choice.
-Benefits we lost and could have achieved from the next best alternative.
-The government may choose to spend their money on education rather than healthcare
The Economic Problem
-How to determine what is being produced
-How factors of production are to be allocated
-"Economics revolves around the methods and possibilities of solving the economic problem."
How the Market works and Failures
Social Costs and benefits
-All businesses activity taking place has has some benefits and costs attached.
-Benefits go to the firm owners and external stakeholders (groups or people who are interesting the working of a business)
-Both have to pay costs for the business activities in the same way.
-Cost of setting up a business
-Owners have to pay for hiring machinery, buying materials, paying wages.
-Momentary benefits i.e revenue (entire amount of income earned before deductions are made) earned by a firm --> benefit for the owner.
-Problems external stakeholders have to bear due to the firm's activity.
E.g: cleaning up a river polluted by the firm's waste products
-Private firms usually ignore external costs
-Benefits to external stakeholders due to firm's activity.
E.g: firm trains workers, who are given better wages in other firms. These are free external benefits.
SOCIAL COSTS (paid for by society due to firm's activity) = EXTERNAL COSTS + PRIVATE COSTS
SOCIAL BENEFIT (total benefit arising due to the production of goods and services by a firm) = PRIVATE BENEFITS + EXTERNAL BENEFITS
Market Price and Equilibrium Price
-Equilibrium Price Definition: price at which the quantity demanded is equal to the quantity supplied.
-Market Price Definition: price prevailing in the market.
-Prices are determined by supply and demand forces.
-The Market Price isn't always equivalent to Equilibrium price.
Follow the link for the EQUILIBRIUM RPICE point graph and for the DIAGRAM of EFFECTS ON SUPPLY AND DEMAND:
Factors Effecting Supply
-Price of the commodity: A rise in price will result in more of the commodity being supplied to the market and vice versa.
-Prices of other commodities: For example if it is more profitable to produce LCD TVs then producers will produce more LCD TVs as compared to PLASMA TVs. Thus the supply curve for PLASMA TVs will shift inwards i.e. a fall in supply.
-Change in cost of production: Increase in the cost of any factor of production may result in the decrease in supply as reduced profits might see producers less willing to produce that commodity.
-Technological advancement: Improvement in technology results in lowering of cost of production and more profits for the producer and thus more supply of that commodity.
-Climate: Climate and weather conditions affect the supply of commodities especially agricultural goods.
Changes in Supply
Movement along the Supply curve
Extension of supply
-The increase in supply of a commodity with the rise in price (other factors remaining unchanged)
Contraction of supply
-The fall in supply of a commodity when its prices fall (other factors remaining unchanged)
Shift in Supply Curve
-When factors other than price affect the supply it results in the shift of supply curve. -The supply curve moves inward or outward.
-When the supply curve shifts right,there is an increase in supply (at the same price level)
-When the supply shifts left,there is less being supplied( at the same price level)
What is Supply?
-Amount of goods and services firms or producers are willing and able to sell at a possible price.
Law of Supply
-As price increases, supply increases
-Reason is that more suppliers are willing to supply the goods and services at that price that is rising
Factors Affecting Demand
-Change in people’s income: More the people earn the more they will spend and thus the demand will rise. A fall in income will see a fall in demand.
-Changes in population: An increase in population will result in a rise in demand and vice versa.
-Change in fashion and taste: Commodities or which the fashion is out are less in demand as compared to commodities which are in fashion. In the same way, change in taste of people affects the demand of a commodity.
-Changes in Income Tax: An increase in income tax will see a fall in demand as people will have less money left in their pockets to spend whereas a decrease in income tax will result in increase of demand for products and services because people now have more disposable income.
-Change in prices of Substitute goods: Substitute goods or services are those which can replace the want of another good or service. For example margarine is a substitute for butter. Thus a rise in butter prices will see a rise in demand for margarine and vice versa.
-Change in price of Complementary goods: Complementary goods or services are demanded along with other goods and services or jointly demanded with other goods or services. Demand for cars is affected the change in price of petrol. Same way, demand for DVD players will rise if the prices of DVDs’ fall.
-Advertising: A successful advertising campaign may affect the demand for a product or service.
