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ECONOMIC$

Author: Jethro(:

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Table of Contents
Preliminaries!
What is Economics?! Forms of Economics ! Application of Economics!

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Opportunity Cost !
What?! Costs! Rational Choices ! Microeconomic Objectives ! Problems with calculating OC! Production Possibilities Frontiers (PPF)! Markets! Economic Systems !
Pros and Cons of Command Economy!

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The Free-market Economy!


Pros and Cons of Free-market Economy!

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The Perfect Combination: The Mixed Economy !

Supply and Demand!


Basic Assumptions of the Model! Demand! Determinants of demand!
Ceteris Paribus!

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Movements Along and Shifts in the Demand Curve !

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Other useful not in syllabus terms:!

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Supply! Determinants of supply !

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Firms & How They Operate!


Objectives of the Firm!
Revenue! Prot Maximization!

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Costs in the Long Run!


Internal Economies of Scale (IEOS)! Internal Diseconomies of Scale (IDisEOS)! External Economies of Scale (EEOS)! External Diseconomies of Scale (EDisEOS)!

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Growth of Firms!
Measuring Growth! Methods of Growth! Motives for Growth!

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Survival of Small Firms! Market Structure: Things to Note! Price Discrimination!


Conditions necessary for Price Discrimination! Types of Price discrimination! Costs and Benets of Price Discrimination!

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Preliminaries
What is Economics? The study of choice under conditions of scarcity Study choices individuals make Study the consequences of these choices Examples of scarcity (individual) Time Spending Power Our society faces a scarcity of resources Labour: time humans spend in producing goods and services Capital Physical: physical goods; machinery, equipment etc. Human: skills/knowledge of labour force Land: Physical space on which production takes place Entrepeneurship: Ability and willingness to combine the above 3 resources Ofcial denition: Economics is a social science that studies the allocation of scarce resources to the production of goods and services used to satisfy consumers unlimited wants. Forms of Economics Scale Microeconomics: Deals with individual actors 3 main categories of choice that must be made What G&S are going to be produced How are they going to be produced; using technology or manual labour? For whom are they going to be produced? These choices do not concern the total amount of national output, and are thus considered microeconomic choices Macroeconomics: Concerns the behavior of the behavior of the overall economy Societies are concerned that resources are used as fully as possible (efciency), and that over time their national output should grow A balance between aggregate demand(The total level of spending) and aggregate supply (the total amount of output) must be found If aggregate demand is too high relative to aggregate supply Ination: A general rise in prices If demand rises substantially, rms are likely to raise prices to increase revenue and prots Balance of trade decits: There is excess of imports over exports People more likely to buy more imports, resulting in home-produced goods being uncompetitive with foreign goods. Results in us purchasing more imports again, and people abroad not purchasing our exports If aggregate demand is too low relative to aggregate supply Recession: Output in economy declines; growth is negative Associated with a low level of consumer spending; shops nd themselves with unsold stock, thus buying less from manufacturers, resulting in reduced production Type
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Positive: study of how the economy works Disagreements arise from factual errors (understanding of economy is imperfect) Normative: study of what should be; used to make judgements Disagreements arise due to different values, weighing various consequences differently Application of Economics Create models An abstract representation of reality Should be as simple as possible to accomplish its purpose; accomplished by making assumptions Simplifying: any assumption that makes a model simpler without affecting any major conclusions Critical: Any assumption that affects the conclusions of a model in an important way

Opportunity Cost
What? What we must forego when we make the choice Not only about money; though it is easier to put a price for comparison When the alternatives to a choice are mutually exclusive, only the next best choice the one which would be chosen otherwise is used to determine the opportunity cost of that choice Costs Explicit: The dollars sacriced Figure 1: A basic PPF graph Implicit: value of something sacriced when no direct payment is made Opportunity cost of a choice includes both explicit and implicit costs Time is money: Quantifying time All production carries an opportunity cost: to produce more of something society has to shift more of its resources from somewhere else The Law of Opportunity Cost: The more of something we produce, the greater the opportunity cost of producing it, resulting in the concave shape for PPFs Rational Choices Choices that involve weighing up the benet of any activity against its opportunity cost Marginal costs and benets The costs and benets of doing a little bit more or less of a specic activity (Like derivatives - a tiny change) Rational decision making involves weighing the marginal benet and marginal cost of any activity

