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The study of how the forces of supply and demand allocate scarce resources. Subdivided into microeconomics, which examines the behavior of firms, consumers and the role of government; and macroeconomics, which looks at inflation, unemployment, industrial production, and the role of government Economics is the social science that studies the production, distribution, and consumption of goods and services A definition of modern economics is that of Lionel Robbins in a 1932 essay: "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." Scarcity means that available resources are insufficient to satisfy all wants and needs. Economic concepts Common problems among different types of economic systems include: * what goods to produce and in what quantities (consumption or investment, private goods or public goods, etc.) * how to produce them (coal or nuclear power, how much and what kind of machinery, who farms or teaches, etc.) * for whom to produce them, reflecting the distribution of income from output. The subject thus defined involves the study of choices as they are affected by incentives and resources Areas of economics may be divided or classified into various types, including: * microeconomics and macroeconomics * positive economics ("what is") and normative economics ("what ought to be") * mainstream economics and heterodox economics * fields and broader categories within economics. One of the uses of economics is to explain how economies, as economic systems, work and what the relations are between economic players (agents) in the larger society. Economic system Define. Set of principles and techniques by which a society decides and organizes the ownership and allocation of economic resources. At one extreme, usually called a free-enterprise system, all resources are privately owned. This system, following Adam Smith, is based on the belief that the common good is maximized when all members of society are allowed to pursue their rational self-interest. At the other extreme, usually called a pure-communist system, all resources are publicly owned. This system, following Karl Marx and Vladimir Ilich Lenin, is based on the belief that public ownership of the means of production and government control of every aspect of the economy are necessary to minimize inequalities of wealth and achieve other agreed-upon social objectives. No nation exemplifies either extreme. As one moves from capitalism through socialism to communism, a greater share of a nation’s productive resources is publicly owned and a greater reliance is placed on economic planning. Fascism, more a political than an economic system, is a hybrid; privately owned resources are combined into syndicates and placed at the disposal of a centrally planned state “Explain the concept of opportunity cost and explainwhy accounting profits and economic profits are not the same.” Scarcity Economics is the study of how people make choices under scarcity. What is scarcity? Scarcity means that resources are limited. There are not enough resources available to satisfy everyone’s wants. This is clearly true for individuals. Your income is limited. You cannot buy everything you want, so you must choose between different alternatives. Your time is also limited. You cannot do everything you want to, so you are forced to choose between different alternatives. If you choose to spend the day at the beach, you give up going to class or working. Opportunity Cost This concept of scarcity leads to the idea of opportunity cost. The opportunity cost of an action is what you must give up when you make that choice. Another way to say this is: it is the value of the next best opportunity. Opportunity cost is a direct implication of scarcity. People have to choose between different
alternatives when deciding how to spend their money and their time. Milton Friedman, who won the Nobel Prize for Economics, is fond of saying “there is no such thing as a free lunch.” What that means is that in a world of scarcity, everything has an opportunity cost. There is always a trade-off involved in any decision you make. The concept of opportunity cost is one of the most important ideas in economics. Consider the question, “How much does it cost to go to college for a year?” We could add up the direct costs like tuition, books, school supplies, etc. These are examples of explicit costs, i.e., costs that require a money payment. However, these costs are small compared to the value of the time it takes to attend class, do homework, etc. The amount that the student could have earned if she had worked rather than attended school is the implicit cost of attending college. Implicit costs are costs that do not require a money payment. The opportunity cost includes both explicit and implicit costs. Explicit costs are costs that require a money payment. Implicit costs are costs that do not require a money payment. Opportunity cost includes both explicit and implicit costs. The notion of opportunity cost helps explain why star athletes often do not graduate from college. The cost of going to school includes the millions of dollars they could earn as a professional athletes. If Kobe Bryant had decided to attend college for four years after high school instead of signing with the Lakers, his implicit cost would have been over $10 million, the salary he earned in his first four years as a Laker. Economic Profits and Accounting Profits Economists use opportunity costs to understanding the behavior of firms as well as individuals. The goal of the firm is to maximize profit. Profit is equal to revenue minus cost: Profit = Total Revenue - Total Cost When economists refer to cost, they mean opportunity cost. The firm’s cost of production includes explicit costs, like payroll, cost of raw materials and other direct costs. But it also includes implicit costs. One of the most important implicit costs is associated with the firm’s capital. For example, consider Josephine Csun, who starts a business with $100,000 she inherited from her rich uncle. The opportunity cost of this capital is what Josephine could have earned if she had taken the money and invested it elsewhere. If the rate of return on her best alternative investment opportunity is 10%, the implicit cost of capital is $10,000. This would be added to her other explicit costs of doing business to compute the opportunity cost. Accountants also compute costs. However, the costs that appear on an accountant’s balance sheet are only explicit costs. The firm’s accounting profit is equal to total revenue minus explicit costs. In the above example, an accountant would not count the $10,000 in income that Josephine is giving up because she chose to use her $100,000 to start her own business rather than investing it elsewhere. However, if Josephine had no rich uncle and had to borrow the $100,000 from the bank at 10% interest, the interest payment of $10,000 would appear as an explicit cost. Economic profit is total revenue minus opportunity cost. Accounting profit is total revenue minus explicit cost. Opportunity costs are higher than explicit costs because opportunity costs also include implicit costs. As a result, economic profits are lower than accounting profits. Accountants do not include implicit costs because they are difficult to measure. An accountant does not always know what investment opportunity was given up to use the money to start a business, but this does not mean opportunity costs are unimportant. Firms and individuals use them to make key decisions. For example, consider Farmer Jones who owns a 100-acre farm. Farmer Jones is also a well-known banjo player in the area and could earn $20 an hour giving banjo lessons. If he plants $100 worth of seed, which takes 10 hours, the wheat produced can be sold for $400. An accountant would count the cost of producing wheat as $100 and calculate an accounting profit of $300. However, an economist would calculate the cost of producing wheat as $300. This $300 opportunity cost includes both the $100 explicit cost of seed and the $200 implicit cost of Farmer Jones giving up teaching banjo lessons to plant wheat. Farmer Jones earns an economic profit of $100 ($400 minus $300), which is lower than his accounting profit of $300 ($400 minus $100). If Farmer Jones could hire a laborer to plant his wheat for $5/hour, he should do so. His economic profit would increase even though his explicit costs would rise, because he would now be free to earn $20/hour giving banjo lessons. Summary: The opportunity cost of any decision is what is given up as a result of that decision. Opportunity cost includes both explicit costs and implicit costs. The firm’s economic profits are calculated using opportunity costs. Accounting profits are calculated using only explicit costs. Therefore, accounting profits are higher than economic profits. Difference between macroeconomics and microeconomics Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize it's production and capacity so it could lower prices and better compete in its industry. (Find out more about microeconomics in Understanding Microeconomics.)
Microeconomics (from Greek prefix micro- meaning "small" + "economics") is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economywide phenomena, such as Gross National Product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate. (To keep reading on this subject, see Macroeconomic Analysis.) While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained.
Macroeconomics (from Greek prefix "macr(o)-" meaning "large" + "economics") is a branch of economics dealing with the performance, structure, behavior, and decision-making of the entire economy. This includes a national, regional, or global economy.  With microeconomics, macroeconomics is one of the two most general fields in economics. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy
Economic Theories Macro and Micro Economics Macro Economics may be defined as that branch of economic analysis which studies the behaviour of not one particular unit, but of all the units combined together. Macroeconomics is a study of aggregates. It is the study of the economic system as a whole ï¿½ total production, total consumption, total savings and total investment. The following are the fields covered by macroeconomics: • Theory of Income, Output and Employment with its two constituents, namely, the theory of consumption function, the theory of investment function and the theory of business cycles or economic fluctuations. Theory of Prices with its constituents of the theories of inflation, deflation and reflation. Theory of Economic Growth dealing with the long-run growth of income, output and employment. Macro Theory of Distribution dealing with the relative shares of wages and profits in the total national income. The study of macroeconomics is indispensable as it is the main agent for formulation and successful execution of government economic policies. It is also indispensable for the formulation of microeconomic
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Supply and demand is an economic model of price determination in a market. An important tool used in that of microeconomics is that of Marginal Analysis. Theory of Factor pricing. while on the other side are supply considerations based on marginal cost. Theory of Economic Welfare. represents the amount of some good that producers are willing and able to sell at various prices. the opposite of the standard convention for the representation of a mathematical function. Though this view is accepted by almost every economist. resulting in an economic equilibrium of price and quantity. The graphical representation of supply and demand The supply-demand model is a partial equilibrium model representing the determination of the price of a particular good and the quantity of that good which is traded. depicted graphically as the supply curve. 3. Changes in the values of these variables are represented by shifts in the supply and demand curves. responses to changes in the price of the good are represented as movements along unchanged supply and demand curves. the theory of consumer behaviour and • • the theory of production and costs. It concludes that in a competitive market. In microeconomics. or a particular firm. By contrast. In fact. it has recently been challenged seriously. which studies the economic behaviour of the individual unit. If supply increases and demand remains unchanged. An equilibrium price is supposed to be at once equal to marginal utility (counted in units of income) from the buyer's side and marginal cost from the seller's side.models. then it leads to higher equilibrium price and quantity. it is an indispensable tool used in microeconomics. the standard graphical representation. The following are the fields covered by microeconomics: • Theory of Product pricing with its two constituents. assuming all 4 . a commodity) is for sale in multiple locations. The four basic laws of supply and demand are: 1. assuming ceteris paribus. such as consumers' income. Supply schedule The supply schedule. we study the various units of the economy. It is a study of one particular unit rather than all the units combined together. taxes etc. and it constitutes the core of mainstream economics.[by whom?] When an identical item (e. input prices and so on. the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price). Determinants of supply and demand other than the price of the good in question. the Law of one price is generally believed to hold. If demand decreases and supply remains unchanged. essentially stating that the cost difference cannot be greater than that incurred by shipping. If demand increases and supply remains unchanged. 4. then it leads to higher price and lower quantity. On the one side are demand considerations based on marginal utility. 2. Microeconomics may be defined as that branch of economic analysis. maybe a person. then it leads to lower equilibrium price and higher quantity. usually attributed to Alfred Marshall. Theory of price asserts that the market price reflects interaction between two opposing considerations. has price on the vertical axis and quantity on the horizontal axis.g. namely. Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good. how they function and how they reach their equilibrium. Price Theory price is the quantity of payment or compensation given by one party to another in return for goods or services. then it leads to lower equilibrium price and quantity. are not explicitly represented in the supply-demand diagram. that is. If supply decreases and demand remains unchanged. Some of the important laws and principles of microeconomics have been derived directly from marginal analysis. a particular household.
