Major Economic Problems - Essay Example

? Economics [Module [Module Question The Economic Problem? The basic economic problem revolves around “Scarcity”. Individuals and all societies have unlimited wants or and have limited resources to fulfill these unlimited wants and this is called scarcity of resources. According to business dictionary (2011), scarcity is defined as: “Ever-present situation in all markets whereby either less goods are available than the demand for them, or only too little money is available to their potential buyers for making the purchase. This universal phenomenon leads to the definition of economics as the science of allocation of scarce resources." To understand more clearly, lets understand that we have three factors of resources that are necessary to for production process as described in (Sloman: 2006, p. 4): Human resources: labor. The labor force is limited both in number and in skills. Natural resources: land and raw materials. The world’s land area is limited, as are its resources. Manufactured resources or capital. Capital consists of all those inputs that have themselves been produced in the first place. The world has a limited stock of capital: a limited supply of factories, machines, transportation and other equipment. The productivity of capital is limited by the state of technology. Hence, scarcity arises due to comparative unlimited human wants in the limited set of available resources to satisfy these wants. In other words, in free market economy scarcity occurs either because of increase in demand or decrease in supply. Economics, deals with issues arises due to ‘scarcity’; distribution of resources and products among individuals or societies, regions or countries of the world. Investorwords (2011) defines “Free market system” as a system in which, “Business governed by the laws of supply and demand, not restrained by government interference, regulation or subsidy”, or “a foreign exchange market that is not controlled by the government”. Also known as pure capitalist system; where individuals are free to make their demand decisions. The decisions of consumers and firms pertaining to the demand and supply of goods are transmitted to each one of them via the effect of these decisions on prices. This in turn, sets the equilibrium price level in the economy. Hence, prices are set via free interaction of demand and supply of goods and services, in a market where consumers are free to make their own choices according to their own income levels, firms are free to supply what they decide according to their own investment. The present world markets are likely to be known as mixed economies where minimal government interference to run the economic system exists with the help of businesses. United States, however, is a good example of free market system where government intervention is minimal and mostly prices are determined through market forces of demand and supply. Command system or planned economy is defined in investorwoods (2011) as: “an economy where supply and price are regulated by the government rather than market forces. Government planners decide which goods and services are produced and how they are distributed. The former Soviet Union was an example of a command economy”. Command economies are usually recognizable in places where the presence of socialist or communist systems of economy exists. It is in these economic systems that land and capital are collectively owned. State is the sole decision maker. It decides how to allocate resources for the future trends and also for the current ongoing requirements of the economic system. The State also governs the generation and distribution between customers of output from each industry and firm. In these centrally planned economies, the government could achieve high growth rates by allocating resources into investments; and could minimize unemployment levels by critically planning the allocation of labor according to the production levels and labor skill levels, and hence, can be able to equally distribute the national income. Although, command economies are one of the extremes, Russian, North Korean and Cuban economies are best explains the command economic system. The Difference between Macro and Micro Economics?  Microeconomics is the study of the individual units of the economy like households, firms or industries. So it focuses on questions like how the price and output level of individual goods and services determine? What are the factors that determine supply and demand of a particular good? How government policies such as price controls, subsidies, and excise taxes affect the price and output levels of individual markets? (SIEGEL et al. 2005:3). As discussed in Sloman (2006: 6-7) microeconomics study deals with, “ three main categories  of choices that must be made in any society.   What goods and services are going to be produced and in what quantities, given that there are not enough resources to produce all the things people desire? How are things going to be produced, given that there is normally more than one way of producing things? What resources are going to be used and in what quantities? For whom are things going to be produced? In other words, how will the nation’s income be distributed?” Whether made by individuals, firms or governments, each and every economy has to decide from these choices. Hence, they are said to be microeconomic choices, as they deal only with the individual goods and services. Macroeconomics studies the economy as a whole on an aggregate level. It deals with the aggregate price level, output, inflation, international trade, unemployment and national income levels. It particularly answers the questions pertaining to the factors that may determine national income and employment levels. Moreover it involves responses to queries such as: What determines the general price level or rate of inflation? What are the policies that combat typical economic problems such as inflation, unemployment and recession? (SIEGEL. et al 2005:3) So, macroeconomics deals and solves the problems that arise with fluctuations in aggregate demand and aggregate supply in markets which, as a result, leads to problems of inflation, and deficits in balance of payments, and unemployment. The Determinants of Demand? Determinants of Demand Factors that determine the demand for goods and services are: Substitutes - if the price of Pepsi is raised, the demand for Coke rises and vice versa. Complements - if the price of ink pens goes up demand for ink decreases due to decrease in demand for ink pens Income of the customers – This refers on how much a consumer can spend on a particular good or service. For instance if the income remains constant and an increase in price of “Pringles” from $0.75 to $1.5 leads to decrease in demand from eight packs to four packs. This is because income remains the same and a consumer spends $6 on Pringles, now the increase in price leads to decrease the demand of the quantity. Income distribution: in low income areas the demand for branded goods will be low as people prefer to buy cheaper goods on the other hand in high income level groups, people prefer for branded goods instead of local or cheaper goods. Consumers’ tastes or fashion – This phenomenon can be explained by the fact that consumers’ are now more inclined towards iPods than laptops or notebooks. So a shift towards iPods decreases demand for laptops and notebooks likewise. This decrease in demand is due to the choices made by consumer in accordance with his tastes or action. Expectations – Around Christmas holidays the fares for air-tickets of international flights are likely to increase. It is cheaper to reserve seats for the holiday season in advance as the rates are reasonable then. The demand for seats, along with their fares, for air travel increases as the season nears. The Determinants of Supply?  