Supply & demand & elasticity issues. Theories of the firm. Macroeconomic issues - Essay Example

?Supply & Demand and Elasti Issues, Theories of the firm, Macroeconomic issues Summary The firms are affected by various factors in the microeconomic and macroeconomic environment in its operations. The part I of this paper seeks to study the fundamental principles of supply and demand and elasticity issues relating to the firms by way of analysing particular economic situations a firm may encounter in its operations. To render focus to the analysis of the specific issues in connection with the study of supply and demand elasticity, some of the statements given have been analysed conclusions arrived at as to whether these statements are conceptually correct or not. In Part II of the study, various theories of the firm are discussed. Much of conventional analysis within microeconomics is centered on the classical firm and its objective of profit maximization. The paper analyses the premises which underline the profit maximization objective to understand their relevance under the changed economic conditions over the period of time since they have been postulated. Mainly the criticisms are with regard to the assumptions made by the classical theorists in respect of competition, full information, full employment and pricing of the products. The major changes which have occurred over the period of time and its effect on business are discussed. The evolution of theories in line with these changes needs to be considered, and in this regard, some of the important micro economic theories, viz. neoclassical theory, transactions cost theory, principal agent theory evolutionary theory and behavioral theories are discussed in this context to reflect upon their utility under the current economic environment. In Part III the impacts of macro-economic factors on the firms are analyzed. The relevance of GDP and budget deficit to the operations of the firm in terms of its impact on their business is discussed with particular reference to Spain’s economy. The government actions by way of cuts in spending, taxation and borrowing and the multiplier effect of investments on the economy have impact on the businesses. The aggregate demand and aggregate supply in an economy and the governmental actions needed to spur growth of the economy are also discussed in Part III. The governmental actions include labor reforms which are discussed under a separate head. Supply & Demand and Elasticity Issues, Theories of the firm, Macroeconomic issues Table of contents PART ONE: Supply & Demand and Elasticity Issues 4 1. Supply and demand 4 2. Elasticity of demand 5 PART TWO: Theories of the Firm 7 1. Premises which underline the classical firm 7 Competitive markets 7 Perfect information 8 Full employment 8 Pricing of the products 9 2. Environmental changes 9 Role of the governments 9 Legal system 10 Globalization and liberalization 10 Corporate social responsibility 10 3. Theories of the firm 11 The Neoclassical Theory 11 The Transactions Cost Theory 12 The Principal–Agent Theory 12 Evolutionary theory 12 Behavioural theory 13 PART THREE: Macroeconomic Issues 15 i) GDP and Budget deficit 15 ii) Governmental actions and economy 16 Cuts in spending   16 Tax hikes 17 Borrowing money 18   Multiplier effect 18 Aggregate Demand 19 Aggregate Supply 20 Specific actions 20 iii) Supply side reform of the labour market 21 Conclusion 22 References 23 PART ONE: Supply & Demand and Elasticity Issues 1. Supply and Demand - Analysis of Statements “Both factors of demand depend on the market price. When the market price for a product is high, the demand will be low. When price is low, demand is high.” (Whelan & Msefer, 1996, p. 6) a) The price of a good falls, causing the demand for another good to rise. Hence, the two goods are substitutes. In fact in the case of substitutes, the demand for the substitute will fall leading to the price of the substitute to fall. Example: If the price of mutton falls, demand for mutton will increase, and not the demand for chicken which is a substitute for mutton. Conclusion: The statement is not correct. b) During 2006, incomes for a majority of British households grew sharply. This change would likely lead to an increase in prices of both normal and inferior goods. When the income levels of the households increase sharply, people would go for normal goods with quality which will result in increase in their prices. Therefore, this situation leads to outward shifting in the case of normal goods. The income level is negatively correlated to the demand for the inferior goods and outward shifting will be noticed in the case of normal goods. In the case of inferior goods, due to lack of demand prices will come down. Conclusion: The statement is partly correct with reference to normal goods. The statement is not correct in respect of inferior goods. c) Two normal goods cannot be substitutes for each other. Normal goods can be substitute for each other. For example, Coke and Pepsi are substitute to each other. If Coke or Pepsi is not available in a sales outlet, the customer who would like to have beverage prefer the other available product, Pepsi or Coke as the case may be. ‘Chicken and Mutton’ is another example goes with the same argument. Conclusion: The statement is not correct. d) The price of Good ? rises. This causes a decrease in the price of Good ?. Hence, goods ? and ? are complementary. This situation arises when a good’s use is interrelated to the use on another good. If the prices of cars increase for example, the demand for cars is reduced. Consequently demand for the associated good gasoline decreases. Going by the inter relationship between the demand and price, if the demand reduces, the price comes down due to negative cross elasticity of demand. Conclusion: The statement is correct. 