Economics: Principals, Problems, and Policies - Example

Market and Cost Paper Introduction Economics is a social science which includes the study of how the individuals, firms, government and nation interact with each other in order to fulfill their needs, wants and demands. Since the area of economics deals with studying the human interactions, it often reveals how and why individuals, governments and firms make their choices on the scare resources in order to satisfy incomprehensible demand. Moreover, economics is a wider concept which is divided into two dimensions i.e. micro and macroeconomics. Microeconomics as the name suggests refers to small (micro), which concentrates on the action and the behavior of individual units, including individuals, households and firms where the firms attempt to understand the basic decision making of individuals with the focus on interacting with them in the buying and selling activities. Microeconomics focuses on demand and supply aspects related to individual markets due to changes in the price level. The three major problems microeconomics seek to answer are what to produce, how to produce and for whom to produce. Conversely, macroeconomics is a broader view of analysis of the economy and its effect in the entire nation and in the international market, as a whole. Besides, it is the analysis of a country’s economic performance and structure along with the government policies affecting the economic condition. A macroeconomic study includes the relationship amid the aggregate variables such as purchasing power, price income and money. The three biggest issues in macroeconomics are what determine the standard of living along with cost as well as why economy fluctuates (McConnell et al., 2009). With these considerations, the paper intends to address the key determinates of micro and macroeconomics which include Ceteris Paribus, Law of Supply and Law of Demand by defining and delineating the relationships amid these variables. Besides, factors such as demand curve, price elasticity of demand, along with the relationship to profitability of Marginal Revenue (MR), Marginal Cost (MC), Average Fixed Cost (AFC) and Total Cost (TC) among others will be comprehended. Discussion Ceteris Paribus Ceteris paribus in the economics term refers to considering “other-things-equal” or constant, which signifies towards keeping the variable constant as in every context variables or the states play a prior role in the effective change. Economics theory is based on the assumption of ceteris paribus by keeping the other variable as constant like in law of demand and supply (McConnell et al., 2009). Law of Demand Law of demand asserts that there prevails an inverse relationship amid the price as well as quantity demanded for any kind of product, service or resource when the price of product decreases the quantity demanded will augment and vice versa. The relationship between the price as well as the quantity of demand is inverse or negative considering the price as a variable factor and other factors as fixed or constant such as taste, income, number of buyers along with keeping the price of substitute goods unchanged, however the demand fluctuates (McConnell et al., 2009). Figure A: Demand Curve Source: (McConnell et al., 2009) Law of Supply Law of supply reveals just the opposite to what is stated in the law of demand, wherein as the price rises, the quantity supplied will also rise and if the price falls the quantity supplied will fall keeping the other factor apart from price as constant. This relation amongst the price and the quantity supplied is known as law of supply. Moreover, this is due to the concept that the firms will produce and sell more of its goods at the higher price than at a lower price which signifies according to the law of supply that there is a positive correlation between the price and quantity supply (McConnell et al., 2009). Figure B: Supply Curve Source: (McConnell et al., 2009) Difference between Movements along the Demand Curve versus a Shift of the Curve Movement along with the demand curve refers to the situation when the consumer moves along with the demand curve that is when the price of product changes, either increases or decreases, the demand of the products, services or resources will move spontaneously as per stated in the law of demand. At the same time, the shift in the demand curve refers to the situation where the demand of the products, services or resources will be affected due to the changes in the desire and perception of customers towards its price that is the demand increases with keeping the price as unchanged which will shift the curve towards right and if the consumer is keen to pay less for the product then the demand curve shifts towards left. These movements towards right and left are known to be shift in the demand curve (McConnell et al., 2009). For example, if the price of petrol increases, people will respond accordingly and shift their demand by purchasing in lesser quantity and accordingly if the income also increases, there would be a rightward shift within the demand curve. In the figure C, D1 refers to movement along with demand cure whereas D2 & D3 denotes shift in the demand curve. Figure C: Movement along the Demand Curve and Shift in the Demand Curve Source: (McConnell et al., 2009) Price Elasticity of Demand Law of demand states that the demand of a product changes with respect to the change in its price, subsequently price elasticity of demand measures these changes and the relationship between the changes in the quantity demanded with the alteration in its prices. This change is measured by using a mathematical formula: Elasticity of demand (Ed) = Percentage change in relation to the quantity demanded for a product/ Percentage change in its price. If the price elasticity of the product is more than one, the demand is said to be perfectly elastic that is slight change in the price will create a huge impact in the quantity demanded. If the elasticity is equal to zero, the price is determined be perfectly inelastic where there is no change in its demand in respect of the changes in the price. Moreover, if the elasticity equals to one, the demand is unit elastic that is percentage change in its demand equals to change in the price