A Brief Explanation of
Economics
"Everything you
should have learned
during that one semester you took from your high school's volley
ball coach." -Brandon
v1.0 - Updated 06-15-09
Index:
Economics Defined:
What is Economics
A Few Important Economic
Terms
Basic Economic Principles
Basic Macro-Economic
Indicators
Resources
Economics Defined: What is Economics?
Economics is the study of managing infinite needs and wants with a limited amount of resources. Such resources include Labor, Capital, Natural Resources and Technology. Micro-Economists are interested in the choices that individuals make to fulfill their own needs and wants and Macro-Economists study the same principles on a national level.
We will make the following assumptions:
1. Human's will act to fulfill their own self interests.
2. Humans will act rationally to fulfill their unlimited wants and needs.
3. Humans will respond to incentives.
4. Cost is not necessarily money, but what you have to give up to obtain something whether it be time, opportunity cost, money etc...
A few important economic terms:
Public Good: A public good is anything that all people can enjoy regardless of whether or not they paid for it. Public goods include things like public parks, firework displays, subsidized healthcare, police assistance etc. but are not necessarily provided by the government. For instance, a large corporation might purchase a statue and dedicate it to the public for all to see free of charge. It is difficult to perform cost-benefit analysis on public goods because it is hard for everyone to agree on the value amount to be spent to save a single human life vs. more flowers being planted around the court building downtown. Public goods also create what are called "Free Riders".
Free Rider: A "Free Rider" is a person who consumes a "public good / service" without paying for it. For those who do contribute to public goods / services, seeing people who benefit without contributing to those public goods / services provides disincentive for those people to continue contributing in the future.
T.I.N.S.T.A.F.L. : "There Is No Such Thing As A Free Lunch". Everything has a cost associated with it whether it is revealed or not. For instance, you may think you're getting "free samples" of pizza when you visit the grocery store on a Saturday morning, but in actuality the cost of those samples have been included in the final sale of that frozen pizza. Whether or not you chose to buy the product, the grocery store passed the price of those samples on to those who did purchase the pizza.
Ceteris Paribus: Ceteris Paribus is a Latin phrase, literally translated as "with other things the same." It is commonly rendered in English as "all other things being equal." Economist use this term to acknowledge and rule out chaotic factors by simplifying assumptions in order to explain an analytical framework that does not necessarily prove cause and effect but is still useful for describing fundamental concepts. For instance, an economist might say that the price of soda goes up every time the price of sugar goes up, Ceteris Paribus. Ceteris Paribus in this instance is ruling out all other factors such as labor union strikes, aluminum can prices etc...
Moral Hazard: A Moral Hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. For instance, as automobile safety devices become more advanced people feel safer (at least in the short run) and tend to drive more recklessly.
*** On a side note: It is often sarcastically suggested by some economists that if spikes were placed in the steering wheel of every car instead of airbags we would have no more reckless drivers. Most people struggle with this notion because it would cause instant death however it is argued by many economists that overall fatalities would fall drastically.
Adverse Selection: Adverse Selection (or anti-selection) is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "negative" results occur when buyers and sellers have access to different information. The "negative" products or customers are more likely to be selected. For instance, a man who welds in his garage (knowing that he will most likely be the cause if his house were to catch fire) may purchase additional insurance for his home. Without any form of risk assessment on the insurer's end, there is no way to protect them from the information known only to the welder.
Opportunity Cost: Opportunity cost is the value of what is foregone in order to have something else. This value is unique for each individual and is determined by his or her needs, wants, time and resources (income etc.). For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times they go to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading them to choose the less expensive service.
Production Possibility Frontier (PPF): The production possibility frontier represents the point at which an economy is most efficiently producing its goods & services. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide through the course of free market trade what combination of goods and services can be produced.
It is obvious that an economy produces more than 2 goods & services, but we have only shown 2 for this example. In order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A.
Point X means that the country's resources are not being used to efficiently produce enough cotton or wine given the potential of its resources. Point Y represents an output level that is currently unreachable by this economy. However, if there was a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.
Specialization and Comparative Advantage: An economy can focus on producing all of the goods and services it needs to function, but this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a person / business / economy can concentrate on the production of one thing that it can do best, rather than dividing up its resources.
For example, let's look at a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose that Country A has very little fertile land and an abundance of steel for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton.
Each country can produce one of the products more efficiently (at a lower cost) than the other. Country A, which has an abundance of steel, would need to give up more cars than Country B would to produce the same amount of cotton. Country B would need to give up more cotton than Country A to produce the same amount of cars. Therefore, County A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) specialize in producing the goods with which they have a comparative advantage. If they trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower opportunity cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B.