2. Elasticity of demand - Analysis of the statement “The supply of meat in France falls, causing meat prices to rise. Higher prices will definitely result in French households spending less on meat”. Is this statement true or false? Whatever response you give you must provide some detailed reasoning, covering all possible scenarios. Kumar et al (2011, p.1) state that a study has revealed that “the estimated income elasticities vary across income classes and are lowest for cereals group and highest for horticultural and livestock products. The analysis of price and income effects based on the estimated demand system has suggested that with increase in food price inflation, the demand for staple food (rice, wheat and sugar) may not be affected adversely but, that of high-value food commodities is likely to be affected negatively.” The people in the economically weaker sections of the society are likely to spend larger proportion of their income on bread, even if there is increase in its price by restricting their consumption of meat or other expensive food. The demand is inelastic, and law of demand does not apply to this situation. This is called as Giffen’s Paradox. “As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it” (Jensen & Miller, 2008, p. 1553). But, meat is not the staple food of the poor households. Therefore, in the case of meat the demand is elastic and law of demand is valid, and the higher prices will definitely result in French households spending less on meat. Conclusion: The statement is true. PART TWO: Theories of the Firm 1) Premises which underline the classical firm Much of conventional analysis within microeconomics is centered on the classical firm and its objective of profit maximization. The premises which underline the profit maximization objective are subjected to criticism by the scholars as they are not realistic under the prevailing economic conditions. Competitive markets Competition is good in an economy. Only, through the principle of competition has political economy any pretension to the character of science. So far as rents, profits, wages, prices, are determined by competition, laws may be assigned for them. (Mill, 1848, p.147) Classical theories assume that there are no entry barriers in the markets, and the people are free to enter and exit at will. But, there are entry barriers and the laws impose obligations on the part of the entrepreneurs to comply with several statutory regulations to avoid litigations while entering and exiting a business. It is assumed that the market is perfect and driven by demand and supply and there is no monopoly in the market. The prices and wages are not very flexible as considered under these theories. For example, the increase or decrease in labor supplies and increase or decrease in wages and salaries depending upon the increase or decrease in the levels of production and increase or decrease in wages and salaries based on the output or other factors in a particular business as envisaged in the theories is not possible in real life due to several factors at interplay. The assumption that no individual buyer or seller has the power to influence the market in terms of price or supply will not hold well when the pricing could be vitiated in monopoly or monopolistic conditions. Schumpeter (1942, p. 81) argues “An entirely imaginary golden age of perfect competition that at some time somehow metamorphosed itself into the monopolistic age, whereas it is quite clear that perfect competition has at no time been more of reality than it is at present.” Perfect information The classical theories assume free flow of information and the business and its various stakeholders take decisions based on the information. It is also assumed that there is no cost involved or is negligible in acquiring the information required. But in real life all the participants in the process are not taking decisions with complete information. The consumers are not aware of the prices charged by various traders for the products they want to buy. The workers may not be aware of the salary structure prevailing in various companies in the industry. Full employment The theories are based on the full employment situation and assume equilibrium among the forces in the long run. The salaries and wages in the current management structure of the companies tend to become fixed in nature. Therefore, the concept of marginal costing is applied by the industries for the purpose of segregating expenses based on variability in its incidence. Due to influence and authority gained by the trade unions over the period of time, there are several hurdles in appointment and retrench of the employees at will by the management. The labor laws introduced by the governments places several restrictions in this regard. Pricing of the products The classical theories assume that the prices are determined by the market forces. There are several factors involved in pricing of the products. The governments have introduced several laws to impose restrictions on the producers to fix the prices. Apart from competition, the policy of the government in imports, taxation, and availability of raw materials, capital and other considerations are involved. 