Economics for Business and Management - Essay Example

? ASSIGNMENT Module Economics for Business and Management Module BC115008S Question In 1976, Mr. Adam Smith who is also said to be thefather of economics devised the term invisible hand in his book. He said that if everyone tried to pursue their own motives and benefits through trade and activity, the economy as a whole will benefits from it more than the hard work put in. (Investopedia, 2011). It is a natural force that comes into effect in free market through improving efficiency. Resource allocation refers to the process of distributing resources in an economy. There are a number of ways in which an economy can allocate resources amongst itself. As we know that resources are scarce and wants are unlimited, so there are alternatives uses of the resources available with us. Therefore there has to be a way to make the most efficient allocation of resources, where the largest number of wants is satisfied (Glossary, 2011). Some of the most common ways of allocating resources include Command economy Free market economy Mixed economy Free market or pure market economy refers to capitalist economy where the resources for production of goods and services are allocated by market price, which is determined by market forces of demand and supply. Command economy is one in which resources are allocated by a central authority, and the good of maximum number of people is looked for. Mixed economy is a combination of both pure market and command economy. In it there is private as well as public sector, the private sector comprises of individuals who are free to allocate resources anywhere they want as long as they have the financial strength to do so, whereas the public sector comprises of government control over the economy to an extent. Demand refers to the quantity of goods or service that consumers desire to have at a given price. The law of demand says that as price of a product goes up, its quantity demanded falls, with other things held constant. The reason for it is that as the price goes up the opportunity cost of buying it also rises so people are willing to forgo its consumption and look for alternatives. The graph below shows demand function. As the price decreases, more consumers are willing and able to buy more of the product, hence the downward sloping curve. None of the consumers is willing to buy anything at $3 or $2.5, therefore the demand is 0. The factors that commonly influence demand conditions (with other things held constant) are, changes in tastes and preferences, income of people influences the demand of normal and inferior goods, changes in the size of population, weather, changing expectations and prices of other related goods such as substitutes and complements. Changes in these factors will shift the demand curve. The graph below shows the demand of the product increases without any change in the price. This is because some of the non-price factors have changed causing a shift of the curve. Had this been only a price change, the quantity demanded would have moved on the slope. Supply refers to the quantity of a product that the producers are willing and ready to produce at a given price. The graph below shows supply function. The supply function is upward sloping. This is because the greater the price, the greater will be incentive to produce more and hence the supply will increase. Changes in supply curve can occur because of a number of reasons such as change in technology, the cost of producing other goods and services such as substitutes, taxes and subsidies, changes in input costs, number of producers in the market and weather. Change in these factors causes the supply curve to shift. The market equilibrium is where the demand and supply curves intersect. This is the point where there is a balance between the demand and supply of a product. The price where the curves intersect is called the market price and this is where both the consumers and producers are willing to supply a certain quantity. The graph below shows In the short run period when the producers cannot adjust all the factors of production, the market can come into a new equilibrium point after a supply shock or due to major changes in demand; but in the long run when all the factors of production are variable, prices can adjust and can come to their original position as it was before the shock. Consumer Surplus: Consumer surplus is when the consumer is able to buy a product at a price which is lower than what the consumer is willing to pay for a certain quantity. Consumer surplus is represented on the graph by the area under the demand curve and above the market price. (Tutor2U). In this case, the consumers are purchasing the product $1. However, the consumers are willing to pay more for certain quantities. For example, consumers are willing to pay $1.5 for a quantity of 20. Therefore all the area between the demand curve and the market price line is classified as consumer surplus. Producer Surplus: Producer surplus is when the producer is able to sell a product at a price which is higher than the lowest price the producer is willing to supply at. The producer surplus is represented on the graph below by the area in green above the supply curve and below the market price. For example, the producer is willing to supply a quantity of 50 for a price of $10, but still producer is earning a price of $15 for a quantity of 50. Producer surplus is the area below the market price and above supply curve. Deadweight Loss: Deadweight loss is when the quantity produced is either greater than or less than the optimal quantity. When there is over-production or under-production, there is said to be inefficiency in the market because the quantity demanded and supplied is not at the optimal point. The graph below shows dead weight loss as the area shaded in blue. For example, if the quantity produced is 5000, then the area colored blue on the left of equilibrium quantity is dead-weight loss. A major disadvantage of price mechanism