EXTERNAL ANALYSIS – ECONOMIC FACTORS

CHAPTER 7
CHAPTER LEARNING OBJECTIVES

 Define the concept of demand and supply for goods and services
 Explain elasticity of demand and the impact of substitute and complementary goods
 Explain the economic behavior of cost in the short and long term
 Define perfect competition, oligopoly, monopolistic competition and monopoly
 Define macro-economic policy and explain its objectives
 Explain the main determinants of the level of business activity in the economy and how variations in the level of
business affect individuals, households and businesses
 Explain the impact of economic issues on the individual, the household and businesses: inflation, stagnation,
unemployment, international payments disequilibrium
 Describe the main types o economic policy that may be implemented by the government and supra-national
bodies to maximize economic welfare
 Recognise the impact of fiscal and monetary policy measures on the individual, the household and businesses
INTRODUCTION

Economics
 Economics is the study of how society allocates
scarce resources, which have alternative uses,
between competing ends.
 It is the study of wealth creation.
Microeconomics Macroeconomics
MACRO AND MICRO ENVIRONMENT
ELEMENTS OF MICRO ENVIRONMENT
MICROECONOMICS

Microeconomics focuses on how the individual parts of an economy make

decisions about how to allocate scarce resources.
IMPORTANT CONCEPT

 Utility: Pleasure, satisfaction or benefit derived from consumption of goods or services.

 Total utility: Total satisfaction that people derive from spending their income on consuming goods.
 Marginal Utility: Satisfaction gained from consuming one additional unit of goods or satisfaction
forgone by consuming one unit less.
 Economists assume consumer act rationally: prefer more goods, substitute goods. That is
consumer attempt to maximize total utility with a limited income.
 Price theory: Market prices for goods are arrived at through the interaction of demand and supply.
DEMAND

 Demand is the desire, ability,

and willingness to buy a product
 Law of demand states that other
factors being constant (cetris peribus),
price and quantity demand of any
good and service are inversely related
to each other.
 Substitution effect and income effect
IMPACT OF MARGINAL UTILITY IN DEMAND
DEMAND
DEMAND

 Factors affecting demand curve:

 Price
 Income effect
 Tastes
 Price of other goods(substitution effect)
(complementary effect)
 Population
Note: If price is changes keeping other factors
constant the demand curve expand or contract.
If price is Keep constants and other factors
changes the demand curve shift.
ELASTICITY OF DEMAND

Elasticity refers to the relationship between two variables and measures the
responsiveness of one (dependent) variable to a change in another (independent)
variable.
ELASTICITY OF DEMAND
PRICE ELASTICITY OF DEMAND (PED)

Point PED = % change in

quantity demanded / % change in
price Description PED Example
Arc PED = % change in quantity Relatively inelastic <1 Tea, Salt
demanded relative to average Unit Elastic =1 -
demand / % change in price
relative to average price
Relatively elastic >1 Camera, air travel
PRICE ELASTICITY OF DEMAND (PED)
ARC ELASTICITY VS POINT ELASTICITY OF DEMAND

Point Elasticity of Demand

Arc Elasticity of Demand
 Use to measure elasticity of demand at one
particular point in the demand curve.
 Use to measure elasticity to a large change in price.  Assume that demand curve is straight line
 Measure of elasticity of demand between two points  Measure as percentage change in quantity divided
in the demand curve. percentage change in price.
 Measure as percentage change in quantity relative
to average quantity divided percentage change in
price relative to average price.
ARC ELASTICITY OF DEMAND
SOLUTION
QUESTION
SOLUTION
FACTORS THAT INFLUENCE PED

 Proportion of income spent on the good

 Substitutes
 Necessities
 Habit
 Time
 Definition of market
INCOME ELASTICITY OF DEMAND
INCOME EFFECT

 What will be the effect of price

quantity demanded and
quantity supplied of luxury
sports car if income tax is
significantly reduced?
EFFECT OF INCREASE IN INCOME ON LUXURY GOODS
CROSS ELASTICITY OF DEMAND (XED)

 XED measures the Sign of XED Type of goods Example

sensitivity of demand for Positive Substitute goods Butter and
one good to changes in the Cheese
price of another good.
Negative Complementary Bread and
goods Butter
CROSS ELASTICITY OF DEMAND (XED) - SUBSTITUTE
CROSS ELASTICITY OF DEMAND (XED) - COMPLEMENTARY
SUPPLY