Production costs The technology used in production The price of related goods Firm's expectations about future prices Number of suppliers Demand schedule The demand schedule. There may be rare examples of goods that have upward-sloping demand curves. The market demand curve is obtained by summing the quantities demanded by all consumers at each potential price. economists distinguish between the demand curve of an individual and the market demand curve. the demand curve is generally downward-sloping. the marginal utility of alternative consumption choices. consumers will buy more of the good. individual firms' supply curves are added horizontally to obtain the market supply curve. This is because each point on the supply curve is the answer to the question "If this firm is faced with this potential price. conceptualizing a supply curve requires that the firm be a perfect competitor—that is. The determinants of demand follow: 1. The determinants of supply follow: 1. if the marginal utility of additional consumption is equal to the opportunity cost determined by the price. individuals' demand curves are added horizontally to obtain the market demand curve. Following the law of demand. Firms will produce additional output as long as the cost of producing an extra unit of output is less than the price they will receive. The demand schedule is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time. Thus in the graph of the supply curve. The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price. that the firm has no influence over the market price. Under the assumption of perfect competition. 2. so its decision of how much to buy influences the market price. enabling them to better adjust their quantity supplied at any given price. meaning that as price decreases. then the firm is not "faced with" any price. Furthermore. In the long run. demand curves are determined by marginal utility curves. represents the amount of some good that buyers are willing and able to purchase at various prices. and the number of firms in the industry. Economists also distinguish the short-run market supply curve from the long-run market supply curve. and the price of complementary goods. Income 5 . how much output will it be able to and willing to sell?" If a firm has market power. tastes and preferences. and the question is meaningless. By its very nature. conceptualizing a demand curve requires that the purchaser be a perfect competitor— that is. As described above. 4. Thus in the graph of the demand curve. such as technology and the prices of factors of production. assuming all determinants of demand other than the price of the good in question. depicted graphically as the demand curve. the demand curve is almost always represented as downward-sloping. long-run market supply curves are flatter than their short-run counterparts. and the question is meaningless. the price of substitute goods. By its very nature. remain the same. firms have a chance to adjust their holdings of physical capital. Economists distinguish between the supply curve of an individual firm and the market supply curve. how much of the product will it purchase?" If a buyer has market power. 3. then the buyer is not "faced with" any price. two things are assumed constant by definition of the short run: the availability of one or more fixed inputs (typically physical capital). In this context. such as income. Two different hypothetical types of goods with upwardsloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods made more fashionable by a higher price). remain the same. Just as the supply curves reflect marginal cost curves. 5. that the purchaser has no influence over the market price. As with supply curves. supply is determined by marginal cost. This is because each point on the demand curve is the answer to the question "If this buyer is faced with this potential price.determinants of supply other than the price of the good in question. that is. in the long run potential competitors can enter or exit the industry in response to market conditions. For both of these reasons. Consumers will be willing to buy a given quantity of a good. so its decision of how much output to provide to the market influences the market price. at a given price.
A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand. P1) to the point Q2. If the demand decreases. this raises the equilibrium price from P1 to the higher P2. represented as shifts in the respective curves. and decreases to D1. reflecting the fact that the supply curve has not shifted. Increased demand can be represented on the graph as the curve being shifted to the right. The increase in demand could also come from changing tastes and fashions. but the equilibrium quantity and price are different as a result of the 6 . Comparative static analysis: Examines the likely effect on the equilibrium of a change in the external conditions affecting the market.2. This raises the equilibrium quantity from Q1 to the higher Q2. At each price point. there has been an increase in demand which has caused an increase in (equilibrium) quantity. a shift of the curve. Number of Buyers Microeconomics Equilibrium Equilibrium is defined to the price-quantity pair where the quantity demanded is equal to the quantity supplied. P2). the equilibrium price will decrease. Changes in market equilibrium Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity. and the equilibrium quantity will also decrease." that is. Note in the diagram that the shift of the demand curve. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium. represented by the intersection of the demand and supply curves. Demand curve shifts Main article: Demand curve An outward (rightward) shift in demand increases both equilibrium price and quantity When consumers increase the quantity demanded at a given price. If the demand starts at D2. incomes. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Market Equilibrium: A situation in a market when the price is such that the quantity that consumers wish to demand is correctly balanced by the quantity that firms wish to supply. a greater quantity is demanded. then the opposite happens: a shift of the curve to the left. and number of buyers. it is referred to as an increase in demand. Buyer's expectations about future prices 5. by causing a new equilibrium price to emerge. as from the initial curve D1 to the new curve D2. In the diagram. resulted in movement along the supply curve from the point (Q1. market expectations. Tastes and preferences 3. Prices of related goods and services 4. price changes in complementary and substitute goods. In the example above. The quantity supplied at each price is the same as before the demand shift.
As a result of a supply curve shift. Elasticity is a measure of relative changes. the quantity of pens increased by 2%. thereby increasing the effective price. Likewise. the constant term of the demand equation. Otherwise stated. The movement of the demand curve in response to a change in a non-price determinant of demand is caused by a change in the x-intercept. the price and the quantity move in opposite directions. Often. the opposite happens. The quantity demanded at each price is the same as before the supply shift.4. But due to the change (shift) in supply. The supply curve shifts up and down the y axis as non-price determinants of demand change. elasticity refers to how strongly the quantities supplied and demanded respond to various factors. For discrete changes this is known as arc elasticity. 7 . knowledge of the price elasticity will help us to predict the size of the resulting effect on the quantity demanded.change (shift) in demand. If the quantity supplied decreases. the equilibrium quantity and price have changed. Elasticity is calculated as the percentage change in quantity divided by the associated percentage change in price. point elasticity uses differential calculus to determine the elasticity at a specific point. The movement of the supply curve in response to a change in a non-price determinant of supply is caused by a change in the y-intercept. respectively. which calculates the elasticity over a range of values.00 to $1. so the price elasticity of supply is 2%/5% or 0. In contrast. the constant term of the supply equation. assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. In this context. For example. This is known as the price elasticity of demand or the price elasticity of supply. the supply curve shifts. producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward. and the price increased by 5%. how will this affect the amount of their good that customers purchase? This knowledge helps the firm determine whether the increased unit price will offset the decrease in sales volume. and shifts leftward to S1.05. This increase in supply causes the equilibrium price to decrease from P1 to P2. to S2—an increase in supply. or when technological progress occurs. and as a result the quantity supplied goes from 100 pens to 102 pens. If the supply curve starts at S2. Supply curve shifts Main article: Supply (economics) An outward (rightward) shift in supply reduces the equilibrium price but increases the equilibrium quantity When the suppliers' unit input costs change. For example. if a government imposes a tax on a good. If a monopolist decides to increase the price of its product. reflecting the fact that the demand curve has not shifted. it is useful to know how strongly the quantity demanded or supplied will change when the price changes. the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded. including price and other determinants. Elasticity Main article: Elasticity (economics) Elasticity is a central concept in the theory of supply and demand. The equilibrium quantity increases from Q1 to Q2 as consumers move along the demand curve to the new lower price. One way to define elasticity is the percentage change in one variable (the quantity supplied or demanded) divided by the percentage change in the causative variable. if the price moves from $1.
Complements are goods that are typically utilized together. The typical roles of supplier and demander are reversed. which try to buy the type of labor they need at the lowest price. The equilibrium quantity is always Q. If the quantity changes by a lesser percentage than the price did. the quantity of new cars demanded decreased by 20%. then there is a vertical supply curve. The suppliers are individuals. the supply curve is a vertical line. If supply is perfectly inelastic. where no one economic agent could ever be expected to know every relevant condition in every market. One of the most common to consider is income. then demand or supply is said to be elastic. if.Since the changes are in percentages. Short-run supply curves are not as elastic as long-run supply curves. information. In real economic systems. that is. This is often considered when looking at the relative changes in demand when studying complements and substitute goods. the price and quantity in any market would be able to move to a new equilibrium position instantly. and markets take some time before they reach a new equilibrium position. This is due to asymmetric.  Vertical supply curve (perfectly inelastic supply) When demand D1 is in effect.  8 . and if the price of one good rises. changing the unit of measurement or the currency will not affect the elasticity. who try to sell their labor for the highest price. because in the long run firms can respond to market conditions by varying their holdings of physical capital. Cross elasticity of demand is measured as the percentage change in demand for the first good divided by the causative percentage change in the price of the other good. Another elasticity sometimes considered is the cross elasticity of demand. in the market for labor. and any shifts in demand will only affect price. Any change in market conditions would cause a jump from one equilibrium position to another at once. In a frictionless economy. and because in the long run new firms can enter or old firms can exit the market. and supply is called perfectly inelastic. which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. How strongly would the demand for a good change if income increased or decreased? The relative percentage change is known as the income elasticity of demand. Elasticity in relation to variables other than price can also be considered. one may purchase less of it and instead purchase its substitute. without spending any time away from equilibrium. Other markets The model of supply and demand also applies to various specialty markets. the price will be P2. For an example with a complement good. The model is commonly applied to wages. in response to a 10% increase in the price of fuel. demand or supply is said to be inelastic. The equilibrium price for a certain type of labor is the wage rate. If the quantity demanded or supplied changes by a greater percentage than the price did. Substitute goods are those where one can be substituted for the other. the cross elasticity of demand would be -2. When D2 is occurring. The demanders of labor are businesses.0. Ultimately both producers and consumers must rely on trial and error as well as prediction and calculation to find the true equilibrium of a market. where if one is consumed. If the quantity supplied is fixed in the very short run no matter what the price. the price will be P1. markets don't always behave in this way. or at least imperfect. has zero elasticity. usually the other is also.
that little of the empirical work done with the textbook model constitutes a potentially falsifying test. an "inelastic" variable describes one which does not change much in response to changes in other parameters. based on simulation results. in particular consumer surplus. including the reduction of minimum wages. Graham White  argues. Michael Anyadike-Danes and Wyne Godley  argue. consequently.  Robert L. if the central bank of a country chooses to use monetary policy to fix its value regardless of the interest rate. Elasticity is also crucially important in any discussion of welfare distribution. On the other hand. Empirical estimation Demand and supply relations in a market can be statistically estimated from price. Macroeconomic uses of demand and supply Demand and supply have also been generalized to explain macroeconomic variables in a market economy. Similarly. Compared to microeconomic uses of demand and supply. even given all its assumptions. the money market is analyzed as a supply-and-demand system with interest rates being the price. which regresses each of the endogenous variables on the respective exogenous variables. Elasticity is one of the most important concepts in neoclassical economic theory. argue that that this model of the labor market. It also has implications for monetary theory  not drawn out here. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis. Demand and supply are also used in macroeconomic theory to relate money supply and money demand to interest rates. and. different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. also called the "elasticity of y with respect to x". Houthakker and Lester D. In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. An alternative to "structural estimation" is reduced-form estimation. the "x-elasticity of y". The Aggregate Demand-Aggregate Supply model may be the most direct application of supply and demand to macroeconomics. producer surplus." the estimated algebraic counterparts of the theory. In economics. and other data with sufficient information in the model. is logically incoherent. but other macroeconomic models also use supply and demand. elasticity is the ratio of the percent change in one variable to the percent change in another variable. elasticity of substitution between factors of production and elasticity of intertemporal substitution. Frequently used elasticities include price elasticity of demand. and Arrigo Opocher & Ian Steedman). both of which are endogenous variables) are needed to perform such an estimation. that the policy of increased labor market flexibility.  Mathematical definition The definition of elasticity is based on the mathematical notion of point elasticity. in this case the money supply curve is perfectly elastic. marginal concepts as they relate to the theory of the firm. The money supply may be a vertical supply curve. This criticism of the application of the model of supply and demand generalizes. partially on the basis of Sraffianism.  the money supply curve is a horizontal line if the central bank is targeting a fixed interest rate and ignoring the value of the money supply. The Parameter identification problem is a common issue in "structural estimation. and to relate labor supply and labor demand to wage rates. This can be done with simultaneous-equation methods of estimation in econometrics. particularly to all markets for factors of production. or government surplus. In both classical and Keynesian economics. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way. is: 9 . in this case the money supply is totally inelastic. Taylor." Typically. Vienneau. quantity. income elasticity of demand. an "elastic" variable is one which responds "a lot" to small changes in other parameters. It is useful in understanding the incidence of indirect taxation. price elasticity of supply. and distribution of wealth and different types of goods as they relate to the theory of consumer choice. A major study of the price elasticity of supply and the price elasticity of demand for US products was undertaken by Hendrik S. empirical evidence hardly exists for that model. Generally. The demand for money intersects with the money supply to determine the interest rate. variables other than price and quantity. including the quantity of total output and the general price level. does not have an "intellectually coherent" argument in economic theory.A number of economists (for example Pierangelo Garegnani. data on exogenous variables (that is. building on the work of Piero Sraffa. Such methods allow solving for the model-relevant "structural coefficients. In general.
