Management Economics Issues - Assignment Example

Table of Contents Introduction 2 Question 1: Positive Externalities. 3 Increasing Demand 5 Net Welfare Loss 6 Demand Shifts 7 Increase in demand 9 Decrease in demand 10 Implications. 10 Question 2: Multiplier and Accelerator Concepts. 12 Multiplier 12 Accelerator 13 Gift Cards 13 Question 3. Exercise. 14 References 15 Introduction The paper is composed of answers to assignment on the course Economics for Management. The assignment is done based on class lecture notes provided in slides form. Some questions required an opinion that was stated in the first line of the answer followed by an explanation of the same. Comments are based on underlying principles as required by the particular question. Management economics aims at providing the best information for the purpose of macroeconomic decisions. This paper uses the provided information from the questions to provide an opinion on the same. Question 1: Positive Externalities. Government intervention is necessary when positive externalities are present. Positive externality, in this case, refer to the benefits that accrue to third parties as a result of an economic transaction for which they contributed nothing in terms of input. The existence of such a phenomenon and merit goods and services is a justification for government’s intervention. Government involvement ensures not only market efficiency but also equitable resource distribution. Third party beneficiaries and individuals, in that regard, referred to as free riders could naturally look to monopolize the resulting benefits, thus the need for government intervention. It is the role of governments to develop, promote and implement policies that encourage positive externalities. To do so, most authorities in a free market economy apply two basic approaches that are influenced by equilibrium-seeking market forces i.e. Increasing the supply of merit goods and services; healthcare, education and transportation logistics are just but examples of services that benefit all in society. Increasing the demand for goods and services that create widespread external benefits. Increasing Supply It is mainly achieved by reducing the production costs incurred by producers of goods that generate positive externalities. Governments around the world make it through grants and subsidies to the said producers. The purpose of the subsidy is to increase the marginal benefit obtained from consuming an additional unit of the good. In turn, the supply of merit goods such as healthcare and education increases and governments fund them through taxation. By working with the price mechanisms, the government first estimates the value of the positive externality that could result from the increase in supply. It then pays a subsidy to producers that is equivalent to the appraised value, thus encouraging production without an increase in prices. Figure 1: Use of Subsidies to Increase supply. [Source: Heinemann Economics for Edexcel; Google Books] The vertical space cd represents the value of positive externality equivalent to the subsidy paid. The result is an increase in demanded quantities from Q to Q1. The same economic principle also applies to public goods such roads, airports, ports and bridges since they generate a substantial positive externality. They are therefore usually a base point for governments aiming economic development to begin from. Without government intervention, minority suppliers of goods and services that bring about positive externalities stand to lose. In an unregulated market also, the consumers of merit goods consume less compared to the optimal outcome. The primary source of harm could be the monopolization of the supply and demand chain by well-established suppliers. Increasing Demand Increasing demand can be achieved through persuasion. It can be by reducing the price paid by consumers thus improving their purchasing power. An example is a student loan aimed at subsidizing university fees. It increases demand for university education by young people thus a positive externality for future generations. However, the ultimate persuasion technique is making some merit goods entirely free. For instance, making some aspects of health care such as cancer check-ups entirely free will bring future benefit in terms of the well-being of individuals. Demand can also be increased through advertising, political campaigning and lobbying. The objective is usually to change the attitudes towards most aspects of people’s lives thus affect the outcome of the free market. Unlike in the case of supply, demand mostly depends on the elasticity of demand for the particular good or service. The government is at times charged with setting prices of individual goods such as oil and gas. Through energy regulation boards, it may reduce its prices so as to benefit ordinary consumers and shield them from extreme prices that could come with it being traded in the free market. Government intervention, in this case, has a substantial effect in the transport sector and result in massive positive externalities in that sector. Another strategy available to governments around the world is the use of vouchers. This approach increases consumption by awarding vouchers for those deemed in need of the merit goods. For instance, a voucher to pursue further education can act as a stimulant for those who have a chance to study. The result is more technically equipped individual from which positive externalities can be derived. Net