and if the change in value is in between zero to 1 then the demand is said to be inelastic that is percentage change in the demand is lesser than the percentage change in the price (McConnell et al., 2009). As the percentage change in the price and quantity is always measured in terms of positive values, so the price elasticity of demand can never be negative. Cross Price Elasticity Cross price elasticity of demand evaluates the sensitivity or the response in relation to the change in the customer quantity required due to change in price of other substitutes or complimentary goods. For example, tea and coffee can be highlighted, wherein the increase in the price of one will lead to an increase in the demand of the other. Cross price elasticity could be measured in terms of a mathematical formula: Cross elasticity of demand (Exy) = Percentage change in relation to quantity demanded of product X/ Percentage change in relation to the price of product Y If the cross price elasticity of demand of two products that is sale of the one product moves on the same direction as the price of the other product then the product is said to be belonging to the category of substitute goods and the cross price elasticity of demand is positive. Whereas, if the rise in the price of one decreases the demand of the other then such products are acknowledged to be complementary goods and there is negative cross elasticity of demand (McConnell et al., 2009). Income Elasticity Income is one of the biggest determinates in the demand of the products, services or resources. Income elasticity of demand measures the effect of changes in the demand of the product with respect to the change in the income level of the consumer. In case of most of the goods referred as normal or superior goods, the income elasticity of demand will be always positive which implies that the demands of the goods will rise as the income of the customer rises. The negative elasticity represents the goods as the inferior goods like clothes because the rise in the income level will decrease the demand of that particular product (McConnell et al., 2009). Income elasticity is measured in terms of mathematical formula as below: Income elasticity of demand (Ei) = Percentage change in relation to the quantity demanded /Percentage change in the facet of income (McConnell et al., 2009). Concept of Cost and Revenue Cost refers to the amount of money incurred in the production of goods and services, primarily in general terms, the cost can be classified into fixed and variable cost where fixed cost remains constant in respect of quantity produced and variable cost varies with the production. Revenue refers to total income or the total amount of money received after selling the amount of goods. This value could be derived by multiplying the amount of goods produced with its price. This concept of revenue after deducting the cost will lead to profit (McConnell et al., 2009). Fixed Cost (FC) Fixed cost refers to the cost of production which does not get affected with the change in the output. It has to be incurred when the output is large or small or even zero. This cost is incurred on fixed factors such as land, building and machinery. These are unavoidable contractual costs. FC is also called overhead cost or general cost because these are common for all the units produced (McConnell et al., 2009). Variable Cost (VC) Variable costs (VC) on the other hand, are those costs which vary with changes in the volume of output. These are the costs which are incurred on the employment of variable factors of production such as raw material, labor power and fuel. The quantity of this factor varies in short run therefore VC changes with the change in output (McConnell et al., 2009). Total Cost (TC) Total cost refers to the sum of total fixed cost (TFC) and total variable cost (TVC) or the total expenses acquired in production of outputs. It is represented as: TC = TFC + TVC Figure E: TVC, TFC and TC Source: (McConnell et al., 2009) Relationship between Cost, Revenue and Profit Table: 1. Profit Level at Different Levels of Output Production Source: (McConnell et al., 2009) In the short run, the relationship between the cost, revenue and profit maximization in case of purely competitive firm is determined where the firms are price taker where the profit can be maximized by adjusting the output. This estimation is derived using table 1, assuming the price of the product to be $131. As shown above, the total cost consists of fixed and variable cost whereas, total revenue for each output level is found by multiplying output by price. From the zero to four units of output, TC augments at a decreasing rate as the firm utilizes its fixed resources more effectively and efficiently. From additional unit produced after the fourth unit, the TC begins to rise at an increasing rate as the firm uses more of its variable factors like plants, labors and machinery. As shown in the figure F, TR and TC intersect each other at the two points wherein there are no economic profits at the intersecting levels due to which the economists call these points as break-even points. The level at which the firm can make normal profit but not an economic profit is around 13 and 14 units. Any output produced beyond or below the break-even point would yield loss for the firm and in between the two break-even points the firm can maximize its profit. This relationship is graphically shown in the figure F where it is noticed that the firm earns maximum profit at the output level 9 and any production beyond the level 14 will be non-profitable for the firm. Figure F: Total-Revenue–Total-Cost Approach to Profit Maximization Source: (McConnell et al., 2009) Average Variable Costs (AVC) Average variable costs (AVC) refer to variable costs or expenses per unit of output. These costs are attained by dividing the total variable cost with the number of output produced. In terms of formula: AVC = TVC / Output (McConnell et al., 2009) Average Fixed Cost (AFC) Average fixed cost (AFC) refers to fixed cost incurred per unit for any output level which is determined by dividing the TFC by that output i.e. AFC = TFC /Output (McConnell et al., 2009). Average Total Cost (ATC) Average total cost (ATC) is the amalgamation of average fixed cost and average