2) Environmental changes Since 1945, many of the premises which underpin profit maximisation have been questioned, in particular whether firms operating in the real world actually behave like the “classical” firm. There are changes which have taken place in the structure and/or conduct of industry that provide evidence to reject the “classical firm hypothesis”. Role of the governments The governments’ intervention in the conduct of the business for the purpose regularization of the market forces have increased over the period of time. Mainly the governmental action seeks to reduce monopoly and restrictive trade practices by the businesses through antitrust laws. The import and export policies of the government, subsidies provided to certain sectors to provide food or energy security to the public and the indirect taxes such as VAT and excise duties will affect the market forces differently the different industries. The monetary policies of the central banks of the countries aimed to improve growth and reduce inflation levels affect the consumption patterns in the society. The classical theories fail to take these crucial changes taken place in the economic system into account. Legal system The legal system in a country affects the business either directly or indirectly in several ways. Ever-growing litigations on various matters concerning to the businesses such as patents, antitrust and labour has altered the course of doing businesses in certain sectors of the economy. Globalization and liberalization The concepts of globalization and liberalization of the economies in various countries have created several opportunities for the businesses to grow. At the same time, these cross border transactions have given rise to issues such as double taxation and other legal issues. Intense diversification drives adopted by the companies for growth has led to diversity in work places. In the wake of these developments the companies have been required to restructure their management to cope of with the challenges. Corporate social responsibility There has been growing concern among the social groups and the public to bring the corporate companies under stricter controls in the matters related to environmental protection. The companies are expected to be responsible for environment of the communities in which they operate. There are issues such as wastage disposal, emission of green house gases and pollution of water resources. Madariaga & Cremades (2010) argues that according to theorists, there are four main justifications for CSR-the moral case, the social case, the economy case and the business case (de la Cuesta, 2004). These developments have made the classical theories redundant. Their usefulness in the practical life has diminished. However, it is important to note that the understanding of the basic concepts is essential for charting out new paths towards prosperity. 3) Theories of the firm The changing business environment since 1945 meant that new theories would be required to account for the new behaviour patterns. These invariably took the form of managerial or behavioural theories of the firm. The Neoclassical Theory According to the Neoclassical Theory of the Firm, the profit is maximized at a point where the marginal revenue is equal to marginal cost. At this level, the various management decisions with regard to the important factors such as structure of the markets, pricing policies, entry barriers and economies of scale are taken into account. Hart (1989, p. 1758)states, “It does not explain how production is organized within a firm, how conflicts of interest between the firm’s various constituencies – its owners, managers, workers, and consumers – are resolved, or more generally, how the goal of profit-maximization is achieved.” Assumption of complete information, lack of consideration for agency problem, transaction costs and evolution of the firms are the main shortcomings in this theory. The claims and objectives demanded by different groups must be considered in a balanced way, permitting managers to increase the efficiency of the organization by responding to external requests (Freeman et al., 1990). The Transactions Cost Theory Dietrich (1994, p. 4) states that transaction cost economics derives the basic rationale for the firm from exchange relationships. The Transactions Cost Theory of the Firm deals with the asymmetric information related to the transactions of the firm. This theory takes into account the vertical integrations in the business by way of minimization of input costs and the use of the