Even if one country in this example is smaller and unable to produce either of the two products better than the larger country, both countries still benefit from specialization of trade because both are able to allocate all of their resources to whatever they do best instead of trying to act independently of each other. Therefore free market trade between both countries benefits everyone. *See Absolute Advantage below*.
Absolute Advantage: Sometimes a country or an individual can produce more than another country, even though both countries have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs (arable land, steel, labor), enables the country to manufacture more of both cars and cotton than Country B. A country that can produce more of both goods is said to have an absolute advantage. Better quality resources can give a country an absolute advantage as can a higher level of education and overall technological advancement. It is not possible, however, for a country to have a comparative advantage in everything that it produces, so it will always be able to benefit from trade.
Supply & Demand: Supply and demand is
perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to the quantity of products /
services that are desired by buyers. The quantity demanded is the amount of a
product people are willing to buy at a certain price. Supply represents how much
the market can offer. The quantity supplied refers to the amount of a certain
good producers are willing to supply when receiving a certain price. Price,
therefore, is a reflection of supply and demand (and not the other way around).
The relationship between demand and supply underlie the forces behind the
allocation of resources. In a free market economy, demand and supply will allocate
resources in the most efficient way possible.
The law of demand: The law of demand states that the higher the price of a good, the less quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.
|
|
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantities demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).
Law of Supply: Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. The higher the price, the higher the quantity supplied. This is why the Supply line is upward sloping. Producers supply more at a higher price because a higher quantity at a higher price increases revenue.
|
|
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.
Supply and Demand Relationship: Imagine that a new type
of light bulb is sold for $20. Because manufacturer's
previous analysis showed that consumers will not demand them at a price higher
than $20, only 10,000 were produced because the opportunity cost is too high for
suppliers to produce more. If, however, the 10,000 light bulbs are demanded by 20,000 people, the price will subsequently rise because, according to the demand
relationship, as demand increases, so does the price. Consequently, the rise in
price should prompt more light bulbs to be supplied as the supply relationship shows
that the higher the price, the higher the quantity supplied.
If, however, there are 30,000 light bulbs produced and demand is still at 20,000, the price will
not be pushed up because the supply more than accommodates demand. In fact after
the 20,000 consumers have been satisfied with their light bulb purchases, the price of the leftover
bulbs may drop as producers attempt
to sell the remaining 10,000 light bulbs. The lower price will then make the
bulb more
available to people who had previously decided that the opportunity cost of
buying the them at $20 was too high.
Equilibrium: When supply and demand are equal the
economy is said to be at equilibrium. At this point, the allocation of goods is
at its most efficient because the amount of goods being supplied is exactly the
same as the amount of goods being demanded. Thus, everyone (individuals / firms
/ economies) is satisfied with the current economic condition. At the given
price, suppliers are selling all the goods that they have produced and consumers
are getting all the goods that they are demanding.
|
|
As you can see on the chart, equilibrium occurs at the intersection of the
demand and supply curve, which indicates efficiency. At this point, the price of
the goods will be P* and the quantity will be Q*. These figures are referred to
as equilibrium price and quantity.
Basic Macro-Economic Indicators:
Inflation: Inflation measures the increased cost of living. The rate of inflation is based on a number of consumer and producer price indexes in an economy. Inflation means the value of money decreases. For instance, $0.25 used to buy you can of soda in a vending machine 25 years ago but now the same can might cost as much as $1.25 in a vending machine.
Deflation: Deflation is the opposite of inflation. It means that the value of your money increases. This can be both good and bad. If it is caused by an increase in productivity and lower costs it is good, but if it is caused by an economic recession it can be bad because it discourages people from spending. Recent examples are the decreased price of fuel after this most recent recession.
Hyper Inflation: Hyper inflation occurs when inflation increases at an exponential rate. In extreme cases it can lead to a barter economy where people begin trading goods instead of using currency to make transactions. After WWI, Germany was printing money at an alarming rate in order to pay war reparations and eventually the money wasn't worth the paper it was printed on.
Consumer Price Index: The CPI is a measurement of change in price for a basket of goods which is used to determine the cost of living. The actual goods within the CPI basket are divided into 11 categories: alcohol and tobacco; clothing and footwear; housing; household furnishings, supplies and services; health; transportation; communication; recreation; education. If the original basket had a value of 100 and this quarter's costs have risen to 102 we'll see a CPI rise of 2%. In this example, the inflation rate is 2%. When you hear people say, $1,000,000 in 1920's dollars, they are using the CPI from 1920 compared to today's CPI to get that figure.
Producer Price Index: The PPI is a measurement of change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. The sellers' and purchasers' prices may differ due to government subsidies, sales and excise taxes, and distribution costs.
Gross Domestic Product: GDP is the total value of all goods and services produced within a territory during a given year. GDP is designed to measure the market value of production that flows through the economy. GDP includes only goods and services purchased by their final users. GDP counts only the goods and services produced within the country's borders during the year, whether by citizens or foreigners. GDP excludes financial transactions and transfer payments since they do not represent current production. GDP measures both output and income, which are equal.