All other variables must be held constant. and in which direction. This elasticity is almost always negative and is usually expressed in terms of absolute value (i. The definition of decreasing returns to scale is analogous. etc. the curve shifts horizontally along the x-axis. In these terms. It captures the extent to which one firm reacts to changes in strategic variables (price. A change in the price of a related good causes the demand curve to shift reflecting a change in demand for the original good.The approximation becomes exact in the limit as the changes become infinitesimal in size. It exhibits increasing returns to scale if a percentage change in inputs results in greater percentage change in output (an elasticity greater than 1). Cross price elasticity of demand Main article: Cross price elasticity of demand Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a percent change in the price of another good. Sometimes the elasticity is defined without the absolute value operator. between zero and one demand is inelastic and if it equals one. Specific elasticities Elasticities of demand Price elasticity of demand Main article: Price elasticity of demand Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change in price. then. Cross price elasticity is a measurement of how far. Elasticity of intertemporal substitution Main article: Elasticity of intertemporal substitution Combined Effects It is possible to consider the combined effects of two or more determinant of demand. location. The steps are as follows: PED = (∆Q/∆P) x P/Q. A change in income causes the demand curve to shift reflecting the change in demand. substitutes or unrelated. Goods can be complements. this elasticity could be positive or negative. demand is unit-elastic. sometimes referred to as conjectural variation. A positive crossprice elasticity means that the goods are substitute goods.  In a manner analogous to the price elasticity of demand.e. is a measure of the interdependence between firms.) made by other firms. quantity. it captures the extent of movement along the supply curve. Cross elasticity of demand between firms Main article: Conjectural variation Cross elasticity of demand for firms. Income elasticity of demand Main article: Income elasticity of demand Income elasticity of demand measures the percentage change in demand caused by a percent change in income. IED is a measurement of how far the curve shifts horizontally along the X-axis. as positive numbers) since the negative can be assumed. Elasticities of supply Price elasticity of supply Main article: Price elasticity of supply The price elasticity of supply measures how the amount of a good firms wish to supply changes in response to a change in price. advertising. Elasticities of scale Main article: Returns to scale Elasticity of scale or output elasticities measure the percentage change in output induced by a percent change in inputs. As such. A production function or process is said to exhibit constant returns to scale if a percentage change in inputs results in an equal percentage in outputs (an elasticity equal to 1). it measures the extent of movement along the demand curve. 10 . Convert this to the predictive equation: ∆Q/Q = PED(∆P/P) if you wish to find the combined effect of changes in two or more determinants of demand you simply add the separate effects: ∆Q/Q = PED(∆P/P) + YED(∆Y/Y) Remember you are still only considering the effect in demand of a change in two of the variables. if the elasticity is greater than 1 demand is said to be elastic. With an inferior good demand and income move in opposite directions. With a normal good demand varies in the same direction as income. Income elasticity can be used to classify goods as normal or inferior. A context where this use of a signed elasticity is necessary for clarity is the cross-price elasticity of demand — the responsiveness of the demand for one product to changes in the price of another product. If the price elasticity of supply is zero the supply of a good supplied is "inelastic" and the quantity supplied is fixed. Note also that graphically this problem would involve a shift of the curve and a movement along the shifted curve. since the products may be either substitutes or complements.
See Permanent income hypothesis. The doctrine of utilitarianism saw the maximization of utility as a moral criterion for the organization of society. See Income elasticity of demand.Applications The concept of elasticity has an extraordinarily wide range of applications in economics. utility is a measure of relative satisfaction. Price mechanism is an economic term that refers to the buyers and sellers who negotiate prices of goods or services depending on demand and supply. such as illustrated by Edgeworth boxes in contract curves. Utility is often modeled to be affected by consumption of various goods and services. Price mechanism also restricts supply when suppliers leave the market due to low prevailing prices. In particular. According to utilitarians. Individual utility and social utility can be construed as the value of a utility function and a social welfare function respectively. Given this measure. An example of a price mechanism uses announced bid and ask prices. Generally speaking. If the price is too high not many goods are sold. Income elasticity of demand can be used as an indicator of industry health. one may speak meaningfully of increasing or decreasing utility. It generally sends the price up when supply is below demand. future consumption patterns and as a guide to firms investment decisions. Also called price system. Analysis of incidence of the tax burden and other government policies. which plot the combination of commodities that an individual or a society would accept to maintain a given level of satisfaction. The price mechanism as you put it. See Marshall–Lerner condition and Singer– Prebisch thesis. Analysis of consumption and saving behavior. Another theory forwarded by John Rawls (1921–2002) would have society maximize the utility of the individual initially receiving the minimum amount of utility. Analysis of advertising on consumer demand for particular goods. When coupled with production or commodity constraints. in most cases automatically Price mechanism is also a System of interdependence between supply of a good or service and its price. See Advertising elasticity of demand Utility In economics. The main advantage of such a method is that conditions are laid out in advance and transactions can proceed with no further permission or authorization from any participant. and increases it when more suppliers enter the market due to high obtainable prices. stocks quickly depleate. the purchaser will announce a price he is willing to pay (the bid price) and seller will announce a price he is willing to accept (the ask price). such as Jeremy Bentham (1748–1832) and John Stuart Mill (1806–1873). under some assumptions. See Markup rule. Such efficiency is a central concept in welfare economics. and thereby explain economic behavior in terms of attempts to increase one's utility. See Tax incidence. possession of wealth and spending of leisure time. society should aim to maximize the total utility of individuals. aiming for "the greatest happiness for the greatest number of people". Some common uses of elasticity include: • • • • • • Effect of changing price on firm revenue. if it is too low. and down when supply exceeds demand. is actually the way that goods are exchanged for money. when two parties wish to engage in a trade. A price mechanism or market-based mechanism refers to a wide variety of ways to match up buyers and sellers through price rationing. Utility is usually applied by economists in such constructs as the indifference curve. a transaction occurs. So this mechanism is the methods by which the price and the quantity being sold over a specific short time become equivalent to 11 . an understanding of elasticity is fundamental in understanding the response of supply and demand in a market. Effect of international trade and terms of trade effects. these functions can be used to analyze Pareto efficiency. When any bid and ask pair are compatible.
They argue further that. companies doing the "bidding" argue that Earth's atmosphere can be seen as affected almost uniformly by emissions anywhere on Earth. The crisis caused more nations to start producing its own oil due to dramatic price increases of oil. there are almost no local effects. The minimum bid may or may not be set by the seller. then the demand of fuel would not decrease fast but eventually companies will start to produce alternatives such as biodiesel fuel and electrical cars. Most of the time. accepted by those who are compensated not in money but in additional credits to keep using the system. or the first one to reach a preset ask price. In most applications of such methods. Effects of Price Mechanism Price Mechanism causes many changes in the economic environment. An example of price mechanism in the long term is the oil crisis during the 1970’s. Or. the bid and ask prices remain very close to the market value of the share. if the share is worth $10. The result of this mechanism being in action in a pure competitive setting is that supply and demand are equal which is called Say's law. Such orders can have execution limits. Other Applications If the terms "pay" and "sell" are understood very generally. even in a conventional market. Stock market When trading in a stock market. then. a political party could trade support for different measures in a platform. Though there are many concerns about liquidating any given transaction. the supply curve shifted more to the right meaning there was more supply of oil. and was quite successful in reducing overall smog output there. The negotiation often comes in the form of adjusting the bid prices and the ask prices as the value of the share goes up and down. Internet dating for instance could be based on offers to talk for a period of time. who may choose to predetermine an ask price. perhaps using allocation voting to "bid" a certain amount of support for a measure that a leader has "asked" them to support: if the measure has enough support in the party. a seller may be forced to reduce his asking price.the rate at which the goods are being currently produced. If there is an increase in demand. Price Mechanism affects every economic situation in the long term.97 (3 cents less). however. then prices will go higher causing a movement along the supply curve. if the value of the stock goes up. a person who has shares to sell may not wish to sell them at the current market price (quote). the leader will proceed. For example. If the value of the stock goes down. If fuel becomes more expensive. Another good example of price mechanism in the long run is fuel for cars. The trader specifies the number of shares and his bid/ask price (depending on whether he is buying or selling). the comprehensive outcome of the transaction is not so easily measured or universally agreed. In greenhouse gas emissions trading. The difference between the bid and ask price is called the Bid/ask spread. of a greenhouse gas emission. Some theorists assert that. Some negotiation is necessary in order for a transaction to occur. and a seller may ask for $10. a market 12 . Since more nations started to produce oil. Likewise. would be awarded the transaction. there are ideologies which hold that the risks are outweighed by the efficient rendezvous. a very explicit model of so-called "political capital". a very broad range of applications and different market systems can be enabled this way. and only a measurable and widely agreed climate change effect. the approach was applied even earlier to sulfur dioxide emissions in the United States. The highest bidder. a buyer may be forced to increase his bidding price. with appropriate controls. In actual trading. a buyer may "bid" $9. justifying a "cap and trade" approach. the parties involved might use a limit order to specify which bid or ask price he wishes to trade at. a person who wishes to buy shares may not wish to pay the current market price either. Somewhat more controversially. often separated by only a couple of cents. Conversely. as a result.02 (2 cents more). such as "by end of day" or "all or nothing". Auctions Main article: Auction An auction is a price mechanism where bidders can make competing offers for a good.
just the sum of the quantities demanded by individual buyers. or otherwise given convex indifference curves. Hence. This is a problem even with the commodity markets and any other financial markets. so it too decreases as price increases.  but this work has been relatively uninfluential on the mainstream of economic thought. In any case buyers are modelled as pursuing typically lower quantities. Marginalists in the tradition of Marshall and neoclassical economists tend to represent the supply curve for any producer as a curve of marginal pecuniary costs objectively determined by physical processes. and the theory of the firm. Given the “law” of diminishing marginal utility. even a command hierarchy.  Supply Both neoclassical economics and thorough-going marginalism could be said to explain supply curves in terms of marginal cost. A more thorough-going marginalism represents the supply curve as a complementary demand curve — where the demand is for money and the purchase is made with a good or service. which they would cause to come true. who should receive what for maximum amiability and minimum capital asset sale and lifestyle disruption Application to price theory Marginalism and neoclassical economics typically explain price formation broadly through the interaction of curves or schedules of supply and demand. however. Production theory 13 . principal concepts include supply and demand. as price is increased. This has since been generalized into the prediction market idea which the Pentagon proposed to operate as part of Total Information Awareness. where a single person's choices or fate might be influenced. however. rational choice theory. there are markèd differences in conceptions of that cost. which models are usually captured by relatively simple graphs. and accordingly. The aggregate quantity demanded by all buyers is.mechanism can replace a hierarchy. budget constraints. any given buyer has a demand schedule that generally decreases in response to price (at least until quantity demanded reaches zero). May. opportunity cost. the rates are such that the willingness to forgo money for the good or service decreases as the buyer would have ever more of the good or service and ever less money. or decided by someone already in the market. at any given price. a prospective buyer has some marginal rate of substitution of money for the good or service in question. marginalism. Demand Demand curves are explained by marginalism in terms of marginal rates of substitution. by ordering actions for which the highest bid is received: An infamous example is the assassination market proposed by Timothy C. utility. Other marginalists have sought to present more realistic explanations.  Markets By confining themselves to limiting cases in which sellers or buyers are both “price takers” — so that demand functions ignore supply functions or vice versa — Marshallian marginalists and neoclassical economists produced tractable models of “pure” or “perfect” competition and of various forms of “imperfect” competition. NB In microeconomics. At any given price. Less controversial applications of bid and ask matching include: • • • • industrial process control various applications in social networks (including dating above) calculating interest in court judgments or homestead credit determining which of several assets in a divorce are most prized by each party. with each being willing to trade until the marginal value of what they would trade-away exceeds that of the thing for which they would trade. and sellers offering typically higher quantities. with an upward slope determined by diminishing returns. this proved controversial as it would theoretically let assassins predict and then benefit from their predictions. which were effectively bets on someone's death.  The shape of that curve is then determined by marginal rates of substitution of money for that good or service. predicted.
and key managerial personnel. There are three aspects to production processes: 1. In the long run. the form of the good or service created. Examples include major pieces of equipment. storing. is defined as a period in which at least one of the factors of production is fixed. Factors of production Main article: Factors of production The inputs or resources used in the production process are called factors of production by economists. transportation services. Total. They see every commercial activity other than the final purchase as some form of production. This can include manufacturing. size. In the short run. shipping. Production uses resources to create a good or service that is suitable for exchange. however. length and distribution of these goods and services available to the market place. The “short run”. output increases as more inputs are employed up until point A. Because it is a flow concept. suitable factory space. (If there are other inputs used in the process. A fixed factor of production is one whose quantity cannot readily be changed.Production refers to the economic process of converting of inputs into outputs. A production process can be defined as any activity that increases the similarity between the pattern of demand for goods and services. A variable factor of production is one whose usage rate can be changed easily. a firm’s “scale of operations” determines the maximum number of outputs that can be produced. they are assumed to be fixed. the temporal and spatial distribution of the good or service produced. Examples include electrical power consumption. The maximum output possible with this production process is Qm.) 14 . form. all of these factors of production can be adjusted by management. production is measured as a “rate of output per period of time”. These factors are: • • • • • Raw materials Machinery Labour services Capital goods Land In the “long run”. and marginal product Total Product Curve The total product (or total physical product) of a variable factor of production identifies what outputs are possible using various levels of the variable input. and packaging. The diagram shows a typical total product curve. the quantity of the good or service produced. and as such it occurs through time and space. This can be displayed in either a chart that lists the output level corresponding to various levels of input. average. Production is a process. 2. or a graph that summarizes the data into a “total product curve”. 3. The myriad of possible inputs are usually grouped into five categories. shape. In this example. and the quantity. Some economists define production broadly as all economic activity other than consumption. there are no scale limitations. and most raw material inputs.