-Climate: Changes in climate affects the demand for certain goods and services.
-Interest rates: A fall in Interest rate will see a rise in demand for goods and services.
Changes in Demand; extension, contraction, rise, fall
Movement along the demand curve
Extension of demand
-Increase in demand due to price fall (other factors remain constant)
Contraction of demand
-Decrease in demand due to price rise (other factors remain constant)
Shifts in the Demand Curve
-Demand might be affected by factors other than price.
-This will result in the change in demand (though price will remain the same)
-This change in demand may cause the demand curve to SHIFT inwards or outwards.
- Shift of demand curve OUTWARDS shows an increase in demand at the same price level. It is known as INCREASE IN DEMAND.
- Shift of demand curve INWARDS shows that less is demanded at the same price level. It is known as a FALL IN DEMAND.
What is Demand?
-The want or willingness of consumers to buy goods and services at a certain price.
-Effective demand is when in economics the consumer is willing and able to buy a good and service
Law of Demand
-When price falls, demand rise
-When price rises, demand fall
-An economy that contains both market economy and planned economy characteristics.
-"This system overcomes the disadvantages of both the market and planned economic systems."
-Resources owned by government and private individuals
- Has both private and public sector
-"Market forces prevail but monitored by the government"
-Producers and consumer have sovereignty to choose what to produce and what to consume
-Government can intervene in the production and consumption of harmful goods and services
-Government can reduce social cost of business activities by carrying out cost-benefit analysis.
-The government's role may cause less income inequality (compared to market economy)
-Monopolies are under close supervision by the government.
-The government owns and manage the factors of production.
-Thus the Government decides what to produce, how much to produce and for whom to produce. (Government intervention)
-E.g: North Korea, Iran, Cuba, Libya, Laos
-Government owns and manages all resources
-Consumer or producer sovereignty.
-Market forces aren't allowed to set the price of the goods and services.
-The government aims to provide goods and services to everybody (not profit)
-Prices are kept under control, so everybody can afford to consume goods and services.
-Less inequality of wealth.
-No duplication as allocation of resources is centrally planned.
-Low level of unemployment (government aims to provide employment to everybody)
-Elimination of waste resulting from competition between firms.
-Consumers can't choose, only goods and services are produced which are decided by the government.
-Lack of profit motive may lead to firms being inefficient.
-Lot of time and money is wasted in communicating instructions from the government to the firms.
Market Economic System
-Producers and consumers who decide how to utilise the resources.
-The market forces decide what to produce, how much to produce and for whom to produce.
-All resources are privately owned by people and firms.
-Profit is the main motive of all businesses.
-No government interference in the business activities..
-Consumers are free to choose.
-Prices are decided by the Price mechanism i.e. the demand and supply of the good/services.
-Free market responds quickly to the people’s wants: Thus, firms will produce what people want because it is more profitable
-Anything not demanded is taken out of production.
-Wide Variety of goods and services: wide variety available in the market to suit everybody’s taste.
-Efficient use of resources encouraged: Profit drives the firms to produce goods and services at lower cost and more efficiently, leading to firms using latest technology to produce at lower costs.
- Unemployment: Businesses in the market economy will only employ those factors of production which will be profitable, thus more unemployment as more machines and less labour will be used to cut cost.
- Certain goods and services may not be provided: Those who might want to use but don’t want to pay may not be available because the firms may not find it profitable to produce. E.g: Public goods (street lighting)
- Consumption of harmful goods may be encouraged: May provide goods and services that may be harmful to society, just for profit.
- Ignore Social cost: To maximise profits, businesses might not consider the social effects of their actions.
What is an economic system?
-Since there are scarce resources and unlimited wants, it's always a problem to allocate resources efficiently
-We are constantly facing three basic questions:
- What to produce?
- How to produce?
- For whom do we produce?
-Every community/country has to choose and develop its own way of solving these problems.
-The Economic system is the way a country decides what to produce, how to produce and for whom to produce for.
The three Economic Systems existing are:
- Market Economic system
- Planned Economic System
- Mixed Economic System
There are no PURE market economies, no PURE command economies, just a continuum of different characteristics
Individual producer, consumer
What is Specialization?