Determinants of Supply: The law of supply states that as the cost of a good is raised so its supply is also increased. Thus, it refers to the positive relationship between prices and the quantity supplied. The factors that determine the quantity supplied and affect its increase, according to Sloman (2006: 40) are: “As firms supply more, they are likely to find that beyond a certain level of output costs rise more and more rapidly The higher the price of the good, the more profitable it becomes to produce. Firms will thus be encouraged to produce more of it. Given time, if the price of a good remains high, new producers will encouraged to set up in product.” Other determinants of supply are: The cost of production - rent, wages, interests, and prices of materials used in producing goods highly affect the supply of goods. When the input prices rise, this increase might cause to shut down many firms, and the quantity of goods supplied in the market falls down. In other words prices of inputs and quantity supplied are negatively related to each other. The profitability of alternative products - If profitability of producing margarine rises suppliers tend to shift from butter to produce margarine instead. It means when the profitability of substitutes to supply more than before, producers produces substitutes instead. Climate – natural disasters affect the supply of goods and services. For instance drought conditions are likely to decrease the supply of food items due to record decline in crops’ output which are the basic raw materials. Technology – new technology and inventions are improving the productivity and output levels. For instance, the biotechnology inventions have improved the seeds’ quality and a significant increase in output levels tends to increase quantity supplied. The Market Equilibrium? Mankiw 2009 (pp. 77) defines the Market Equilibrium as follows: “At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balance the quantity that sellers are willing and able to sell”. He defines more “The equilibrium price is sometimes called the market-clearing price because, at this price, everyone in the market has been satisfied”. Let us understand the concept through an example. Refer to the data from Table 1 and Figure 1 in next section, showing the price, quantity demanded and quantity supplied of T-shirts. At price 1 pound, quantity demanded for t-shirts (20 million t-shirts) exceeds quantity supplied for t-shirts (4 million), thus, creating a “deficit” or “shortage” of t-shirts in the market. This shortage leads to increase the prices of t-shirts leading to decrease the quantity demanded and increase in quantity supplied, until the point where the quantity demanded and quantity supplied equate each other. At this point of equilibrium consumers are willing to buy 12 million t-shirts at price level 5 pounds per t-shirt and suppliers are willing to sell the same quantity at this price. In another case at price 8 pounds per t-shirt consumers are willing only to buy 6 million t-shirts and sellers are willing to produce 18 million t-shirts. This leads to a surplus of 10 million t-shirts, forcing prices to fall down from 8 pounds per t-shirt, leading to increase in quantity demanded and decline in quantity supplied until the price 5 pound per t-shirt where quantity demand and quantity supplied equates at 12 million t-shirt. Thus eliminating the excess from the market and achieve equilibrium price level. Price Elasticity of Demand? Price elasticity of demand refers to the responsive change in quantity demanded due to a change in price. Consider a rise in price levels of electricity and bananas. A rise in price for electricity will lead to very slight change in consumption levels of electricity but for bananas there are many other fruits available in the market so how much change this be? As electricity is the necessity and there are many other choices available in the market instead of banana. So how much responsive the product is, depends on elasticity of product. Price elasticity of demand can be measured by the formula: PED = (% change in QD ) / (% change in P) where; PED means price elasticity of demand, QD means quantity demanded and P refers to price Hence, a 20 percent rise in price of electricity case the quantity demanded to fall by 10 percent, the price elasticity would be – 0.5: PED = - 10% / 20% = - 0.5 The negative sign with elasticity refers to the negative behavior between quantity demand and price, that is a rise in price (positive change) leads to a fall in quantity demand (negative change), vice versa. Now, it is the value of the price elasticity of demand that tells us its elasticity. A good is categorized in three types of elasticity. Elastic demand: when elasticity is greater than 1 that is (E > 1). This refers to a change in price causes a proportionately larger change in quantity demanded. Denominator is smaller than numerator. Inelastic demand: when elasticity is less than 1 that is (E < 1). A change in quantity demanded is proportionately smaller due to a rise in price. Numerator is smaller than denominator. Unit elastic demand: when elasticity is equal to 1 that is (E = 1). A rise in price brings equal decline in quantity supplied so the proportionate change is same. a) Equilibrium price and quantity: Table 1 Price (pounds) 8 7 6 5 4 3 2 1 Quantity demanded (in millions) 6 8 10 12 14 16 18 20 Quantity supplied (in millions) 18 16 14 12 10 8 6 4 quantity demand = quantity supply = 12 million t-shirts at price 5 pounds 5 pounds is the equilibrium price level for t-shirts b) The demand rose by 4 million at each price level so there would be rise in equilibrium price level according to the law of demand that as demand increases price also increases as shown in the table (2) below. Table 2 Price (pounds) 8 7 6 5 4 3 2 1 Quantity demanded (in millions) 10 12 14 16 18 20 22 24 Quantity supplied (in millions) 18 16 14 12 10 8 6 4 At 14 million t-shirts quantity demanded it is equal to quantity supplied new quantity demand = new quantity supply =14 million t-shirts at price 6 pounds 6 pounds the new equilibrium price for t-shirts c) see Table 1 for graph Figure 1 The new equilibrium price and quantity refer table (2) for data Figure 2 References: Business Dictionary (2011) Scarcity [online] available from [25 July 2011] Investorwoods (2011) Free Market [online] available from [25 July 2011] Investorwoods (2011) Command Economy [online] available from [25 July 2011] SHIM K. J, SIEGEL G. J. 2005 Macroeconomics 2nd ed. Barron’s Educational Series, Inc. New York. MANKIW G. N. 1997 Principles of Microeconomics. Harcourt Brace College Publishers. SLOMAN, J. 2006 Economics. Delhi: India Binding House Read More