in free market is that at times there is misallocation of resources because only those quantity of goods is produced which can be measures by the buyer and seller only. However there are a number of third-party costs and benefits which people other than the buyer and seller face due to an economic activity. These are external costs and benefits. External costs These are third-party costs which are incurred by people who are not involved in the transaction, for example the costs of bearing a polluted environment for people living near industrial area. External benefits These are the benefits enjoyed by people who are not involved in the transaction, e.g. if there is a new farm near your area, you will benefit from the improved view of the area and possible appreciation of land prices. These benefits result social benefits that are not part of the demand curve so the equilibrium quantity produced and consumed is less than the equilibrium or efficient quantity that should be produced. The graph below shows the social demand to be more than the private demand, because the social demand includes the social benefits and gives the benefits gained by the society as a whole. Thus the ideal equilibrium is at price Ps and the quantity at Qs; whereas the actual equilibrium, which includes only private benefits and costs, has a lower quantity Qp and lower price Pp. Imperfect competition Monopoly Monopoly is when there is a single supplier of a product in the market and there is no good substitute available. For a firm to become and maintain a monopoly position in a market it is important to have high barriers to entry. These barriers can be Legal, such as patents, copyrights, and government-related franchises. Natural barriers, such as economies of scale production, gaining control over natural resources etc. Monopolies can involve in single-price pricing strategy or in price discrimination. Monopolies are motivated to capture as much or consumer surplus as they can, thus creating dead weight loss, thus earning supernormal profits. The graph below shows short-run cost and revenue curves of a typical monopoly earning supernormal profits by setting he quantity at which marginal cost and marginal profits intersect, and pricing them at the average revenue curve. Oligopoly Oligopoly is form of competition in the market in which there are a small number of sellers, which have high interdependence. They produce similar or differentiated products, and put large barriers to entry in an industry usually through economies of scale. The firms in an oligopoly do not work together explicitly but the moves of a large firm have a significant impact on the strategies of other firms in the market. Auto-industry is an example of oligopoly. In the dominant firm oligopoly model, these is one large firm that has the lowest industry costs, has a large proportion of market share and has significant influence over other market participants. Prisoners’ dilemma is a very noteworthy oligopoly game which examines the strategic behavior of firms in an oligopoly. Cartels Cartel is an explicit form of agreement among firms in which they agree to limit quantity, fix prices and are involved in non-price competition only. There are private and public cartels. In public cartels, the government is involved in enforcing the cartel, whereas private cartels are enforced by firms on their own. Public goods These goods are non-rivalry and non-excludable goods that can be consumed by many people simultaneously without reducing their value because of consumption e.g. national defense. Due to the inherent benefits of such goods and their non-excludable nature, they are provided by government because no private firm does so without charity. Market price is not a good way to determine the price of such goods. Conclusion Relying on market forces represents a unique way of allocating resources according to the price and quantity determined by the market forces of demand and supply. This way the consumer can choose from whatever they want to buy, and producers can pursue the risks and rewards to produce what they want. Free market is also driven by innovation that leads to new products and more choice for the consumers, which is duly rewarded in the form of profits. Competition is a prominent feature of free market where a large number of producers compete in the market to earn economic profit. The best products in the market are the ones that earn sufficient enough to stay and have adequate quantity sold, whereas the poor performers have to quit because they cannot support themselves financially in the long-run. But at the same time free market has a lot of disadvantages in the practical world. For instance it is very difficult to reach a single price for a sufficient amount of time because market forces make the price very volatile. Firms also produce for profit motive only and goods for lower income groups are usually not produced because they cannot afford to pay for it. Because of free market the competition has increased and firms have to produce in their most efficient manner, they layoff worker without caring about the level of unemployment in the economy (Economy-Watch, 2011). In the long-run, mixed economy is the best option because it encourages efficiency in the private sector and provides the welfare role of state in the public sector in the economy. Question 2 Credit crunch refers to credit crisis or an economic situation where obtaining capital is difficult. It is most prevalent in recession when the supply of funds falls drastically due to unstable and poor financial performance of the economy (Investopedia, credit crunch, 2011). The financial crisis of late 2000s was also triggered by shortfall of finances in the US banking system, which eventually impacted world economy. Large financial organizations in USA collapsed and had to be bailed out. Credit crunch usually results due careless lending e.g. on subprime mortgages, which lead to large number of non-performing loans increase. As people