Welfare Loss There exist more social benefits than private benefits from merit goods that have a positive externality. It, therefore, means that the marginal social benefit (MSC) is greater than marginal private benefit (MPB). It, therefore, tends to drain out the efforts of hard working individuals by re-distributing the resulting benefits. Figure 4: Welfare loss in relation to positive externalities. The quantity supplied in a free market would be simply Q. However, when the social benefit is taken into consideration, the output rises to Q1. Under a free market, MSC is greater than MSB thus the need for more Q meaning an opportunity cost to the society exists. It is represented by the area ABC. Economically therefore, without government intervention in economies with positive externalities, some parties could be harmed through such factors as monopolization of supply and demand, re-distribution of efforts and welfare losses. Demand Shifts The macroeconomic definition of aggregate demand in simple terms refer to the quantity of goods or services that consumers are willing and able to acquire at a particular price level. It can be expressed in the form of an equation; Where C is consumption I is level of investments. G for government expenditure. X-M represents the net exports. In the aggregate demand/aggregate supply framework, the demand curve usually shifts either left or right depending the underlying parameter changes. The gradient of the AD curve denotes the level to which real balances affect the equilibrium spending level. Shifts to the right imply an increase in demand while to the left implies a decline. In most instances, increase in money supply mostly due to income level rising, is the primary reason for the aggregate demand curve shifting to the right. This can be attributed the fact that, monetary expansion policies aimed at increasing the nominal stock of money in the market, results in a rise in the purchasing power of consumers at every price level. Determinants of demand include; Price of substitute and complement goods and services. Income level Increase in demand Increase in demand could be due to i. Rise in consumption; usually due to rise in income level of consumers; consequently leading to the growth of the purchasing power of the consumers. The fact that their ability to purchase is higher means they can fund prevailing demands. Low prevailing interest rates also make borrowing of finances much cheaper. The consumers then have adequate disposable income to spend in consumer goods. ii. When prices of substitute good increase; this makes the products in question more affordable, and thus consumers demand it more. iii. Growth in investments; this can be due to factors such as better technology, readily available funds for investing and economic growth. The result of which is consumer confidence in the quality of goods and services, and consequently higher demand for those goods. iv. Decrease in price of compliment goods; consumers this view a combination of both goods as more affordable than individual good. v. Increase in exports. When local goods are of higher quality compared to those from competing countries, it makes them more competitive. Value addition also makes those goods and services more desirable. It results in a shift of the demand curve to the right from A to B; Figure 5: increase in demand. Decrease in demand Alternatively, decreases in demand results in shifting of the demand curve to the left. It is determined by fall in the income level of consumers, decrease in the price of substitute goods making them more desirable than the good in question. Demand can also fall as a result of increase in the price of compliment goods. Figure 6: decrease in demand. In macroeconomic terms, the left-ward shift from A to B as seen above, represents a fall in GDP. It is driven by factors such as decline in public consumption, drop in the levels of investment, increase in price of compliment goods, and reduction in net exports. It is mostly witnessed when the balance of payment is unfavorable, i.e. when the imports are more than the exports. Implications. In the real world, citeris paribus rarely holds therefore it is difficult to determine what the new equilibrium will be. In reality nothing is held constant. However there are some obvious implications of the shifts in aggregate demand. i. It implies that the exchange rate of a country’s economy has increased. The net exports will then decrease, so will aggregate expenditure. ii. Consumer expectations about the future tend to rely on the level of aggregate demand.  Whenever consumers are expecting a bright economic future, their propensity to save increases thus lowering total expenditure. However, if they foresee high prices on commodities they can spend less now, then logically they would spend on them now. iii. Income distribution occurs whenever consumers have more disposable income. Whenever they spend on goods and services, their income is transferred to other sectors of the economy. Figure 7: the aggregate supply - aggregate demand framework. The main result of a right-ward shift is that nominal inventory of money in the economy will rise. Purchasing power of consumers therefore increase at every price level. It then cause the prevailing interest rates to drop. The public is then inclined to hold higher real balances as opposed to investing. Furthermore, the equilibrium level of income and spending will rise as a result of stimulation of aggregate