Microeconomic Objectives Achievement of economic efciency A situation where each good is produced at the minimum cost and where individual people and rms get the maximum benet from their resources. Efciency in production -> maximum output for given amount of inputs Efciency in consumption -> expenditures return maximum satisfaction Efciency in specialisation and exchange -> benets maximised relative to costs Last two known collectively as allocative efciency Achievement of equity
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Income distribution such that it is fair and just. Equitable distribution equal distribution Problem is people have different perspectives and notions of fairness Problems with calculating OC Requires time and information Sometimes not all information is at hand before we actually make a decision Varies with circumstance A context is required for such calculations; implicit costs vary under different circumstances Production Possibilities Frontiers (PPF) A curve showing all combinations of 2 goods that can be produced with the resources and technology currently available Point B, C and D lie on the curve, while point A lies in the curve This means that there is productive inefciency (One can tell that there is productive inefciency when there a greater quantity of a resource can be produced without a change in quantity of the other resource produced) Over time, the production possibilities of a nation are likely to increase. Investment in new plant and machinery will increase the stock of capital; new raw materials may be discovered; technological advances are likely to take place; through education and training, labour is likely to become more productive. This growth in potential output is illustrated by an outward shift in the production possibility curve. This will then allow actual output to increase

Markets
Barter economy: Workers paid with goods Money economy: forms exchange G&S for money Markets: The interaction between buyers and sellers Economic Systems Extreme systems Planned or Command Economy Decisions are taken by government/central authorities, rms and households have no power to inuence decisions Free-market economy 0 government intervention, households and rms act individually Most economies are a mixture of the two; the degree of government distinguishes economies from others (Eg. in communist systems government plays a better role) The informal sector: Parts of the economy that involve production and/or exchange, but with no money payments Economic activities in poorer areas involve subsistence production, and much of the production is in the informal sector To ensure that required inputs are available, input-output analysis is conducted Division of economy into sectors, each sector a user of inputs from and a supplier of outputs to other sectors, examining these inputs and outputs, matching to the total resources available Pros and Cons of Command Economy Pros
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Easy achievement of high growth rates by directing large amount of resources into investment Avoid unemployment by planning allocation of labour More equal distribution of national income Cons Complex economies result in costly administration Prices are set arbitrarily by state which results in inefcient use of resources; it is difcult to assess the relative efciency of two alternative techniques Difcult to devise appropriate incentives to be more productive without reduction in quality of production (eg. quantity vs quality balance) Loss of individual liberty The Free-market Economy Consumers are free to make demand decisions, but these are transmitted through their effect on prices; through the price mechanism Prices are those that both rms and consumers must accept The price mechanism: Prices respond to shortages and surpluses. When demand > supply (shortage), cost of the good will rise, and there is incentive to supply more to increase their overall revenue, but this will at the same time

discourage buyers from buying so much. When supply < demand (surplus), price will drop so producers can sell off their surplus produce, and consumers are thus more willing to buy the product. The price where demand = supply is the equilibrium price. (The same analysis can be used for labour, but in this case individuals are supply, while rms are demanders for labour, with wage being the price) A change in demand and supply will cause disequilibrium, which results in a change in price restoring equilibria. More of which will be discussed in the next chapter (Supply and Demand)

Pros and Cons of Free-market Economy Pros It functions automatically on its own
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Markets are highly competitive; no one has great power, and there is great competition between rms, so rms have incentive to become more efcient to maximise prots. Cons Some rms can monopolise the industry, charging high prices resulting in more prots, while powerless rms are driven to bankruptcy Macroeconomic instability: There can be periods of recession with high unemployment Can result in undesirable practices by rms to increase efciency (eg. releasing of sewage into rivers) The Perfect Combination: The Mixed Economy Most real-world economies have the government in control of the following: Relative prices of goods, through means of taxing and subsidy Relative incomes Resource allocation, through means of taxing and subsidy Control of bank lending and interest rates -> to solve problems of unemployment