variable cost incurred in the production of a particular quantity. ATC = AFC + AVC (McConnell et al., 2009). Marginal Revenue (MR) Marginal revenue refers to the revenue received by selling one extra or ‘additional unit’ of output or rather it can be ascertained that MR is the additional revenue that the firm generates by employing an extra variable input. For example, if the company sells its 20 units at a price of $25 then the total revenue generated is $500 and if the order of sales is 21 units, it must reduce its price to $24, when the total revenue would rise to 21*$24 or $504 thus the marginal revenue earned by selling the 21st unit is $4 (McConnell et al., 2009). Marginal Revenue = Change in the total revenue/Change in the output (McConnell et al., 2009). Marginal Cost (MC) Marginal cost (MC) is referred as the cost incurred in producing an extra unit of output in the production or changing the total cost by making one addition unit. The concept of marginal cost is applied to the manufacturer engaged in production of goods and services. In this regard, a time would arrive when the benefits of producing one extra unit of output would be lesser than the revenue of producing such unit of output. Therefore, in order to reach economies of scale, the marginal cost is taken into consideration, which is calculated as: Marginal Cost = Change in the total cost / Change in unit of output produced (McConnell et al., 2009). Relation of MC to AVC, AFC and ATC According to figure G, it has been noticed that the ATC decreases in decreasing rate whereas the MC also decreases due to the fall in the AFC and below it till the output level 4. It further intersects AVC and ATC at its minimum whereas AVC will go down and rise up as fast as the marginal cost grows and AFC will remain declining due to the additional unit of output production. Moreover, the combined effect of AVC and AFC will affect ATC and increase it from the point when MC intersects ATC owing to the law of diminishing return (McConnell et al., 2009). Figure G: Relationship between ATC, AFC, AVC, and MC Source: (McConnell et al., 2009) Relationship of Marginal Revenue (MR), Marginal Cost (MC), Average Variable Costs (AVC), Average Total Cost (ATC) in the Profitability The relationship of MR, MC, AVC, and ATC in profit maximization in the short run market under perfect competitive marker would be derived assuming a production table as shown in the table 2 where the price or the MR of the output is kept at $131. Table:2 Showing MR, MC, AVC, ATC and Profit Source: (McConnell et al., 2009) In order to achive the output level were the firm maximizes profit in the short run, it has to adjust its variable factor or resources (labor and materials) of production as the firm has a fixed plant. Through comparing its TR and TC in the production, the firm attains the level at which maximium profit can be gained. This could be further done by comparing MR and MC. For profit maximization under MR and MC analysis, two conditions should be satisfied, one being that the MR should be above MC and the other being that the MC intesects MR from below. As per the above table 2, AVC constantantly decreases after reaching to its minimum then it gradually increase as more and more output is produced. Due to the combined effect of AVC and AFC, the ATC decreases and later on increases at decresing rate due to the law of dimising marginal utility. Furthermore, MC cuts ATC and AVC at its minimum but lower than MR therefore it adds to the firm’s profit and upto the level of nine units, the firm should produce. The tenth unit is ascertained to be adding more cost ($150) then generating revenue ($131). A firm calculates its economic profit using formula: Profit = (P - ATC) * Q where, P is price and Q is the quantity produced. Thus, at 9th level of output produced, the firm earns a profit of $(131-97.78)*9 = $299 along with satisfying the two conditions with MR=MC. The above table 2 is graphically shown in the figure H below. A vital factor noticeable is that at 9th level, per unit profit is lower than the 7th unit but if the firm produces only 7 units, it will be forgoing the production of two more units that would contribute to its total profit. Nonetheless, the firm is happier to produce two additional units as they are contributing towards total profit. Figure H: AVC, ATC, MC, and MR Source: (McConnell et al., 2009) Conclusion From the foregoing discussion, it has been comprehended that economics is not a narrow concept to deal with and it is a study of the behavior of people, firms, governments and nations as a whole on how they deal with the scared resources to satisfy their ever-changing needs, wants and demands. Correspondingly, the concept of economics is broken down into two parts i.e. micro and macroeconomics where microeconomics is a specific segment of economics which concentrates on individual units such as how individuals, households, firms and industry behave. Conversely, macroeconomics deals with the behavior of the economy as a whole by treating the economy as a one unit. It is further determined that the change in the price level has a huge impact in the demand and supply of the product with respect to individual and firms point of view respectively with the help of law of demand and supply. Apart from the price, other factors such as income, tastes, preferences, number of buyer, price of related goods and expectations also act as pivotal factors in shifting the demand. In addition, the concept of cost considering both fixed and variable cost and revenue is very crucial for determining the profitability for a firm as the fixed cost in the early manufacturing process is a significant burden to them. Finally, from the above study, it is quite apparent that for a firm it is quite a difficult task to determine what should be the optimal quantity it should produce in order to maximize their profit wherein not only the concept of total cost and revenue is optimally measured, but also the concept of marginal revenue and cost is also taken into consideration as it reflects the net additional cost of producing one extra unit of output. Reference McConnell, C R., Brue, S L., & Flynn, S M. (2009). Economics: Principals, problems and policies. United States: McGraw-Hill/Irwin. Read More