demand. The opposite is true with contraction monetary policies i.e. the aggregate demand curve will shift left-ward. It results in certainty in price; when demand and supply shift in opposite directions, say demand shifting to the left and supply shifting to the right, equilibrium price will definitely go down. The level of output on the other hand will definitely rise and vice-versa. It then becomes easier to forecast future parameters such as price levels and rates of inflation. The AS-AD model above can also be used to illustrate real and potential levels of output. An economy is said to be close to its potential output when price increases is dominant. Question 2: Multiplier and Accelerator Concepts. Multiplier The multiplier concept also referred to as the Keynes Multiplier Theory, relates public investment and government spending in investments to the resulting effects on the income level and employment. In an economy, employment level is affected by consumption and investment. However, consumption and investment have a direct relationship such that when one increases so does the other. Therefore, when investment increases and so does consumption, employment opportunities are generated.     The only time the two parameters have an inverse relationship is when full employment have been achieved. At that point, an increase in one results in a decrease in the other. However, this only occurs in ideal situations that are rarely achieved in an ordinary economy. The multiplier effect therefore implies that an increase in aggregate demand as a result of injections i.e. investment, government expenditure and exports, will result in an increase in GDP by the same amount. Figure 8: the multiplier effect on GDP growth Accelerator To meet the increased demand, the level of investment and production must rise. Initially, this increase may lead to straining of the existing factors of production but in the long run, increased profits will induce investors to expand their production facilities. Thus, an increase in income consequently leads to a rise in investment in the long-run thus the term accelerator effect. This concept works best when the features of that economy indicates a shift towards full employment or during instances when the targeted level of production has not yet been achieved. It becomes undesirable when decrease in income speeds up depletion in capital since it may result in cyclic systems. It is important to note that, positive marginal propensity to consume is what determines investment acceleration. Both principles deal with investment as an important parameter in economic growth. While one multiplier deals with the effects of increased or decreased investment, accelerator focuses on investment as the consequence of increased income. Gift Cards In definition, a gift card refers to a prepaid payment card that is loaded with a given sum of money for which one can use in place of actual money. The credit reputation of the user does not affect their ability to use a gift card. Financial institutions issue gift cards and so do stores, but the former works more like money. However, gift cards cannot be treated as a form of money supply due to the following reasons; i. They do not meet the flexibility characteristic of actual cash. Resell is usually illegal or difficult compared to actual cash that can be exchanged freely. ii. Liquidity is low compared to actual money. It is difficult if not impossible to cash in on gift cards whereas actual money is available in liquid form. iii. Gift cards are usually available at values above their face values. That means one can actually pay more than the intrinsic value. iv. Gift cards do not adequately serve the function of being a unit of account in that the transaction does not involve an actual transfer of cash. v. Gift cards are not universally accepted like liquid cash. It makes it unreliable and inflexible. Thus they cannot be considered as part of the money supply. Based on this analogy, gift cards do not form part of money supply even though it affects demand. Question 3. Exercise. Given the following information about the economy, $ Billion Total sales value of production by firms = 150,000 Total expenditure on intermediate products by firms = 130,000 Consumption = 10,000 Investment = 5,000 Net exports = -500 Required: What is the GDP in this case? What is the government expenditure? Solution 1. GDP In this case it can be calculated using the income approach, i.e. Where NI is the net business income which can be calculated as follows; Where; W is the wages R represents rental income Interest income is i PR are business profits But PR is given by; Therefore; 2. Government Expenditure. GDP (Y) of a particular economy can also be determined by the summation of consumption (C), investment (I), government spending (G) and net exports (X – M). i.e. References Ayres, Ian, and Steven D. Levitt. Measuring positive externalities from unobservable victim precaution: an empirical analysis of Lojack. No. w5928. National Bureau of Economic Research, 1997. Conlon, Jennifer, and Jon Whitacre. "System and method for customizing designs for credit cards, ATM/debit cards, checks, gift cards, and membership cards." U.S. Patent Application 11/047,593. Samuelson, Paul A. "Interactions between the multiplier analysis and the principle of acceleration." The Review of Economics and Statistics 21.2 (1939): 75-78. Grant, Susan, and Chris Vidler. Heinemann Economics for Edexcel. Heinemann, 2004. Read More