Supply and Demand


Basic Assumptions of the Model The markets examined with this model are perfectly competitive/competitive Individuals too numerous to have power over pricing Acceptance of prices for things they buy -> price takers Consumers make sure the price they are paying is less than the satisfaction they obtain from their purchase Demand The law of demand: When the price of a good rises, the quantity demanded will fall Quantity demanded: the amount of a good a consumer is willing and able to buy at a given price per unit time 2 Reasons: Income effect: People will feel poorer; the purchasing power of their real income has diminished Substitution effect: People will turn to cheaper alternative goods Demand curves Represent the quantity demanded against price Determinants of demand Tastes: The more desirable the good, the higher the demand. Substitute goods: The higher the price of substitute goods, the higher the demand for the good in question Complementary goods: The supply and price of complementary goods (goods that are used together with the original good) affects the demand of the original good. If the price of a complementary good rises, the demand for the original good will fall Income: Normal goods -> a good whose demand rises as peoples incomes rise Inferior goods -> a good whose demand drops as peoples incomes rise Expectation of future price changes: If people expect the price of the good to rise in the future, the demand of the good will rise Distribution of income: rising income gap results in the demand for both inferior and normal goods to rise Ceteris Paribus Means all other things equal. A latin term commonly used in economics that states the assumption that none other determinants are varied. Movements Along and Shifts in the Demand Curve When one of the determinants of demand changes, a new demand curve has to be constructed A shift in the demand curve is a change in demand; a movement along the demand curve is a result of a change in quantity demanded Other useful not in syllabus terms: Demand function: equation showing the mathematical relationship between quantity demanded and the values of the various determinants of demand Regression analysis: A statistical technique which allows a functional relationship between two or more variables to be estimated
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Econometrics: The science of applying statistical techniques to economic data in order to identify and test economic relationships Supply When the price of a good rises, the quantity supplied will also rise (Law of Supply) As rms supply more, they are more likely to nd that beyond a certain level of output, costs rise more rapidly. Higher output involves higher costs of production per unit. Higher the price of the good, the more protable it is to increase production. New producers are also encouraged to set up in production First two affect short-run supply, third one affects long run Determinants of supply Costs of production: The higher the costs of production, the less prot made at any price, and thus rms cut back on production Change in input prices: wages

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Firms & How They Operate


The production function is the relationship between output and factor inputs The short run refers to period of time over which at least one FOP is xed The following assumptions are made during the SR TP = f(labour, capital) only Labour is the variable FOP and is considered homogenous Capital is the xed FOP and technology is held constant The Law of Diminishing Marginal Returns states that as more units of variable factors are applied to a given quantity of a xed factor, there comes a point beyond which each additional unit variable factor adds less to the total output than the previous variable factor.

Objectives of the Firm


Explicit costs are payments made to outside suppliers of inputs Implicit costs are costs which do not involve a direct payment to a third party Accounting cost is the monetary value of the explicit costs of production Economic cost is the total monetary value of explicit and implicit costs of production

Revenue Total revenue = Price Quantity Average revenue = Price = Demand Marginal revenue is the change in the rms total revenue resulting from a change in its sale by one unite The shape of the MR curve reects the shape of a rms DD curve The MR curve is always below a rms DD curve Prot Maximization Normal Prots Accounting Prot = Implicit Cost Zero economic prot Supernormal Accounting Prot > Implicit Positive economic prot Prots Costs Subnormal Accounting Prot < Implicit Negative economic prot Prots Costs Costs in the Long Run Increasing returns to scale Constant returns to scale Decreasing returns to scale output increase more than output increases output increases less than proportionately to the proportionately to the proportionately to the increase in inputs increase in inputs increase in inputs (technical economies of (technical diseconomies of scale) scale) The LRAC curve is a typically U-shaped curve From the producers point of view, all points on the LRAC are PE From the consumers point of view, only the lowest point on the LRAC (the MES) is PE The downward sloping half of the LRAC reect technical EOS The upward sloping half of the LRAC reect technical DOS

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Internal Economies of Scale (IEOS) IEOS are savings in average costs that occur to a rm as a result of expansion of the rm (LRAC falls) Technical EOS: Technical and engineering factors Factor indivisibility Equipment cannot be used fully when output is small Higher output = more efcient use of machines Increased dimensions Large machines may be more efcient More output for a given amount of input Less people needed to operate machines Linked processes A large factory may take a product through several stages in its production Save times and costs no need to move semi-nished products from one factory to another Specialization and division of labour In large scale factories, worker do simpler and repetitive jobs Less training is needed More efcient in a particular job More time saved in switching from one operation to another By-product economies waste to a small plant may be used in manufacture by larger plants Managerial EOS: Employment of specialists like nancial experts etc. Division of work increases efciency of workers in their own areas of responsibility Decentralisation of decision making also increase efciency of management o Distortion and delays of information are avoided Marketing/Commercial Economies: Large rms have bargaining advantage Preferential treatment buying in bulk Unit costs of transportation is decreased as well Financial Economies: Large rms nd it easier and cheaper to raise funds Risk-bearing Economies: Large rms have an advantage in bearing non-insurable risk R&D Economies: Large rms can afford R&D facilities Welfare Economies: Efciency of workers can be increased by provision of welfare services Economies of Scope: Large rms enjoy can enjoy economies of scope by increasing the range of products being produced xed costs are shared among products Internal Diseconomies of Scale (IDisEOS) IDOS are increases in average costs that occur to a rm as a result of expansion (LRAC rises) Complexity Management: A more complex organization requires more skilful entrepreneurs and managers to coordinate and control Expansion of ownership incentives for manages to reduce costs/increase prots decrease Long chains of authority leads to a time-lag in decision implementation Extensive red-tape leads to slow responses to change in D&S conditions Strained Relationships: Lack of personal loyalties on behalf on workers toward the company External Economies of Scale (EEOS) EEOS are the savings in average costs that occur to all rms in an industry as a result of expansion of the industry, or the concentration of rms in a certain location (LRAC shifts down)
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Economies of Concentration: More rms located in the same area derive mutual benet Availability of Skilled Labour increased demand for particular skills give benets Educational institutions set up Joint development of research and training facilities Well developed infrastructure Better infrastructure is set up to cater for economies of concentration Reputation large, well established industries builds up a name which customers associate with quality 1. Brand loyalty, steady clientele Economies of Disintegration: Creation of subsidiary industries to cater to need of a major industry Economies of Information: Publication of trade journals increase productivity of individual rms External Diseconomies of Scale (EDisEOS) EDOS are increases in average costs that occur to all rms in an industry as a result of the expansion of the industry or the concentration of rms in a certain location. (LARC shifts up) Increased strain on infrastructure: Infrastructure will be taxed to its limits 2. Congestion, increased fuel consumption Rising costs of FOPs: Growing industries may create a shortage of RMs or skilled labour