Nominal GDP: Nominal GDP measures the value of output during a given year using the prices prevailing during that year. Over time, the general level of prices rise due to inflation, leading to an increase in nominal GDP even if the volume of goods and services produced is unchanged.
Real GDP: Real GDP measures the value of output in two or more different years by valuing the goods and services adjusted for inflation. For example, if both the Nominal GDP and price level doubled between 1995 and 2005, Real GDP would remain the same. Real GDP is usually the preferred indicator because it gives a more accurate view of the economy. Real GDP = Nominal GDP - Inflation.
Measuring GDP:
Expenditures Approach: GDP = (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) - Imports (M))
Income Approach: GDP = NI (National Income) = Employee compensation + Corporate profits + Proprietor's Income + Rental income + Net Interest.
Value Added Approach: The value of sales of goods - purchase of intermediate goods to produce the goods sold.
GDP Deflator: The GDP Deflator measures the ratio of nominal (or current-price) GDP to the Real (or chain volume) measure of GDP. It is useful to think of the price deflator as the ratio of the current-year price of a good to its price in some base year. The price in the base year is normalized to 100. For example, for the price of a new Plasma TV, we could define a "unit" to be a TV with a specific level of features. A price deflator of 400 means that the current-year price of this Plasma TV is quadruple the price of its base-year's "Tube TV". This indicates price inflation. A price deflator of 25 means that the current-year's price is 1/4 the base year price. This indicates price deflation.
GDP Deflator = Nominal GDP / Real GDP x 100
Gross National Product: Like GDP, GNP is the value of all goods and services produced in a country in one year, plus income earned by its citizens abroad, minus income earned by foreigners in the country.
Unemployment Rate: The Unemployment Rate is the percentage of those in the labor force who are unemployed. The labor force is defined as the non-military people of working age (above 16 in USA) and below retirement age within an economy who are participating workers, that is people actively employed or looking for work. Excluded are persons confined to institutions such as nursing homes and prisons, and persons on active duty in the Armed Forces. The labor force is made up of the employed and the unemployed. The remainder who have no job and are not looking for one, are counted as "not in the labor force."
Types of Unemployment: Unemployment can be a good and bad thing. How can unemployment be a good thing? Well sometimes people quit one job to look for a better one. Sometimes people are seasonally unemployed. Typically the rate of unemployment in the United States is around 6% which is very close to what we consider the the Natural Rate of Unemployment in the US which accounts for these following examples. The "natural" rate of unemployment is defined as the rate of unemployment that exists when the labor market is in equilibrium and there is pressure for neither rising inflation rates nor falling inflation rates.
Cyclical Unemployment: This refers to unemployment that rises during economic downturns and falls when the economy improves.
Frictional Unemployment: This refers to people in the midst of transiting between jobs. It is sometimes called search unemployment. Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to skills, payment, worktime, location, attitude, taste, and a multitude of other factors. Workers as well as employers accept a certain level of imperfection, risk or compromise, but usually not right away; they will invest some time and effort to find a better match. This can be beneficial to the economy since it results in a better allocation of resources.
Structural Unemployment: This refers to a mismatch between the sufficiently skilled workers looking for jobs and the vacancies available. Even though the number of available jobs may be equal to the number of the unemployed, the unemployed workers may lack the skills needed for those jobs or are in the wrong part of the country / world to take the jobs offered.
Seasonal Unemployment: Like that of cyclical unemployment, the number of job-seekers exceeds the number of vacancies. However, this is not due to the lack of demand for these jobs. In this situation, real wages are higher than the market-equilibrium wage. In simple terms, institutions such as "the minimum wage" deter employers from hiring all of the available workers because the cost would exceed the benefit of hiring such workers. Some economists theorize that this type of unemployment can be reduced by increasing the flexibility of wages (e.g., abolishing minimum wages or employee protection), to make the labor market more flexible.
Hidden Unemployment: Hidden, or covered, unemployment is the unemployment of potential workers that is not reflected in official unemployment statistics, due to the way the statistics are collected. Those who have given up looking for work (and sometimes those who are on Government "retraining" programs) are not officially counted among the unemployed, even though they are not employed. The same applies to those who have taken early retirement to avoid being laid off, but would prefer to be working. The statistic also does not count the "underemployed" - those with part time or seasonal jobs who would rather have full time jobs.
* Full Employment: Full Employment refers to a 0% unemployment rate. In theory, it is possible to abolish unemployment all together, however this can be a very bad thing. Typically, unemployment and inflation are inversely related to each other except in rare instances of stagflation.
Wikipedia
Bureau of Labor Statistics
The Economist
Investopedia