Diminishing Marginal returns . then the amount of the variable input labour could be varied and the resultant efficiency determined. A typical average physical product curve is shown (APP). This is point A on the total product curve. the marginal physical product curve must intersect the maximum point on the average physical product curve. then the average returns. then the average product of variable labour input is 5 units per day. This point is illustrated as the maximum point on the marginal physical product curve. The marginal physical product curve is shown (MPP). Putting it in a chronological order. navigation. The discrete marginal product of capital is the additional output resulting from the use of an additional unit of capital (assuming all other factors are fixed). Assuming the number of available trucks (capital) is fixed. are decreasing. refers to the point where the MPP curve starts to slope down and travels all the way down to the x-axis and beyond. Therefore. during this period. Diminishing Average returns . This occurs after point A in the graph. when the average physical product is rising. the marginal physical product must be less than the average. Likewise. At least one labourer (the driver) is necessary. Diminishing marginal returns These curves illustrate the principle of diminishing marginal returns to a variable input (not to be confused with diseconomies of scale which is a long term phenomenon in which all factors are allowed to change). The marginal physical product of a variable input is the change in total output due to a one unit change in the variable input (called the discrete marginal product) or alternatively the rate of change in total output due to an infinitesimally small change in the variable input (called the continuous marginal product). Finally we reach a point when MPP crosses the x-axis. APP starts to reduce because every additional unit is adding less to APP than the average product. 3. Additional workers per vehicle could be productive in loading. followed finally by the total returns. 2. The continuous marginal product of a variable input can be calculated as the derivative of quantity produced with respect to variable input employed. It is the output of each unit of input. you will reach a point beyond which the resulting increase in output starts to diminish. For this reason. we know that when the average physical product is falling. both. Average and Marginal Physical Product Curves The average product typically varies as more of the input is employed. the average as well as marginal products. An example is the employment of labour in the use of trucks to transport goods. At this point every additional unit starts to diminish the product of previous units. If there are 10 employees working on a production process that manufactures 50 units per day. Shehzad Inayat Ali). Up until this point every additional unit has been adding more value to the total product than the previous one. But the average product is still increasing till MPP touches APP. Notes: MPP keeps increasing until it reaches its maximum. or around the clock 15 . Diminishing returns Diminishing returns can be divided into three categories: 1. Because the marginal product drives changes in the average product. It assumes that other factor inputs (if they are used in the process) are held constant. it must be due to a marginal physical product greater than the average. But the total product is still increasing because every additional unit is still contributing positively. but the total product is still increasing. so this relationship can also be expressed as a chart or as a graph. possibly by getting into their way. which implies reduction in total product with every additional unit of input. unloading. It can be obtained from the slope of the total product curve. Therefore the total product starts to decrease at this point. It can be obtained by drawing a vector from the origin to various points on the total product curve and plotting the slopes of these vectors. Diminishing Total returns . (Courtesy: Dr. every additional unit adds less to the total product compared to the previous one – MPP is decreasing. at first the marginal returns start to diminish. At this point. This states that as you add more and more of a variable input. which refers to the portion of the APP curve after its intersection with MPP curve. From this point onwards. From this point onwards.The average physical product is the total production divided by the number of units of variable input employed. an additional unit is adding the same value as the average product.
K) is a production factor. they are sometimes called short run production functions. Let. However. it is also possible to assess the mix of inputs employed in production. it is possible to look at the mix of outputs that are possible for any given production process. and the function would be a long run production function. which will be capable of producing an equal quantity of output. Trains are able to transport much more in the way of goods with fewer "drivers" but at the cost of greater investment in infrastructure. The most efficient distribution of labour per piece of equipment will likely be one driver plus an additional worker for other tasks (2 workers per truck would be more efficient than 5 per truck). the rise in marginal product means that the workers use other means of production method. then output would be expressed relative to inputs of a fixed composition. i. such as in loading. or around the clock continuous driving. and marginal physical product curves mentioned above are just one way of showing production relationships. some economists think that the “keeping other things constant” should not be used in this theory. It indicates what combinations of outputs are possible given the available factor endowment and the prevailing production technology. If the mix of inputs is held constant. The isoquants are thus contour lines. They express the quantity of output relative to the amount of variable input employed while holding fixed inputs constant.e. For this reason. navigation. As the production remains the same on any point of this line.: There is an argument that if the theory is holding everything constant. the economic niche occupied by trains (compared with transport trucks) has become more specialized and limited to long haul delivery. Because they depict a short run relationship.S. Isoquants Isoquant Curve/Isocost Curve Two Isoquants (Interior and Corner Solutions) An isoquant represents those combinations of inputs. unloading. Rather than comparing inputs to outputs. It indicates all possible combinations of inputs that are capable of producing a given level of output. Resource allocations and distributive efficiencies in the mix of capital and labour investment will vary per industry and according to available technology. and the function would indicate long run economies of scale. the producer would be indifferent between them. it is also called equal product curve. Q0 = f(L. which trace the loci of equal outputs. division of labour should not be practiced. If all inputs are allowed to be varied. But at some point the returns to investment in labour will start to diminish and efficiency will decrease.. Q0 = A fixed level of production. Where. This is done with a production possibilities frontier. then the diagram would express outputs relative to total inputs. An isoquant (see below) relates the quantities of one input to the quantities of another input.continuous driving. the production method should not be changed. Many ways of expressing the production relationship The total. L = Labour K = Capital 16 . average. P. With the advent of mass production of motorized vehicles. Rather than looking at the inputs used in production.
In this case we are looking at the marginal rate of technical substitution capital for labour (which is the reciprocal of the marginal rate of technical substitution labour for capital). Now to increase the labour keeping the production same the organization have to decrease capital. 'Land' includes not only the site of production but natural resources above or below the soil. on the other hand. the marginal rate of substitution of labour for capital gives the amount of capital that can be replaced by one unit of labour while keeping output unchanged. and equal to infinity where it becomes vertical. B and C produces 10 units of product. Factors of production In economics. If. is equal to the marginal physical product of labour divided by the marginal physical product of capital. To move from point C to point D. the isoquant would be linear (linear in the sense of a function ). The marginal rate of technical substitution Marginal Rate of Technical Substitution Isoquants are typically convex to the origin reflecting the fact that the two factors are substitutable for each other at varying rates. which is A on the isoquant. labor (the ability to work). The opposite is true when going in the other direction (from D to C to B to A). factors of production (or productive inputs or resources) are any commodities or services used to produce goods and services. For example. The marginal rate of technical substitution of labour for capital is equivalent to the absolute slope of the isoquant at that point (change in capital divided by change in labour). and capital goods applied to production. It measures the reduction in one input per unit increase in the other input that is just sufficient to maintain a constant level of production. This rate of substitutability is called the “marginal rate of technical substitution” (MRTS) or occasionally the “marginal rate of substitution in production”. and these zero-substitutability isoquants would be shown as horizontal or vertical lines. there is only one production process available. The primary factors facilitate production but neither become part of the product (as with raw materials) nor become significantly transformed by the production process (as with fuel used to power machinery). It is equal to 0 where the isoquant becomes horizontal. It can also be shown that the marginal rate of substitution labour for capital. than the isoquant will be like Figure 1. 10 units. Each of the factor combinations A. Similarly. 'Factors of production' may also refer specifically to the primary factors. To move from point A to point B in the diagram. which are stocks including land. Recent usage has distinguished human capital (the stock of knowledge in the labor force) from labor. factor proportions would be fixed. 10 units of product may produce at point C on the isoquant with capital K1 and labour L3.If three combinations of labour and capital A. the amount of capital is reduced from Kc to Kd while the amount of labour is increased from Lc to Ld. y = a − bx 17 . B and C produces the same level of output. In the unusual case of two inputs that are perfect substitutes for each other in production.In Figure 1 B is the point where capital decreases to K2. Here we see that the combination of L1 labour and K3 capital can produce 10 units of product. the amount of capital is reduced from Ka to Kb while the amount of labour is increased only from La to Lb. while labour increases to L2.
Thus any innovation or improvement in technology may be accompanied by an increase in supply. If price rises from P1 to P2 in diagram 1 then one may expect most producers in that market to raise production in order to gain more revenue.  Sometimes the overall state of technology is described as a factor of production. when combined with other factors. determines the amount of output of a particular good or service. while maintaining similar levels of profit.Generally in classical economic theory any improvement in technology will probably reduce unit cost of a good or service. quantity supplied increases as price increases. Thus the shift along the supply curve results in overall quantity sold to become Q2. Generally. This is shown in diagram 1. an increase from Q1 to Q2. Thus one can expect there to be an increase in quantity supplied by the market. including entrepreneurship) as the primary factor of production. Fundamentally the higher the cost of production the lower the output will be per each possible price. since it is required to produce capital goods and to utilize the gifts of nature. This conclusion is made on the assumption that stock levels of this good are negligible and that economies of scale as well as diseconomies of scale play no part in production. This can be demonstrated in diagram 2. assuming all other factors are constant. The generalisation can be shown on a graph of price against quantity of sales in a certain time period. other authors argue that "entrepreneurship" is nothing but a specific kind of labor or human capital and should not be treated separately. But this debate is more about basic economic theory (the role of the factors in the economy) than it is about the definition of the factors of production Supply Introduction Diagram 1. Thus anything which affects the cost of factors production will affect supply. empirical emphasis. in the Austrian view—often shared by neoclassical and other "free market" economists—the primary factor of production is the time of the entrepreneur. depending on theoretical purpose. Differences are most stark when it comes to deciding which factor is the most important. For example. This may not be so in real life. For example an improvement in technology could increase profitability thus allowing people to work less and thus reducing supply.  The number and definition of factors varies.Entrepreneurship is also sometimes considered a factor of production. This is because higher price justifies the higher costs of larger volume of production for a firm and more importantly higher price allows for greater revenue which means that there is an increased potential for more profit to be made. which. Added by GregLoutsenko There are several factors which affect supply. seeing labor (in general. An improvement in technology may shift the supply curve from S to S2. The supply curve. or school of economics. Thus the following factors may affect supply: • Technology. Added by GregLoutsenko Supply is complete description of quantity of particular good or service which a firm is able and willing to at each possible price. Factors affecting Supply Edit Diagram 2. The Marxian school goes further. from S to S2 in diagram 2. However classical economics assumes that firms are run purely for profit and that the owners of firms will desire only more profit. However. that is. 18 .