available markets. The firm itself produces the specific inputs or procure them from their allies. Again agency costs are ignored in this theory also. Similarly the concept of evolution of the firm is not dealt with in this theory. The Principal–Agent Theory According to Dietrich & Krafft (2012, p.85) principal agent problem is both under-analyzed and under-appreciated. The Principal–Agent Theory could be considered as an extension of the neoclassical theory. Apart from the principal – agent relationship, problems due to asymmetric information, is also considered in this theory. However, this theory ignores transaction costs and evolution of the firm completely. Evolutionary theory An important difference with this theory, compared to the earlier theories is in its stress on product innovation. The resources utilized in the firm, unique to it and its capabilities are duly recognized in this theory. The theory has categorized the resources, and stressed the organizational resources in addition to human, financial and physical resources. The firm’s reaction to the environment is another important concept which is dealt with properly in tune with the developments in the business and the firm’s evolutionary process. According to this theory, the creative destruction could pave way for emergence of new industries and the growth of the economy. An important difference with this theory is its recognition of ‘entrepreneurship’. According to Holzl (2005), “The evolutionary theory of the firm in its original form as proposed by Nelson and Winter (1982) is similar to the 'black-box' view of neoclassical economics a device to study evolutionary dynamics. This view of the firm does not consider the organization of the firm in an explicit way. However, the firm is described as entity processing, storing and producing knowledge.” Behavioural theories In a broader sense, these theories are mostly related to the nature of ownership, organizational structure, nature of control and employer employee relationship. Herbert A. Simon could be considered as the pioneer in behavioural theories. According to the Simon’s model, lack of full information and uncertainty are the major challenges to a modern business. Maximization of profit, sales or growth is difficult and a firm can only aim for satisfactory levels of performance on these counts. “Broadly stated, the task is to replace the global rationality of economic man with a kind of rational behaviour that is compatible with the access to information and the computational capacities that are actually possessed by organisms, including man, in the kinds of environments in which such organisms exist.” (Simon, 1955, p. 99) Behavioural theories are concerned with decision making and behaviour of the factors such as demand or prices and allocation of resources. The theory distinguishes between small firms run by the entrepreneurs and larger companies where the management groups are involved in setting goals for the companies, and the aim is satisfying and not maximizing (profits, sales or growth). PART THREE: Macroeconomic Issues 1) GDP and Budget Deficit Deficit running at 8.7% of GDP The GDP has to be adjusted for changes in the value of money to arrive at the real GDP relating to a base year. The ratio of the planned or actual government deficit, defined as the general government net borrowing to gross domestic product at market prices, does not exceed 3 %, unless either the ratio has declined substantially and continuously and reached a level that comes close to the reference value, or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value (Bloomberg, 2012). The relative economic strength of a nation reflected in the purchasing power parity of its currency which is determined by the value at a global exchange rate, say the USD. GDP = C + G + CS + X - I Where C = private consumption, G = government spending, CS = capital spending, X = exports and I = imports. ‘Budget deficit’ is related to government spending meaning net negative inflow, and this can also be called as the national debt. Though the acceptable level for a country varies based on the growth trajectory of a nation, the budget deficit of Spain is alarmingly higher. The borrowing power of Spain in the international market is severely affected on account of this serious economic imbalance in the country. 2) Governmental actions and economy With regard to sucking out 40 billion euros from the economic system, The budget deficit could be rectified in the following ways. i. Cuts in spending ii. Increasing the taxes iii. Borrowing money Spending cuts and hikes in taxes could affect the economic growth. On the other hand borrowing leads to a vicious cycle as it involves interest payment in future which will increase the deficit further. Cuts in spending According to Marcu (2012) “The generalisation of the austerity plans in Europe, in the context of prolonged crisis and market economic system, is confronted with social measures within the last years.” Cuts in planned expenditure will affect the economic growth severely. Non-plan expenditure includes the administrative expenses of the government, travel expenses incurred by the government officials and ministers