 Law of supply is states that, all other factors being

equal, as the price of a good or service increases, the
quantity of goods or services that suppliers offer will
increase, and vice versa.
SUPPLY
SUPPLY

 Upward Shift of Supply

 Higher production costs
 Indirect taxes
 Downward Shift of Supply
 Technological innovations
 Efficient use of existing factors of
production
 Lower input prices
 Reduction/ abolition of indirect tax
EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY
SHIFTS IN SUPPLY AND/OR DEMAND

P1

D1

Q1
EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY

 Price acts as a signal to sellers on what to produce.

 Price rises, with all other market conditions unchanged, will act as a
stimulus to extra supply.
 Equilibrium price is where the plans of both buyers and seller are
satisfied.
MINIMUM AND MAXIMUM PRICES
Minimum Price Maximum Price
FACTOR OF PRODUCTION

Factor of Production Costs

Fixed Those which remains constant irrespective of
volume of production(units) in short run. E.g. land,
machinery
Variable Those which varies with the volume of production
(units). E.g. labour, raw materials
Cost of purchasing fixed factor of production. E.g.
rent, depreciation insurance and other fixed
overheads.
Cost of purchasing variable factor of production.
E.g. wages, raw material cost, and other direct
cost.
THE LAW OF DIMINISHING RETURN

 Diminishing marginal returns (unit) is based on principle of variable proportions.

 assuming one factor is fixed,
 the marginal unit generated from adding one new variable factors will not be
constant.
 In fact, units will rise at first, reach a turning point, and then eventually diminish.
LAW OF DIMINISHING MARGINAL PRODUCTION

 Law of Diminishing Marginal Production

COST OF PRODUCTION IN SHORT RUN

TOTAL FIXED COST TOTAL VARIABLE TOTAL COST

OUTPUT
(TF) COST (TVC) (TF+TVC)

1 100 50 150
2 100 80 180
3 100 100 200
4 100 110 210
5 100 150 250
6 100 220 320
7 100 350 450
8 100 640 740
COST CURVE IN SHORT RUN
AVERAGE FIXED COST

AVERAGE FIXED COST

OUTPUT TOTAL FIXED COST (TFC)
(TFC/Output)
1 100 100
2 100 50
3 100 33.3
4 100 25
5 100 20
6 100 16.6
7 100 14.3
8 100 12.5
AVERAGE FIXED COST CURVE IN SHORT RUN
AVERAGE VARIABLE COST CURVE IN SHORT RUN

AVERAGE VARIABLE COST

OUTPUT TOTAL VARIABLE COST (TVC)
(TVC/Output)
1 50 50
2 80 40
3 100 33.3
4 110 27.5
5 150 30
6 220 36.7
7 350 50
8 640 80
AVERAGE VARIABLE COST CURVE IN SHORT RUN
AVERAGE TOTAL COST

AVERAGE FIXED AVERAGE VARIABLE AVERAGE TOTAL

OUTPUT
COST (AFC) COST (AVC) COSTS (ATC)
1 100 50 150
2 50 40 90
3 33.3 33.3 67
4 25 27.5 52.5
5 20 30 50
6 16.6 36.7 53.3
7 14.3 50 64.3
8 12.5 80 92.5
AVERAGE TOTAL COST CURVE
MARGINAL COST
 Marginal cost is the cost of producing one extra unit of output.
 It is change in total variable cost when output is increased by one unit as fixed cost does not change
with units.

OUTPUT TOTAL COST MARGINAL COST

1 150
2 180 30
3 200 20
4 210 10
5 250 40
6 320 70
7 450 130
8 740 290
MARGINAL COST CURVE
SIGNIFICANCE OF MARGINAL COST

 changes in total and average costs are derived from changes in marginal cost
 The lowest price at which firm is willing to supply is the price that just covers
marginal cost.
RELATIONSHIP BETWEEN ATC AND MC

 Marginal cost will always cut average total cost from below.

 When marginal cost is below average total cost, average total cost is falling, and when
marginal cost is above average total cost, average total cost is rising.