start defaulting, financial intermediaries and institutions face liquidity problems because even they get short of cash. Prices of most large investments come down, for example property prices came down drastically which also discouraged mortgage subscribers to default on payments because of disincentive to pay. This credit crisis originated in America but from there it spread to other parts of the world like England, and Asian countries. The equity markets and exports in almost all countries faced downturn. The purpose of government in an economy is to reduce uncertainties and to smooth business cycles, and it has a number of tools to do so. Government can influence the amount of spending or aggregate demand in an economy as well as the level of inflation. Let’s categorize these tools as part of different government’s economic policies. Fiscal policy Fiscal policy refers to government’s use of taxation and spending to influence the economy and achieve its macroeconomic objectives. Government spending influences aggregate demand in an economy, whereas taxation has supply –side effects that influence long-run aggregate supply. In a given year if the spending is more than taxation then it is budget deficit; however id the tax revenue collected are greater that the spending, it is called budget deficit. In case of budget surplus, the government saves its funds, whereas in case of budget deficit the government has to borrow to finance the deficit. Budget deficits cause funds to fall and interest rates to rise. The sources of investment from the government are national saving, government saving and borrowings from abroad. The purpose of fiscal policy is to smooth business cycles. Monetary policy Monetary policy in an economy is run by its central bank, e.g. Federal Reserve in U.S., its purpose is to control inflation, moderate long-term interest rates and increase help the economy reach full employment level. The central bank has a number of tools available with it to control the monetary condition is an economy such as discount rate, required reserve ratio and open market operations. It is responsible to control the money supply in an economy. The central bank also tries to keep the foreign exchange rates with other countries stable. It is commonly said that the financial crises was a result of excessive monetary expansion on the part of the government (Genetski, 2008). Fed reduced the reserve ratio in the banks, allowing more money to be available for giving loans and investments. The money supply in the economy rose and there was excessive spending that induced inflation. During 2005, the Fed tightened its monetary policy by controlling the money supply, as a result the nominal GDP fell, and spending also went down causing. The Fed then increased the required reserve ratio which further led to fall in spending in the economy. Eurozone: During the financial crisis, European Central Bank reduced it interest rates by cumulative 325 basis points to 1%, in order to enhance the credit flows and financing (Gonzalez-Paramo, 2010). Even the governments in the Eurozone injected significant amounts of funds into the financial institutions and to stabilize the financial sector. During the financial crisis the governments have accumulated a lot of budget deficit to boost the economy in the short-run. The outcome of the financial crises is Europe is such that debt-to-GDP ratio is increasing which is a source of concern. These deficits have exceeded 3% in value. Lessons Some of the lesson that we can learn from the recent financial crisis include that the exchange rates need to be kept flexible in order to automatically reduce the impact of a fiscal shock. For instance if the GDP and exports of a country are low, the value of currency will fall, thus making the exports more competitive and the imports costlier, but if the exchange rates were pegged at high value then the exports couldn’t become competitive and the government would have exhausted its reserves to maintain the exchange rate. Secondly, prudential regulation should be more stringent and there should be checks and limits on the amount that organizations can give out or leverage (Berkmen, Gelos, Rennhack, & Walsh, 2010). Banks should be proactive in finding out the credit worthiness of their clients before giving out loans to them. Moreover the government should keep reserves with it during period of boom, so that they can be utilized in difficult times instead of increasing the supply and creating inflation. Bibliography Berkmen, S. P., Gelos, G., Rennhack, R., & Walsh, J. P. (2010, march 28). The global financial crisis: Why were some countries hit harder? Retrieved april 17, 2011, from vox: http://www.voxeu.org/index.php?q=node/4806 Economy-Watch. (2011). Advantages of Market Economy. Retrieved april 17, 2011, from Economy Watch: http://www.economywatch.com/market-economy/advantages-market-economy.html Genetski, R. (2008, dec 11). The Contribution of Monetary & Fiscal Policies to the Current Financial Crisis - by Robert Genetski. Retrieved april 16, 2011, from heartland.com: http://www.heartland.org/article/24130/The_Contribution_of_Monetary_Fiscal_Policies_to_the_Current_Financial_Crisis.html Glossary, E. (2011). Economic Definition of resource allocation. Defined. Retrieved April 15, 2011, from Economics Glossary: http://glossary.econguru.com/economic-term/resource+allocation Gonzalez-Paramo, J. M. (2010, feb 26). Monetary and fiscal policy interactions during the financial crisis. Retrieved april 17, 2011, from European Central Bank: http://www.ecb.int/press/key/date/2010/html/sp100226.en.html Investopedia. (2011). credit crunch. Retrieved april 16, 2011, from Investopedia: http://www.investopedia.com/terms/c/creditcrunch.asp Investopedia. (2011). Investopedia. Retrieved April 15, 2011, from http://www.investopedia.com/terms/i/invisiblehand.asp Tutor2U. (n.d.). Microeconomics - Consumer Surplus. Retrieved from Tutor2U: http://tutor2u.net/economics/revision-notes/as-markets-consumer-surplus.html Read More