and the subsidies given by the government. Cuts in administration and travel expenses can be handled effectively with rationalization of the procedures with minimum discontent among the people. However, cuts in subsidies will cause furore as the people who are benefited by these cuts are vulnerable to the economic downturn and already suffering. A cut on subsidies will worsen their problems further. Cuts in non-plan expenditure include cutting salaries of public sector and pension entitlements. But, this action will be encountered with stiff resistance from the public since they are used to certain standard of living which will be difficult to change, especially when the country is already reeling under inflationary pressures. This will also lead to overall reduction in consumption and demand which will cripple the economy due to multiplier effect (ibid)   Tax hikes It is based on the premise that the society should be willing to sacrifice in hard times considering the stability of the nation. However, taxation policy should aim at well to do sections of the society and not at the economically weaker sections of the society as they are already under severe pressure. Therefore, tax hikes could be considered on products like luxury cars, gold and diamond jewellery and liquor such as whisky or brandy. Kargbo & Egwaikhide (2012, 432) state, “A core function of the tax system is to generate sufficient revenue to meet the expanding public sector requirements of the state. Nonetheless, most less developed countries (LDCs) face difficulties in generating revenue.” The tax hikes on luxury cars and gold and diamond jewellery will face little resistance from the society. In any way the demand or consumption in such cases will not come down on account of tax hikes, because only rich could afford to buy those items. Increase in tax in liquor will be a welcome measure if it reduces consumption of liquor in the society. On the other hand the chances of reduction in consumption are unlikely. In all these cases, the tax revenues could be increased with minimum resistance from the public. Also, the increase in revenue on account of hikes in taxes is ensured as the purchasing or consumption pattern relating to these goods more or less remain unchanged irrespective of the increase in taxes. Any increase in taxes on the goods commonly used by the public will decrease their purchasing power. The increases in taxes in such cases will lead to inflation which will affect the fixed income people like salaried class or pensioners severely. Increasing the rates of taxes on business profits could be considered by the government. However, increase in the rate of taxes on wages/salaries will directly affect the workers. Also, any increase in taxes on business would be naturally passed on to the consumers, which will indirectly affect the consumers. Therefore, additional taxation on salaries will reduce the purchasing power of the public drastically. Borrowing money Borrowing money involves servicing of the debts. Borrowings by the government are considered when there is temporary mismatch in the economic system. But, the long term growth is not sustainable through borrowings. The government is under pressure to reduce non plan expenditure and increase planned expenditure for economic growth. The interest on borrowings will reduce the outlay for planned expenditure.   Multiplier effect Keynesian theory of employment touches all aspects of the economy and it attaches greater importance to national income and increase in national income. According to Keynes greater the national income, higher will be the employment. He repudiated the doctrine of ‘Laissez-fair’ of the classical economists. He indicated the need for government intervention to activate the economic process through investments at the times of depression. To explain the process of expansion and contraction of the economy, he introduced the tool ‘Multiplier’. ‘Income multiplier’ was developed from the concept of ‘employment multiplier’. Multiplier is the ratio expressing the relationship between the increase in national income and the increase in investment which induces the rise in income. The multiplier can be simply defined as the ratio of change in income to the change in investment. The investment in the economy is a powerful leverage of the national income which will multiply due to multiplier effect. The employment created by investment leads to further investment on account of increase in demand caused by the employment. Therefore, the need of the hour in the case of Spain is to increase the planned expenditure, which means construction of infrastructural facilities such as roads for transport, power generation for industrial use and telecommunication facilities. The expenditure on infrastructure will form the basis for future economic growth and development. The employment opportunities created in this process will act as a catalyst for the economic growth. The increase in personal income will spur demand for goods which will lead to private investment as well. According to Ono (2009, p. 5) in Keynesian multiplier effect there are several issues that may have misled assessments of the effect of fiscal spending