 A firm is most productively efficient at the lowest average total cost, which is also
where average total cost (ATC) = marginal cost (MC)
THE ECONOMIC BEHAVIOR OF COSTS

Short term cost behavior

THE ECONOMIC BEHAVIOR OF COSTS

Short term cost behavior

TOTAL COSTS AND MARGINAL COSTS
 FC
 VC
 TC
 Short run Vs Long Run
 Diminishing Marginal Return
 AFC
 AVC
 ATC
 MC
 MR
 AR
 TR
THE ECONOMIC BEHAVIOR OF COSTS

Long term cost behavior

PERFECT COMPETITION

 A firm in perfect competition faces a perfectly elastic demand curve for its product—that is, the firm’s
demand curve is a horizontal line drawn at the market price level.

 Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by
exactly the same amount equal to the market price.

 Therefore, Firm’s marginal revenue curve is the same as the firm’s demand curve.

 Marginal revenue = changes in total revenue / changes in quantity

PERFECT COMPETITION

 Allocative Efficiency: As output will always occurs where MC=AR (where AR= TR/output units= Price per
unit)

 Productive Efficiency: In short run no productive efficiency as output will not always occur where MC=AC.
However, in long run when the new firms enters competition reduces price of the product and cost of
factor of production at a point where P=MC=AC
 PERFECT COMPETITION IN SHORT RUN

In the short run, it is possible for an individual firm to make an economic profit. This situation is shown in this diagram, as
the price or average revenue, denoted by P, is above the average cost denoted by C .
 PERFECT COMPLETION IN A LONG RUN

However, in the long run, the arrival of new firms or expansion of existing firms causes the (horizontal) demand curve of
each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal
revenue curve. The demand curve will touch its average total cost curve at its lowest point. Therefore, the firm will make
only normal profit (zero economic profit).
PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM

 A perfectly competitive firm has only one major decision to make - what quantity to produce as price
is fixed by market demand and supply.
 To understand why this is so, consider the basic definition of profit:

 Profit =Total revenue−Total cost

=(Price) * (Quantity produced) − (Average cost) * (Quantity produced)
COMPARING MARGINAL REVENUE AND MARGINAL COSTS
IN PERFECT COMPETITION

 In this example, every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by
$4, as you can see in Table. This condition only holds for price taking firms in perfect competition
where marginal revenue = price

Price Quantity Total Revenue Marginal Revenue

$4 1 $4 –
$4 2 $8 $4
$4 3 $12 $4
$4 4 $16 $4
 COMPARING MARGINAL REVENUE AND MARGINAL COSTS
IN PERFECT COMPETITION

As long as MR > MC. a profit-seeking firm should keep expanding production. Expanding production into the zone where MR <
MC reduces economic profits. MR = MC is the signal to stop expanding, so that is the level of output they should target.
PROFIT/LOSS WHEN PRICE IS ABOVE AVERAGE COST
PROFIT/LOSS WHEN PRICE EQUALS TO AVERAGE COST
PROFIT/LOSS WHEN PRICE IS BELOW AVERAGE COST
DETERMINING THE HIGHEST PROFIT BY COMPARING TOTAL
REVENUE AND TOTAL COST IN PERFECT COMPETITION
SHUTDOWN POINT – NOT PRODUCING TEMPORALLY

 Should produce until P > AVC , P <AVC is the shutdown point

 By shutting down a firm avoids all variable costs. As the firm must still pay fixed costs regardless of
whether a firm operates, they should not be considered in deciding whether to produce or shut down.

 Therefore, shutdown if TR < VC

 If the firm decides to operate, the firm will continue to produce where MR = MC which ensure not
only profit maximization (loss minimization) but also maximum contribution.
PERFECT COMPETITION
In perfect competition a firm’s demand curve is a horizontal line drawn at the market price level and that P=MR. With
this in mind, based on the figure below, what is the total costs :

Cost/Price

Output in units
THE SHORT-RUN (SR) SUPPLY CURVE FOR A PERFECTLY
COMPETITIVE FIRM

 The short-run (SR) supply curve for a perfectly competitive firm is the marginal cost (MC) curve
at and above the shutdown point.