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Growth of Firms Measuring Growth 1. Quantity of output sold 2. Turnover (total annual revenue) 3. Market share 4. Capital stock (amount of real assets) 5. Number of employees Methods of Growth Internal Expansion: Making more of a product, or extending a rms product range Mergers & Acquisitions: Forming of new enterprises by the merging with, or taking over of one or more existing rms. 1. Vertical Integration o Merger between rms engaged in different stages of a production process Backward integration (oil reneries buying oil wells) Forward integration (breweries buying pubs) 2. Horizontal Integration o Usually an acquisition of rm(s) at the same stage of production in the industry Market dominance due to reduced competition Greater specialization and economies of scale 3. Conglomeration o Mergers involving rms which are not directly related to each other Diversify output Reduce risks of trading Ensure long term growth Motives for Growth See Measuring Growth 1. Exploit EOS 2. Gaining market share 3. Security through economies of scope 4. Increase market valuation 5. Reduce chances of acquisition by another rm

Survival of Small Firms


Demand-side Factors Supply-side Factors

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Nature of product Bulky and perishable products: bricks, fresh sh Products for which variety is preferred: clothes Specialized products: machines, religious items Prestige markets Markets limited by prices: luxury vehicles, jewelery Direct, personalized services G&S where direct, individual attention Is required: lawyers, doctors, dentists, hairdressers Geographical limitations Local markets due to larger bulk as compared to value and transport costs

DOS setting in early MES is low: tailor shops Vertical disintegration Small rms perform small parts of a larger production process when disintegration occurs Low entry barriers Lack of capital Product-life cycles Banding allows small rms to band together to gain advantages of bulk buyinh Non-traditional motives etc. etc.

Market Structure: Things to Note Bases for comparison of market structures efciency and equity The Theory of Contestable Markets shows how monopolies or near monopolies may practice competitive pricing due to low barriers to entry and exit The market for low cost carriers is extremely contestable (~$10m investments) The concentration ratio of an industry measures the output of an industry largest rm (or rms) as a proportion of the industrys total output. For PC, the concentration ratio extremely low For a monopoly, the concentration ratio is almost 100% Market saturation refers to the situation in which a product has become diffused within a market. A diffused product is one that is available to almost all consumers, or more applicably, almost all households, for example the refrigerator or an automobile. Market growth is constrained and demand cannot be stimulated when a market is saturated. The factors affecting market saturation include Consumer purchasing power and prices Competition Technology (dynamic efciency) Product life cycles (when products will get replaced by newer products) Population growth Price Discrimination Price discrimination is the situation where (a) a producer sells a good to different buyers at two or more different prices or (b) when the same consumer is charged different prices for the same product for reasons not associated with cost differences. Conditions necessary for Price Discrimination 1. Control over market supply 2. Ability to segment the market without possibility arbitrage 3. Market segments must have different PEDs

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Types of Price discrimination First degree Second degree (block pricing) Each customer is charged Different prices are charged his reservation price (the for different blocks of the maximum price they are same good. willing to pay) Auctions Utilities, taxi fare

Third degree Same product sold at different prices to different customers. Admission tickets to parks, etc.

Costs and Benets of Price Discrimination Costs 1. Loss of consumer surplus Benets 1. Higher output 2. Higher prots for the rm 3. Provision of goods that would otherwise not be produced a. With PD, a rm may be able to cover costs

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