Factors affecting PES Edit Supply can experience change in price elasticity of supply.  It plays a central role in production theory. Time. A common sort of example is adding more workers to a job. the use of fertilizer improves crop production on farms and in gardens. but at some point.  The law of diminishing returns does not imply that adding more of a factor will decrease the total production. • • Tax. such as assembling a car on a factory floor. ADVANTAGES OF SPECIALISATION / DIVISION OF LABOUR 19 . This is an example of specialisation. will at some point yield lower per-unit returns. If laws and regulations complicate production supply will decrease. Specialization in an economic sense refers to individuals and organizations focusing on the limited range of production tasks they perform best. The economic concept of specialization helps answer this question. economic actors concentrate their skills on tasks at which they are the most skilled.Diagram 3. adding more workers causes problems such as getting in each other's way. A key decision facing workers. If it is more profitable to produce a good or service then other goods and services which a firm may produce then that firm may increase supply in order to take advantage of higher profitability. adding more of one factor of production. Profitability . and excessive quantities can even reduce the yield. leaving those jobs to others who are better suited for them. This means that the gradient of the supply curve changes. Under specialization. This specialization requires workers to give up performing other tasks at which they are not as skilled. or workers frequently find themselves waiting for access to a part. The law of diminishing returns (also law of diminishing marginal returns or law of increasing relative cost) states that in all productive processes. An increase in tax. This can be seen in diagram 3. SPECIALISATION Economics is about the production. cooperate or indirect tax. adding more and more fertilizer improves the yield less and less. Added by GregLoutsenko • Government regulations. The law of diminishing returns is one of the most famous laws in all of economics. Diminishing returns In economics. a condition known as negative returns. though in fact this is common. while holding the amounts of all other factors of production constant. will decrease supply. Factors which may contribute to such a change are as follows: • • • Spare production capacity. An assembly line. In all of these processes. At some point. diminishing returns (also called diminishing marginal returns) refers to progressive decrease in the marginal (per-unit) output of a production process as the amount of a single factor of production is increased. Specialization has both micro. Mobility of factors of production. is the best example of specialization The DIVISION OF LABOUR is a system whereby workers concentrate on performing a few tasks and then exchange their production for other goods and services.and macroeconomic applications. For example. where individual workers perform specific tasks in the production process. while holding all others constant. Effect of Tax. producing one more unit of output per unit of time will eventually cost increasingly more. distribution and consumption of goods. firms and nations is what goods to produce. due to inputs being used less and less effectively.
pay for specialised work DISADVANTAGES OF SPECIALISATION / DIVISION OF LABOUR To the business: Greater cost of training -Quality may suffer if workers become bored by the lack of variety in their jobs To the worker: Boredom as they Their quality and . There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. e. Sri Lanka Tea.To the business: Specialist workers become quicker at producing goods Production becomes cheaper per good because of this Production levels are increased . managerial (increasing the specialization of managers). Economies of scale do the same may job suffer workers skills Economies of scale. financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments). "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase.May eventually be replaced by machinery OTHER TYPES OF SPECIALISATION REGIONAL Certain areas have specialised in certain industrial production e.Improved skills at that job. Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. They may have natural resources or they may be able to produce goods more cheaply. pottery in Stoke INTERNATIONAL Certain countries have advantages in producing certain goods. in microeconomics. marketing (spreading the cost of advertising over a greater range of output in media markets). The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts). refers to the cost advantages that a business obtains due to expansion.g. and technological (taking advantage of returns to scale in the production function). They then trade these goods for those produced in other countries. coal mining in Yorkshire. Japan electronics.Each worker can concentrate on what they are good at and build up their expertise To the worker: Higher . 20 .  Diseconomies of scale are the opposite.g. Economies of scale are also derived partially from learning by doing.
directly between those two workers.  A firm with a single worker does not require any communication between employees. however. the number of firms in a market. the increase in time and money with firm growth. The concept may be applied to non-market entities as well. recognize the concept as applying to government The rising part of the long-run average cost curve illustrates the effect of diseconomies of scale. General Motors. due to duplication of effort.). Some political philosophies. and therefore costs. since some economies of scale may require a larger market than is possible within a particular country — for example. Here is a chart of one-on-one communication channels required: Worker s 1 2 3 4 5 n Communication Channels 0 1 3 6 10 The one-on-one channels of communication grow more rapidly than the number of workers. Beyond Q 1 (Ideal firm size). the forces which enable larger firms to produce goods and services at reduced per-unit costs. such as libertarianism. but also costs additional money." The exploitation of economies of scale helps explain why companies grow large in some industries. but doesn't stop. A lone car maker may be profitable. or even a team. etc. When firms grow to thousands of workers. Causes Some of the forces which cause a diseconomy of scale are listed below: ] Cost of communication Ideally. it would not be efficient for Liechtenstein to have its own car maker. thus increasing the time. It is also a justification for free trade policies. A firm with two workers requires one communication channel.Economies of scale is a practical concept that may explain real world phenomena such as patterns of international trade. owing to this reduced level of communication. They are less well known than what economists have long understood as "economies of scale". additional production will increase per-unit costs. B & C. A firm with three workers requires three communication channels (between employees A & B. if they export cars to global markets in addition to selling to the local market. and how firms get " too big to fail." Diseconomy of scale Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. A firm with two employees could have duplication of efforts. will take on a project that is already being handled by another person or team. Economies of scale also play a role in a " natural monopoly. for example. but this is improbable. all employees of a firm would have one-on-one communication with each other so they know exactly what the other workers are doing.  Duplication of effort A firm with only one employee can't have any duplication of effort between employees. as the two are likely to know what each other is working on at all times. This reduced communication slows. it is inevitable that someone. developed two in-house CAD/CAM systems: CADANCE was designed by the 21 . and A & C). if they would only sell to their local market. therefore only certain groups of employees will communicate with one another (salespeople with salespeople. production workers with production workers. At some point one-on-one communications between all workers becomes impractical. of communication.
plan an advertising campaign. successful company is far more likely to have this attitude than a new. While "change for change's sake" is counter-productive. then the productivity of the firm has been reduced by 20%. in order to remain successful. is toxic to a company. If that manager does nothing other than manage the workers under them. Also note that higher level managers get higher level pay. before any change could be made. UNIGRAPHICS. The more levels there are. and be able to respond the next day. the lower the percentage of "line workers". companies with higher worker-to-manager ratios and that have "working managers" (who perform other important tasks in addition to managing the people under them) will have their productivity less negatively impacted by growth. CGS. This lack of consequences can lead to poor decisions and cause an upward sloping average cost curve. a company with 16 workers at $10/hr.. This endeavor eventually became so unmanageable that they acquired (and then eventual sold off) Electronic Data Systems (EDS) in an effort to control the situation. For example. GM also used CADAM. If neither the manager nor supervisors do anything but manage the people under them. An old. the single worker donut firm will know immediately if people begin to request healthier offerings. A company with a single worker doesn't need any managers. at great expense. 4 supervisors. $110/hr (41%) of which is on management. By this time smaller competitors may well have grabbed that market niche. A firm with 21 employees might have 16 workers. so there's no need to ever change" attitude (see appeal to tradition). etc. they would likely know that day whether their decision was good or not. These similar systems later needed to be combined into a single Corporate Graphics System. A large company would need to do research. struggling one. so he would not make such a decision.  Cannibalization A small firm only competes with other firms. based on the reaction of customers. as changes in the industry and market conditions will inevitably demand changes in the firm. such behavior would likely cause the company to go bankrupt. In addition to CGS.GM Design Staff. A Buick was just as likely to steal customers from another GM make. create an assembly line. but larger firms frequently find their own products are competing with each other. Smaller firms typically choose a single off-the shelf CAD/CAM system. refusal to consider change. 4 supervisors at $20/hr and 1 manager at $30/hr is spending $270/hr. and thus cost the manager his job. At a small company. thus increasing the cost of translating designs from one system to another. so such "office politics" are in the interest of individual managers.  Slow response time In a reverse example. but should be considered a "necessary evil" as they also reduce overall productivity.8%. This type of behavior only makes sense in a company with multiple levels of management.  Top-heavy companies The more employees a firm has. the larger the firm.  Inertia (unwillingness to change) This will be defined as the "we've always done it that way. a manager might intentionally promote an incompetent worker knowing that that worker will never be able to compete for the manager's job. with no need to combine or translate between systems.  Isolation of decision makers from results of their decisions If a single person makes and sells donuts and decides to try jalapeño flavoring. the more opportunity for this behavior. even when indicated. but is in his personal best interest. To be sure. CATIA and other off-the-shelf CAD/CAM systems. A decision maker at a huge company that makes donuts may not know for many months if such a decision worked out or not. then we now have reduced productivity by 5/21 or 23. and 1 manager. like whole grain bagels. or the lack of communication and cooperation which precipitated this event. complex company. At a large company. but the effect is still there. A firm with five employees might employ one as a manager and the other four as workers. By that time they may very well have moved on to another division or company and thus see no consequences from their decision. For example. and thus cost the company more than their numbers would indicate. such as 22 . Managers are necessary to manage a large. the larger percentage of the workforce will be "management" (this refers to management of people.  Office politics "Office politics" is management behavior which a manager knows is counter to the best interest of the company. A smaller firm would neither have had the money to allow such expensive parallel developments. ultimately leading to bankruptcy. determine which distribution chains to use. as opposed to management of other resources). one bad manager would not have much effect on the overall health of the company. while Fisher Graphics was created by the former Fisher Body division. A recent example is Polaroid Corporation's refusal to move into digital imaging until after this lag adversely affected the company. Thus.
with high associated pension and health costs. (Everybody might go out and buy a new invention next year. Returning to the example of the large donut firm. Unless the total market size in increasing rapidly. as in "Last year. Old firms tend to have a large retiree base. Revenue may refer to business income in general." Profits or net income generally imply total revenue minus total expenses in a given period. with employee decisions (hiring. This self-competition wastes resources that should be used to compete with other firms.  Public and government opposition Such opposition is largely a function of the size of the firm.  Large market portfolio A small investment fund can potentially return a larger percentage because it can concentrate its investments in a small number of good opportunities without driving up the price of the investment securities. not dictated by the corporation. income from activities related to the organization's mission. received during a period of time. Similarly service companies are limited by available labor. Company X had revenue of $42 million. This revenue includes donations from individuals and corporations. Both of these have negative implications for future growth. STEM (Science Technology Engineering and Mathematics professions) being the most cited example. annual revenue may be referred to as gross receipts. and income from fundraising activities. was seen as an anti-competitive and monopolistic threat. Each locale would also have the option of either choosing their own recipes and doing their own marketing. For this reason. but it is unlikely they will all buy cars next year. support from government agencies.) made by local management. firing. promotions.) Solutions Solutions to the diseconomy of scale for large firms involve changing the company into one or more small firms. such as the United Kingdom. as this would require that they control 180% of the original market. This may help to explain why Oldsmobiles were discontinued after 2004. as it was to steal customers from other companies. membership dues. usually from the sale of goods and services to customers. and financial investments such as stock shares in companies.an Oldsmobile. each retail location could be allowed to operate relatively autonomously from the company headquarters. with associated higher labor costs and lower productivity. Purchasing decisions could also be made independently. in bankruptcy. due to Microsoft's size. For instance a timber company can not increase production above the sustainable harvest rate of its land. and also tend to be unionized. Other effects related to size Large firms also tend to be old and in mature markets. thus bringing about public opposition and government lawsuits.  Large market share A small company with only a 1% market share could potentially double market share. sells off its profitable divisions and shuts down the rest. A large company with 90% market share will find it difficult to do so well. in a year. revenue is referred to as turnover. This can either happen by default when the company. dividends or royalties paid to them by other companies. this isn't possible. incremental growth.  For non-profit organizations. Mature markets tend to only offer the potential for small. revenue is income that a company receives from its normal business activities. If the employees own a portion of the local business. or it may refer to the amount. etc.   Inelasticity of supply A company which is heavily dependent on its resource supply will have trouble increasing production. or can happen proactively. many businesses delay such a reorganization until it is too late to be effective. wage scales. with each location allowed to choose its own suppliers. 23 . revenue is often referred to as the "top line" due to its position on the income statement at the very top. or they may continue to rely on the corporation for those services. which may or may not be owned by the corporation (wherever they find the best quality and prices). a large investment fund like Fidelity Magellan must spread its investments among so many securities that its results tend to track those of the market as a whole. as well. Some companies receive revenue from interest. In business. This is to be contrasted with the "bottom line" which denotes net income. Behavior from Microsoft. and hence revenues. they will also have more invested in its success. In accounting. In many countries. which would have been ignored from a smaller firm. if the management is willing. in a monetary unit. since most people already have them. Conversely. Note that all these changes will likely result in a substantial reduction in corporate headquarters staff and other support staff.