 Portions of the marginal cost curve below the shutdown point are not part of the SR supply curve
because the firm is not producing any positive quantity in that range.
TYPES OF MARKET

Perfect Monopoly
Market
Imperfect Monopolistic

Oligopolies
PERFECT MARKET

1. Large number of customers and suppliers – none of whom

have the power to dominate the market.
2. Identical (homogeneous) products and/or services
3. Perfect information
4. No barriers to entry or exit
MONOPOLY

1. Single seller
2. Entry barriers
3. No close substitute
4. Price maker
MONOPOLISTIC COMPETITION

1. Large number of buyers and sellers

2. Free entry and exit
3. Product differentiation
4. Price makers
OLIGOPOLIES

1. Few sellers
2. Barriers to entry
3. Non-price competition
4. Homogeneous or differentiated products
MACROECONOMICS

 Aggregate demand for goods and services

 Output of goods and services
 Supply of factors of production
 Total incomes earned by providers of factors of production
 Labour – Wages
 Land – Rent
 Capital – Interest
 Entrepreneurship – Profit
CIRCULAR FLOW OF INCOME AND EXPENDITURE IN CLOSED
ECONOMY
WITHDRAWAL AND INJECTIONS INTO CIRCULAR FLOW OF
INCOME
THE MULTIPLIER EFFECT IN THE CIRCULATION OF INCOME

 The initial increase in expenditure by government in the economy leads to further

and further expenditure in the economy.
 Total expenditure in the economy is one way of measuring national income.
 The increase in national income will be a multiple of initial increase in government
expenditure (government spending).
 The size of multiple is influence by proportion of new investment and saving.
MACROECONOMIC POLICY

 Main objectives
 Economic growth
 Low inflation
 High employment
 Sustainable balance of payments
LEVEL OF BUSINESS ACTIVITY IN ECONOMY

Consumer spending (C)

+ Investment by firms (I)
+ Government Spending (G)
+ Demand for export (X)
- Demand for import (M)
Aggregate Demand
LEVEL OF BUSINESS ACTIVITY IN ECONOMY

 Consumer Confidence
 Capital
 Government policy
 Exchange rate movements
 Use of resources
TRADE CYCLE
THE EFFECT OF KEY ECONOMIC ISSUES

 Stagnation and economic growth

 Inflation
 Unemployment
 Balance of payment
ECONOMIC POLICY OPTIONS

Fiscal policy
• Two elements: Income and Expenditure
• Budget deficit Vs Budget Surplus
• Expansionary policy Vs Contractionary Policy
• Deflationary gap Vs inflationary gap

Monetary policy
• Interest rates
• Reserve requirement
• Open market conditions
ECONOMICS THEORIES

Classical Theory
• Government does nothing
• Great Depression 1920s and 1930s
Keynesian view
• Government intervention is needed.
• Demand side economics
Monetarist view
• Role of government is only to remove imperfections.
• Supply side economics
ACHIEVING POLICY OBJECTIVES

 Growth
 Unemployment
 Inflation
 Balance of payment
ACHIEVING POLICY OBJECTIVES

Growth Unemployment
 Running a budget deficit  Cyclical unemployment
 Increasing the availability of production  Frictional unemployment
factors  Structural unemployment
 Cutting interest rates
 Seasonal unemployment
 Other policies
 Real wage unemployment
ACHIEVING POLICY OBJECTIVES

Inflation Balance of payments

 Demand-pull inflation  Expenditure-reducing strategies
 Cost-push inflation  Expenditure Switching strategies
 Imported inflation
 Monetary inflation
 Expectation inflation
CHAPTER LEARNING OBJECTIVES

 Define the concept of demand and supply for goods and services
 Explain elasticity of demand and the impact of substitute and complementary goods
 Explain the economic behavior of cost in the short and long term
 Define perfect competition, oligopoly, monopolistic competition and monopoly
 Define macro-economic policy and explain its objectives
 Explain the main determinants of the level of business activity in the economy and how variations in the level of
business affect individuals, households and businesses
 Explain the impact of economic issues on the individual, the household and businesses: inflation, stagnation,
unemployment, international payments disequilibrium
 Describe the main types o economic policy that may be implemented by the government and supra-national
bodies to maximize economic welfare
 Recognise the impact of fiscal and monetary policy measures on the individual, the household and businesses