and concluded that “The net effect of fiscal spending on national benefit consists of its direct benefit and the redistribution effect only, regardless of the budget system or the type of fiscal spending” Aggregate Demand The following are the important determinants of the aggregate demand. Consumption: Overall consumption level in the market is the important factor in determining the aggregate demand. It depends upon the income levels of the various participants in the market. Investments: Private investments on purchase of goods, construction of facilities for manufacturing and other purposes, accumulation of goods and materials for manufacturing or other purposes and other capital investments. These investments are influenced by the monetary policies of the central banks as well as the economic policies of the government. Government’s spending: The government’s spending especially on planned expenditure in procuring goods and services. Net exports: This is greatly influenced by the exchange rates and factors such as the state of international economy and the government’s policies towards imports. Aggregate Supply Aggregate Supply represents the production of goods and services in the economy. The factors of inputs over a period of time are converted into goods or output which could be explained by the formula, Aggregate Supply or Pt = f(Lt,Nt,Rt ) Where P = output in a given economy, L = Labour input available, N = Capital investment available and R = Materials or resources available over a period of time. Specific actions According to Ahmad et al (2012, p. 29) the relationship between government stability (GOV_ST) and real GDP is found to be positive whereas the association between real GDP and corruption is found to be negative. The following specific actions on the part of the government could improve the present economic situation. i. The government should consider increasing the investment (“I” in aggregate demand) spending on capital goods by the private companies. ii. The government should encourage foreign direct investment. The impressive growth of BRIC countries has been in large measure due to FDI inflow. (Rakita et al, 2012, p.309) Spain should embark on the reform processes in the banking sector and in various other fronts such as labour reforms and reforms in administration. iii. The government should spend (“G”) on creating / improving infrastructural facilities for the economic development and to attract foreign direct investments. iv. The government should encourage the industries in their export (“X”) drive by providing necessary concessions such as providing working capital at lower interest for exports through development financial institutions. v. The government can consider increasing the customs duties on non-essential imports. This will reduce the level of imports (“M”) as well as increase the revenues. vi. The government actions will increase the aggregate supply. 3) Supply side reform of the labour market Supply side reforms of the labour market means reforms in labour policies of the government in tune with the globalization and liberalization process in the country. It includes reforms in trade union system and legal system in the country as it involves changes in the labour laws as well. A progressive and popular government cannot ignore the need of the labour unions which aims at the welfare and security of the employees. However, meaningful changes in the law are needed in tune with the changes in the international environment with regard to labour policies. Conclusion The micro and macro economic theories have been evolving over the period time in tune with the changes that have taken place. What is relevant during a particular period of time loses its validity under the changed circumstances. However, the understanding of these concepts is very important for charting out the new course of actions. A firm need to adapt itself to the changed circumstances to overcome the obstacles to growth. A management with good understanding of the principles behind the theories would be able to read the signals provided by the economic system in advance and formulate its future strategies to exploit the opportunities provided by the developments in the system and to avoid threats successfully by adopting suitable strategies for a sustainable growth. After all, “Competition of producers who, in order to undersell one another, have recourse to new divisions of labour, and new improvements of art, which might never otherwise have been thought of” (Smith, 1976, p.706) Maintaining flexibility in production and supplies is essential for responding quickly to the changes in the external environment which may be caused due to competition, governmental actions or state of the economy. References Ahmad, H, Arif, A & Mohyuddin, SM, 2012, Do Economic, Institutional, or Political Variables Explain Economic Growth, International Journal of Business and Management, Vol. 7, No. 24. Bloomberg, 2012, Eurostat Eurozone Budget Deficit or Surplus as a % of GDP, Viewed 23 November 2012 Dietrich, M, 1994, Transaction Cost Economics and Beyond towards a new economics of the firm, Routledge, London. 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