Revenue account names describe the type of revenue. revenue accounts are general ledger accounts that are summarized periodically under the heading Revenue or Revenues on an income statement. For example. revenue is income received by an organization in the form of cash or cash equivalents.k. Price / Sales is sometimes used as a substitute for a Price to earnings ratio when earnings are negative and the P/E is meaningless. a company that manufactures and sells automobiles would record the revenue from the sale of an automobile as "regular" revenue. Revenues from a business's primary activities are reported as sales. Though a company may have negative earnings. In more formal usage. as well as income growth. high income growth would be tainted if a company failed to produce significant revenue growth. Revenue is used as an indication of earnings quality. it almost always has positive revenue. For some businesses. If a company displays solid “top-line growth. Gross Margin is a calculation of revenue less cost of goods sold. sales revenue or net sales. A company’s performance is measured to the extent to which its asset inflows (revenues) compare with its asset outflows (expenses). This includes product returns and discounts for early payment of invoices.. Net Income is the result of this equation. Large governments usually have an agency or department responsible for collecting government revenue from companies and individuals. Conversely.In general usage. companies use revenue to determine bad debt expense using the income statement method. Tax revenue is income that a government receives from taxpayers. and is used to determine how well sales cover direct variable costs relating to the production of goods. 24 . company. cash basis accounting and accrual basis accounting. is calculated by investors to determine how efficiently a company turns revenues into profits. such as manufacturing and/or grocery. In a double-entry bookkeeping system. or “bottom-line growth” is stagnant. Two common accounting methods. Corporations that offer shares for sale to the public are usually required by law to report revenue based on generally accepted accounting principles or International Financial Reporting Standards. Service businesses such as law firms and barber shops receive most of their revenue from rendering services.” analysts could view the period’s performance as positive even if earnings growth. the most important being gross margin and profit margin. such as interest earned on deposits in a demand account. Other revenue (a.. but revenue typically enjoys equal attention during a standard earnings call.a. Net income/sales. do not use the same process for measuring revenue. Consistent revenue growth. is considered essential for a company's publicly traded stock to be attractive to investors. non-operating revenue) is revenue from peripheral (non-core) operations.  Financial statement analysis Main article: Financial statement analysis Revenue is a crucial part of financial statement analysis. revenue is a calculation or estimation of periodic income based on a particular standard accounting practice or the rules established by a government or government agency. or sole-proprietorship.  Sales revenue does not include sales tax collected by the business.. such as "Repair service revenue". There are several financial ratios attached to it.  Government revenue Main article: Government revenue Government revenue includes all amounts of money received from sources outside the government entity. most revenue is from the sale of goods. Also. Most businesses also have revenue that is incidental to the business's primary activities. If that same company also rented a portion of one of its buildings. "Rent revenue earned" or "Sales Business revenue Business revenue is income from activities that are ordinary for a particular corporation. partnership. it would record that revenue as “other revenue” and disclose it separately on its income statement to show that it is from something other than its core operations. or profit margin. Lending businesses such as car rentals and banks receive most of their revenue from fees and interest generated by lending assets to other organizations or individuals. Sales revenue or revenues is income received from selling goods or services over a period of time. This is included in revenue but not included in net sales.
This acquisition cost may be the sum of the cost of production as incurred by the original producer. In this case. It is the amount denoted on invoices as the price and recorded in bookkeeping records as an expense or asset cost basis. and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. They include things like pollution. the price also includes a mark-up for profit over the cost of production. services. money is the input that is gone in order to acquire the thing. Opportunity cost.e. The bearers of such costs can be either particular individuals or society at large. in which case the amount of money expended to acquire it is counted as cost. cost used without qualification often means opportunity cost. Note that external costs are often both non-monetary and problematic to quantify for comparison with monetary values. a cost is an alternative that is given up as a result of a decision. what could have been accomplished with the resources expended in the undertaking. normal profit can also be seen as a cost of production. planners typically make cost estimates in order to assess whether revenues/benefits will cover costs (see cost-benefit analysis). It represents opportunities forgone. products. labour. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. In economics. social. The polluted waters or polluted air also created as part of the process of producing the car is an external cost borne by those who are affected by the pollution or who value unpolluted air or water.  In business..e. also referred to as economic cost is the value of the best alternative that was not chosen in order to pursue the current endeavour—i. For example. External costs (also called externalities). Ison and Wall.There is a question as to whether using generic business based accounting standards can give a fair and accurate picture of government accounts in that with a monetary policy statement to the reserve bank directing a positive inflation rate the expense provision for the return of currency to the reserve bank is largely symbolic in that to totally cancel the currency in circulation provision all currency would have to be returned to the reserve bank and cancelled In business. a cost is the value of money that has been used up to produce something. and accounting. A psychic cost is a subset of social costs that specifically represent the costs of added stress or losses to quality of life. in contrast. Private costs are the costs that the buyer of a good or service pays the seller. Social costs are the sum of private costs and external costs. land tax rates for the car plant. product. Usually. Accounting vs opportunity costs In accounting. overhead costs of running the plant and labour costs) reflects the private cost for the manufacturer (in some ways. The driver does not compensate for the environmental damage caused by using the car. the costs of buying inputs. Costs are often underestimated resulting in cost overrun during implementation.  Comparing private.. This can also be described as the costs internal to the firm's production function.g. 2007. Cost estimates and cost overrun Main article: Cost overrun When developing a business plan for a new or existing company. e. costs are the monetary value of expenditures for supplies. 181). retail. external. p. see. In theoretical economics. and does not include this cost in the price of the car (a Kaldor-Hicks compensation).Government revenue may also include reserve bank currency which is printed. This is done in both business and government. Costs are often further described based on their timing or their applicability. Main causes of cost underestimation and overrun are optimism bias and 25 . it typically involves both private costs and external costs.. things that society will likely have to pay for in some way or at some time in the future. but that are not included in transaction prices. they are said to be external to the market pricing mechanism. are the costs that people other than the buyer are forced to pay as a result of the transaction. and psychic costs When a transaction takes place. or project. This is recorded as an advance to the retail bank together with a corresponding currency in circulation expense entry. Because the manufacturer does not pay for this external cost (the cost of emitting undesirable waste into the commons). the manufacturing cost of a car (i. and hence is not available for use anymore. The income derives from the Official Cash rate payable by the retail banks for instruments such as 90 day bills. the cost may be one of acquisition. equipment and other items purchased for use by a business or other accounting entity.
Direct labor cost. each having a small proportion of the market share and slightly differentiated products. Oligopoly. market structure (also known as the number of firms producing identical products). Generally nonmanufacturing costs are further classified into two categories: 1. Manufacturing overhead cost. Perfect competition is a theoretical market structure that features unlimited contestability (or no barriers to entry). In other words. (b) gathering information on the operator and the market. where many sellers can be present but meet only a few buyers. Direct materials cost. see Routing. where x is the percentage of built in overhead or profit margin. also called competitive market.  Quick Reference to Basic Market Structures Market Structure Seller Entry Seller Buyer Entry Buyer 26 . a monopoly in which economies of scale cause efficiency to increase continuously with the size of the firm. in which a market is dominated by a small number of firms that together control the majority of the market share. The elements of Market Structure include the number and size distribution of firms. and a perfectly elastic demand curve. Administrative Costs Market structures In economics. Examples of such costs are salary of sales personnel and advertising expenses.strategic misrepresentation (Flyvbjerg et al. oligopolists. Marketing and Selling Costs. A firm is a natural monopoly if it is able to serve the entire market demand at a lower cost than any combination of two or more smaller. Reference class forecasting was developed to curb optimism bias and strategic misrepresentation and arrive at more accurate cost estimates. Non-manufacturing Costs are those costs that are not directly incurred to manufacture a product. Monopoly. Manufacturing Costs VS. Duopoly. and the extent of differentiation. Natural monopoly. 2002). typically subject to the seller’s financial need to cover its costs. 3. • • • • • • Monopolistic competition. Path cost Also seen as a term in networking to define the worthiness of a path. monopolists. a market. These somewhat abstract concerns tend to determine some but not all details of a specific concrete market system where buyers and sellers actually meet and commit to trade. • • The imperfectly competitive structure is quite identical to the realistic market conditions where some monopolistic competitors. Manufacturing cost is divided into three broad categories: 1. Examples of manufacturing costs include raw materials costs and charges related workers. three basic approaches can be adopted to deal with problems related to the control of market power and an asymmetry between the government and the operator with respect to objectives and information: (a) subjecting the operator to competitive pressures. 2. and (c) applying incentive regulation. when there is only one buyer in a market. an unlimited number of producers and consumers. competition can align the seller’s interests with the buyer’s interests and can cause the seller to reveal his true costs and other private information. Non-manufacturing costs Manufacturing Costs are those costs that are directly involved in manufacturing of products. 2. is where the Price = Cost plus or minus X%. where there is only one provider of a product or service. Monopsony. more specialized firms. and duopolists exist and dominate the market conditions. Oligopsony.  Cost Plus. In the absence of perfect competition. Competition is useful because it reveals actual customer demand and induces the seller (operator) to provide service quality levels and price levels that buyers (customers) want. where there are a large number of firms. a special case of an oligopoly with two firms. entry conditions.
the type of goods and services being traded. and pure monopoly. Thus a company may vary pricing by location. but then offer bulk discounts as well. market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers. even in fully competitive retail or industrial markets. the moment the seller tries to sell the same good at different prices. by the individual customer's identity. Price discrimination also occurs when the same price is charged to customers which have different supply costs. price discrimination can only be a feature of monopolistic and oligopolistic markets.  In a theoretical market with perfect information.oligopoly. sellers are not able to differentiate between different types of consumers. This arises from the fact that the value of goods is subjective. imperfect competition. price varies over time. Additionally to second degree price discrimination . Combination These types are not mutually exclusive. product heterogeneity. and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage. However. and tour operators Incentive discounts for higher sales volumes to travel agents and corporate buyers Seasonal discounts. including: • • • • • Bulk discounts to wholesalers. It is not accidental that hotel or car rental firms may quote higher prices to their loyalty program's top tier members than to the general public 27 . Types of price discrimination In first degree price discrimination . and even general prices that vary by location. Typically a company starts selling a new product at a relatively high price then gradually reduces the price as the low price elasticity segment gets satiated. Price discrimination or price differentiation  exists when sales of identical goods or services are transacted at different prices from the same provider. the suppliers will provide incentives for the consumers to differentiate themselves according to preference In third degree price discrimination . price varies by attributes such as location or by customer segment. where the attribute in question is used as a proxy for ability/willingness to pay. First degree price discrimination based on customer. Singapore to Beijing can vary widely if one buys the ticket in Singapore compared to Beijing (or New York or Tokyo or elsewhere). consolidators. price varies according to quantity sold. or in the most extreme case. The price of a flight from say. where bulk buyers enjoy higher discounts. who typically travel during the workweek and arrange trips on shorter notice. In price skimming. Larger quantities are available at a lower unit price. Airlines use several different types of price discrimination. In second degree price discrimination . This is particularly widespread in sales to industrial customers. and the degree to which information can flow freely. Both restrictions have the effect of excluding business travelers. perfect substitutes. where market power can be exercised. Otherwise. Thus. Discounted tickets requiring advance purchase and/or Saturday stays. incentive discounts. price varies by customer's willingness or ability to pay.Perfect Competition Monopolistic competition Oligopoly Oligopsony Monopoly Monopsony Barriers No No Yes No Yes No Number Many Many Few Many One Many Barriers No No No Yes No Yes Number Many Many Many Few Many One The correct sequence of the market structure from most to least competitive is perfect competition. The main criteria by which one can distinguish between different market structures are: the number and size of producers and consumers in the market. the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount.
it is the cost of producing one more unit of a good 28 .  It can also be described as the change in total revenue divided by the change in the number of units sold. then these are also factors in the price and output decisions. It will lose money in the short run. by cost structure.10. That is. It depends on the industry whether the social disadvantages outweigh the social advantages. Another potential social advantage to imperfect competition is a higher standard of living: with imperfect competition. Marginal revenue In microeconomics.10. too many restaurants in a neighborhood will mean that some will go out of business. If. but this is a long run strategy designed to increase market share (by eliminating some of the competition).3 Haircutting Financial aid in education Haggling International price discrimination Academic pricing Dual pricing Wage discrimination 4. sometimes equal to price. but they can be long run. where one electrical company in a town can supply electricity cheaper than having two companies both investing in startup costs. Even antitrust laws don't always prohibit mergers. marginal cost is the change in total cost that arises when the quantity produced changes by one unit. to bring the consumer prices that reflect competition. marginal revenue (MR) is the extra revenue that an additional unit of product will bring. This is why government often gets involved with regulating certain industries. firms compete in areas other than price. all costs are variable.Examples of price discrimination o o o o o o o o o o Retail price discrimination Travel industry Coupons Premium pricing Segmentation by age group and student status Discounts for members of certain occupations Employee discounts Retail incentives Incentives for industrial buyers o Gender-based examples o o o o o o 4. It is the additional income from selling one more unit of a good. the firm can. try to undermine the competition by setting a price below cost. This will allow for potential economic profits. the profit maximizing firm can. As far as social implications. But there can be social advantages to imperfect competition: the cost structure of the industry might make having fewer firms be more efficient than having more competition (think of natural monopolies. This can lead to technological advances as well as increased consumer choices. Profits are always maximized at the point where marginal revenue is equal to marginal cost. which happens quite frequently). and research and development is one of those areas. or for oligopoly. not short run decisions. but the price will be higher. So the firm will have short run decisions and long run decisions. In the long run. They still will equate marginal revenue with marginal cost.. and will. with marginal cost being a function of variable cost. short run. etc. you mean the size (scale). imperfect competition always yields a price that is higher than. the government uses them to weigh whether fewer firms in an industry will do more harm than good. Marginal cost In economics and finance. in the long run it will have the power to set a price that is even more above marginal cost. In imperfect competition. what would occur under perfect competition.1 "Ladies' night" 4.2 Dry cleaning Price and output decisions Price and output decisions of firms that want to maximize profits always depend on costs. the ratio of capital to labor. but the long run profit maximizing point will be where marginal revenue equals marginal cost. If this strategy works. and an output level that is lower than.10. set a price that is higher than marginal cost. but it is true based on the fact that the demand curve that the firm faces in imperfect competition is downward-sloping. In oligopoly.
businesses. but unemployed will have to pay the full adult fare. It can be expressed as: NNI = C + I + G + (NX) + net foreign factor income . salaries. profits. This business who may have otherwise have made price discrimination to offer 2. However. 3. while direct material and direct labor are often referred to as prime cost. and may also restrict the goods and services that are counted. E. however. representing the sum of wages. gross national product (GNP). Some Consumers will benefit from lower advantage of cheaper Disadvantages of Discrimination may enable some firms to stay in a loss. leading to allocative inefficient and a loss of consumer surplus.  Variable cost is the sum of marginal costs over all units produced. and pension payments to residents of the nation. For example some old people may be quite rich. Economics the total of all incomes accruing over a specified period to residents of a country and consisting of wages. For instance. All are specially concerned with counting the total amount of goods and services produced within some "boundary". are costs that can easily be associated with a particular cost object. and interest Gross national income (GNI) comprises the value within a country (i. Often those who benefit from lower prices may not be the poorest. The boundary is usually defined by geography or citizenship. less similar payments made to other countries Net national income (NNI) is an economics term used in national income accounting. Some Consumers will face higher prices.depreciation where: • • • • C = Consumption I = Investments G = Government spending NX = net exports (exports minus imports) This formula uses the expenditure method of national income accounting A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region. Direct Costs. E. profits. There may be administration costs involved in separating the markets National Income The total net value of all goods and services produced within a nation over a specified period of time. Variable costs are sometimes called unit-level costs as they vary with the number of units produced. excluding bartered goods. Increased revenue can be used 3.e. not direct costs. Direct labor and overhead are often called conversion cost. Price Discrimination 1. 2.Variable costs are expenses that change in proportion to the activity of a business. not all variable costs are direct costs. Firm will be able to increase revenue. its gross domestic product). while other measures may attempt to include bartered goods by imputing monetary values to them 29 . Advantages and disadvantages of price discrimination Advantages of Price 1. Fixed costs and variable costs make up the two components of total cost. It can also be considered normal costs. including gross domestic product (GDP). interest. rent. together with its income received from other countries (notably interest and dividends). For example.g. It can be defined as the net national product (NNP) minus indirect taxes.indirect taxes . train companies need off peak travel for Research and Development fares. variable manufacturing overhead costs are variable costs that are indirect costs. old people can take fares on trains. rents. Net national income encompasses the income of households.G. some measures count only goods and services that are exchanged for money. and net national income (NNI). and the government.
The total value produced by the economy is the sum of the values-added by every industry.Gross domestic product (GDP) refers to the market value of all final goods and services produced within a country in a given period. However. a subject in macroeconomics Gross National Product (GNP) is the market value of all products and services produced in one year by labor and property supplied by the residents of a country. but the value-added. Larger arrows show primary factors. number of computers produced). Therefore we sum up the total amount of money people and organisations spend in buying things. and expenditures by government are calculated separately and then summed to give the total expenditure. in the United States and some European countries. which defines production based on the geographical location of production. since an output of one industry may be used by another industry and become part of the output of that second industry. whilst the red smaller arrows show subsequent or secondary factors. GNP does not distinguish between qualitative improvements in the state of the technical arts (e. Measures of national income and output National accounts Main article: National accounts Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation.  the systematic keeping of national accounts. only began in the 1930s. increasing computer processing speeds). This amount must equal the value of everything produced. Although some attempts were made to estimate national incomes as long ago as the 17th century. of which these figures are a part. Also.g. GNP allocates production based on ownership. the relationship between the decision-makers in the circular flow model is shown. Gross domestic product is related to national accounts. expenditures by businesses. the difference between the value of what it puts out and what it takes in. and considers both to be forms of "economic growth". a correction term must be introduced to account for imports and exports outside the boundary. the expenditure method. 30 . Market value In order to count a good or service it is necessary to assign some value to it. Usually expenditures by private individuals. It is often considered an indicator of a country's standard of living. and quantitative increases in goods (e. and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as much as possible from a basis of fact. The expenditure method is based on the idea that all products are bought by somebody or some organisation. The total output of the economy is the sum of the outputs of every industry. The value that the measures of national income and output assign to a good or service is its market value – the price it fetches when bought or sold. Three strategies have been used to obtain the market values of all the goods and services produced: the product (or output) method. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics. to avoid counting the item twice we use not the value output by each industry.. The product method looks at the economy on an industry-by-industry basis.g. and the income method. that is. which prescribed a greater role for the government in managing an economy.  Circular flow of income In this simplified image. Unlike Gross Domestic Product (GDP). The actual usefulness of a product (its use-value) is not measured – assuming the usevalue to be any different from its market value..
$100. and $30. their total income must be the total value of the product. If a firm has stockholders. GDP = C + I + G + (X . National income = NDP at factor cost + NFIA (net factor income from abroad). Because of the complication of the multiple stages in the production of a good or service. only the final value of a good or service is included in total output. Wages. including unemployment.M) Where: C = household consumption expenditures / I = gross private G = government consumption and X = gross exports of M = gross imports of goods and services personal consumption domestic gross investment goods and expenditures investment expenditures services 31 . The basic formula for domestic output combines all the different areas in which money is spent within the region. This avoids an issue often called 'double counting'. Royalties paid for the use of intellectual property and extractable natural resources. Their sum gives an alternative way of calculating the value of final output. All remaining value added generated by firms is called the residual or profit. Interest received net of interest paid. The main types of factor income are: • • • • Employee compensation (= wages + cost of fringe benefits. and then combining them to find the total output.depreciation + NFIA (net factor income from abroad) . The output approach The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. they own the residual. The value that should be included in final national output should be $60. the value of the good from the farm may be $10. Since what they are paid is just the market value of their product. This is acceptable. Rental income (mainly for the use of real estate) net of expenses of landlords. Formulae: NDP at factor cost = Compensation of employees + Net interest + Rental & royalty income + Profit of incorporated and unincorporated firms + Income from self-employment. not the sum of all those numbers. and corporate profits are the major subdivisions of income. Profit includes the income of the entrepreneur . The values added at each stage of production over the previous stage are respectively $10. Formulae: GDP(gross domestic product) at market price = value of output in an economy in a particular year intermediate consumption NNP at factor cost = GDP at market price . and then $60 from the supermarket. $20. proprieter's incomes.net indirect taxes The income approach The income approach equates the total output of a nation to the total factor income received by residents of the nation. the total value of all goods is equal to the total amount of money spent on goods. and retirement benefits). In the example of meat production. It focuses on finding the total output of a nation by finding the total amount of money spent. wherein the total value of a good is included several times in national output. health. then $30 from the butchers. by counting it repeatedly in several stages of production. The expenditure approach The expenditure approach is basically an output accounting method. because like income.the businessman who combines factor inputs to produce a good or service. some of which they receive as dividends.The income method works by summing the incomes of all producers within the boundary.
which stands for "net exports" Definitions The names of the measures consist of one of the words "Gross" or "Net". "Net" means "Gross" minus the amount that must be used to offset depreciation – ie. One problem for instance is that goods in inventory have been produced (therefore included in Product).S. in practice minor differences are obtained from the three methods for several reasons.008.S. Note that all three counting methods should in theory give the same final figure. wear-andtear or obsolescence of the nation's fixed capital assets. GDP and GNP Main articles: GDP and GNP Gross domestic product (GDP) is defined as "the value of all final goods and services produced in a country in 1 year". the table below shows some GDP and GNP.679. Gross domestic product 1 Private consumption of fixed capital 1. "Income".M) is often written as XN.1 Statistical discrepancy 25. often used when any of the three approaches was actually used. "Product".6 National Income 9.9 Government consumption of fixed capital 218. We count all goods and services produced by the nationals of the country (or businesses owned by them) regardless of where that production physically takes place. Similar timing issues can also cause a slight discrepancy between the value of goods produced (Product) and the payments to the factors that produced the goods (Income). which is also the mean income. regardless of the use to which it is subsequently put. "Gross" means total product. income payments -273. and "Expenditure" refer to the three counting methodologies explained earlier: the product."  As an example. income receipts from rest of the 55. "GDP(I)". followed by one of the words "Product". Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labour and property supplied by the residents of a country. The output of a French-owned cotton factory in Senegal counts as part of the Domestic figures for Senegal. income receipts 329. "National" means the boundary is defined by citizenship (nationality). so. "Net" gives an indication of how much product is actually available for consumption or new investment. but not yet sold (therefore not yet included in Expenditure). "Income". followed by one of the words "National" or "Domestic". "Domestic" means the boundary is geographical: we are counting all goods and services produced within the country's borders.9 11. income.Note: (X .S. and expenditure approaches. However.063. and similar constructions. "Income" specifically means that the income approach was used. Sometimes the word "Product" is used and then some additional symbol or phrase to indicate the methodology. for instance. including changes in inventory levels and errors in the statistics. "Expenditure" specifically means that the expenditure approach was used.. particularly if inputs are purchased on credit. we get "Gross Domestic Product by income". 3 Net U. but the National figures of France. "Product" is the general term. However the terms are used loosely.2 world U. similar to NNP. All of these terms can be explained separately. or "Expenditure". "GDP (income)".1 U. regardless of by whom.7 • • NDP: Net domestic product is defined as "gross domestic product (GDP) minus depreciation of capital". and NNI data for the United States:  National income dollars) Period Ending and output (Billions of Gross national product 2003 11. and also because wages are collected often after a period of production. GDP per capita: Gross domestic product per capita is the mean value of the output produced per person. 32 .135.
in monetary terms. See Gini coefficient. due to concentration of wealth in the hands of a small fraction of the population. Countries with a skewed income distribution may have a relatively high per-capita GDP while the majority of its citizens have a relatively low level of income. then GDP might roughly double. even though they are both carrying out the same economic activity. but an unpaid parent's time spent caring for children will not.  Income distribution has always been a central concern of economic theory and economic policy. loss of clean beaches) is not measured. It is often associated with the idea of income "fairness". Income inequality is often presented as the percentage of income to a percentage of population. there are serious limitations to the usefulness of GDP as a measure of welfare: • • • • • Measures of GDP typically exclude unpaid economic activity. such as life expectancy. and sustainable national income (SNI) are used Income inequality and distribution In economics. Countries with higher GDP may be more likely to also score highly on other measures of welfare. the impact of economic activity on the environment is not measured in calculating GDP. but can also refer to inequality among countries Income inequality The unequal distribution of household or individual income across the various participants in an economy. National income and welfare GDP per capita (per person) is often used as a measure of a person's welfare. such as the quality of the environment (as distinct from the input value) and security from crime. land. GDP is the mean (average) wealth rather than median (middle-point) wealth. Economists are divided as to whether income equality is ultimately positive or negative and what are the implications of such disparity. for example. education and social status. Per capita income Per capita income or income per person is the numerical quotient of income divided by population. 33 . a paid nanny's income contributes to GDP. For example. Similarly. other measures of welfare such as the Human Development Index (HDI). Comparison of GDP from one country to another may be distorted by movements in exchange rates. GDP takes no account of the inputs used to produce the output. gross national happiness (GNH). It is a measure of all sources of income in an economic aggregate. The term typically refers to inequality among individuals and groups within a society. such as a country or city. that is. but this does not necessarily mean that workers are better off as they would have less leisure time.for example. a statistic may indicate that 70% of a country's income is controlled by 20% of that country's residents.g. However. for example subsistence farming. gender. Genuine Progress Indicator (GPI). spending on cleaning up an oil spill is included in GDP. but the negative impact of the spill on well-being (e. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services. GDP does not measure factors that affect quality of life. the distribution of income between the main factors of production. It is generally considered "unfair" if the rich have a disproportionally larger portion of a country's income compared to their population The causes of income inequality can vary significantly by region. This leads to distortions . labour and capital Economic inequality (or "wealth and income differences") comprises all disparities in the distribution of economic assets and income. This leads to distortions. Because of this. Thomas Malthus and David Ricardo were mainly concerned with factor income distribution. It does not measure income distribution or wealth. income distribution is how a nation’s total economy is distributed amongst its population. most importantly domestic work such as childcare. For example. Classical economists such as Adam Smith. Index of Sustainable Economic Welfare (ISEW). if everyone worked for twice the number of hours.
a small wealthy class can increase per capita income far above that of the majority of the population. If goods cost twice as much in country A and A has twice the per capita income. but a complete cost-of-living index would go beyond this to also take into account changes in other governmental or environmental factors that affect consumers' well-being. and allows for substitutions to other items as prices vary.A.  There are many different methodologies that have been developed to approximate cost-of-living indexes. however. If the distribution of income within a country is skewed. e. A Konüs index is a type of cost-of-living index that uses an expenditure function such as one used in assessing expected compensating variation. the cost of achieving utility level u given a set of prices p. people get the same amount of utility from one set of purchases in year as they would have buying the same set in a different year) leads to a "true cost of living index. C(u. BLS has for some time used a cost-of-living framework in making practical decisions about questions that arise in constructing the CPI. Application to price index theory The United States Consumer Price Index (CPI) is a price index that is based on the idea of a cost-of-living index. and crime that would constitute a complete cost-of-living framework."  Economic theory The basis for the theory behind the cost of living index is attributed to Russian economist A. Konüs. These assumptions can be shown to lead to a "consumer's cost function". Both the CPI and a cost-of-living index would reflect changes in the prices of goods and services.g. are usually not counted.e. or for barter. not a straightforward alternative to the CPI.  The economic theory behind the cost of living index assumes that consumers are optimizers and get as much utility as possible from the money that they have to spend. both between countries and among different groups within a country. such as safety and education. and other broad concerns. International comparisons can be distorted by skewed exchange rates. including methods that allow for substitution among items as relative prices change." The general form for Konüs's true cost of living index compares the consumer's cost function given the prices in one year with the consumer's cost function given the prices in a different year: 34 . water quality. the countries may be equally prosperous despite the income figures. A cost-of-living index would measure changes over time in the amount that consumers need to spend to reach a certain utility level or standard of living. The expected indirect utility is equated in both periods. The same good. but it differs in important ways from a complete cost-ofliving measure. It is an index that measures differences in the price of goods and services.Per capita income as a measure of prosperity Per capita income has several weaknesses as a measurement: • Economic activity that does not result in monetary income. Cost-of-living index regions. one pound of rice may sell for a much different price in two countries... such as food and clothing that are directly purchased in the marketplace. such as health. The US Department of Labor's Bureau of Labor Statistics (BLS) explains the difference: "The CPI frequently is called a cost-of-living index. • • Median income is a more widely accepted measure of prosperity. A cost-of-living index is a conceptual measurement goal. because it is not biased by wealthy outliers. such as services provided within the family. Assuming that the cost function holds across time (i. It is very difficult to determine the proper treatment of public goods.p). The importance of these services varies widely between different economies.
The multiplier may vary across countries. For example. Laspeyres gives the upper bound for the true cost of living index.  Price index A price index (plural: “price indices” or “price indexes”) is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region. compares the cost of what a consumer bought in one time period (q 0) with how much it would have cost to buy the same set of goods and services in a later period. u can be replaced with f(q) to produce a version of the true cost of living index that is based on price and quantities like most other price indices:  In simpler terms. Common uses Two multipliers are commonly discussed in introductory macroeconomics.  Since upper and lower bounds of the true cost of living index can be found. Sometimes. More narrow price indices can help producers with business plans and pricing. respectively. known as the Fisher price index. the geometric average of the two. For example. they can be useful in helping to guide investment. a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable. suppose a one-unit change in some variable x causes another variable y to change by M units. differ between time periods or geographical locations. during a given interval of time. It is a statistic designed to help to compare how these prices. Money multiplier Main article: Money multiplier See also: Fractional-reserve banking In monetary macroeconomics and banking. consider M2 as a measure of the U.Since u can be defined as the utility received from a set of goods measured in quantity. so the true cost of living index only serves as a theoretical ideal. Utility is not directly measurable. For particularly broad indices. because consumers could turn to substitute goods for those goods that have gotten more expensive and achieved the same level of utility from q 0 for a lower cost. and will also vary depending on what measures of money are considered.S. Price indices have several potential uses. It can be shown that the Paasche is a lower bound for true cost of living index. the index can be said to measure the economy's price level or a cost of living. taken as a whole.  Laspeyres only serves as an upper bound. One of the most commonly used formulas for consumer price indices. Since the utility from q0 in the first year should be equal to the utility from q 0 in the next year. more practical formulas can be evaluated based on their relationship to the true cost of living index. through the Laspeyres and Paasche indices. the money multiplier measures how much the money supply increases in response to a change in the monetary base. and M0 as a measure of the 35 . However. is a close approximation of the true cost of living index if the upper and lower bounds are not too far apart. Then the multiplier is M. q. the Laspeyres price index. In contrast. money supply. Some notable price indices include: • • • Consumer price index Producer price index GDP deflator Multiplier (economics) In economics. the true cost of living index is the cost of achieving a certain level of utility (or standard of living) in one year relative to the cost of achieving the same level the next year. not a practical price index formula. a Paasche price index uses the cost of a set of goods purchased in one time period with the cost it would have taken to buy the same set of goods in an earlier time period.
Deflationary gap Economics) Economics a situation in which total spending in an economy is insufficient to buy all the output that can be produced with full employment Economic term describing the situation when Gross Domestic Product is below its full-employment level. This is a concept of Macro Economics. For example. The differential is higher. because it measures the aggregate output in a country's income accounts in a given year. Fiscal multipliers Main article: Fiscal multiplier Multipliers can be calculated to analyze the effects of fiscal policy. The once created gap between real GDP and potential GDP was the sign of forthcoming inflation. The gap created between real GDP and potential GDP is the consequence of inflation. exceeds potential GDP. The investment will be a huge expense against this differential. The real GDP is also known as GDP "adjusted for inflation". monetary base. The short-run aggregate supply decrease makes an upward pressure on the price level. The company can produce only 100 with existing machinery. on aggregate output. if an increase in German government spending by €100. with no change in taxes. In managerial Economics. the company may plan to invest in a new machinery. above the aggregate supply at full employment. Suppose the demand increases to 120 pieces. the rate of change in aggregate Demand to the Rate of Change in Investment. causes German GDP to increase by €150. In theory. But when the demand reaches. i. or other exogenous changes in spending. See also Recessionary gap.5. So the firm's investment is much higher than the demand. or real GDP. like multipliers that describe the effects of changing taxes (such as lump-sum taxes or proportional taxes). Inflationary gap An inflationary gap. Thus acceleration in aggregate demand leads to acceleration in the rate of Investment. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10. "constant prices" GDP or "constant dollar" GDP. On the other hand. this situation cannot last forever. then the spending multiplier is 1. in economics. consequently causing inflation. expressed in base-year prices.S. fiscal policy is the use of government expenditure and revenue collection (taxation) to influence the economy Accelerator in term of managerial economics Accelerator comes from the Principle of Acceleration. This point is known as above full-employment equilibrium . When an initial increase in aggregate demand produces inflation (so called demand-pull inflation) and real GDP increase. then the money multiplier is 10. which should lead to falling prices (deflation) for those resources as the unemployed ones compete in the market What are the causes of inflationary gap? 36 . such a situation would lead to the existence of unemployed resources. the price level and real GDP are determined at the point where the new aggregate demand and the short-run aggregate supply meet. 180 or 200. this is one of the reasons this type of gap is called an inflationary gap. Obviously.U. It will still continue to provide the existing 100 pieces output (without investing in additional machinery) Reason: the diff between demand and Supply is only 20. The demand for the textile good is 60. Eg: A company manufactures 100 pieces of cloth with a textile Manufacturing Equipment. The shortage of labour produces the rise of wage rates. the potential GDP is the quantity of real GDP when a country's economy is at full-employment.e. Acceleration Principle means. since the short-run aggregate supply is above the long-term aggregate supply. In economics. Other types of fiscal multipliers can also be calculated. until it reaches the full-employment level. which makes the short-run aggregate supply decrease. is the amount by which the real Gross domestic product. because there is a shortage of labour. this is another reason this type gap is called an inflationary gap.
In general terms. investment means the use money in the hope of making more money. Total spending may rise faster than the economy's ability to supply goods and services.Inflationary gaps can arise when the economy has grown for a long time on the back of a high level of aggregate demand. as in a deposit account. the purchase of a financial product or other item of value with an expectation of favorable future returns. 2. actual GDP may exceed potential GDP leading to a positive output gap in the economy. such as durable equipment or inventory. wherein risk is higher The concept of investment states that any activity that makes an individual more productive or more potentially more productive is worthwile Investment 1. Saving is income not spent. versus investment. Methods of saving include putting money aside in a bank or pension plan. in the hope of improving future business 37 . Saving also includes reducing expenditures. saving specifies low-risk preservation of money. In finance. or deferred consumption. In business. the purchase by a producer of a physical good. As a result. In terms of personal finance. such as recurring costs.