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The evolution of economic theory and practice up to 2007

Classical economics has been around since the 1700s, with the likes of Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill and Alfred Marshall (amongst many others). It simply states that the economy works through no other mechanism than self interest, and that Supply ‘creates’ demand (Say’s Law). It works along the basic principle that the market will always adjust to find the equilibrium point between supply and demand, and that there is a natural adjustment to full employment. It is a brutal mechanism, concerned only with the markets and has not affection for the human impact! If the market strays from the equilibrium then the simple answer is to sit back, and wait for the re-adjustment. There is little role for governments, other than to maintain the rules and keep the markets free (ie a very laissez-faire attitude). There are certain roles for governments, such as defence etc, but that a balanced budget should be maintained at all costs (ie after the government spend of WW1, taxes were hiked and spending was cut to redress the balance regardless of human consequence). The belief was that if unemployment was high it was because wages were too high and that people were pricing themselves out of the market and that if there was inflation it was due to too large a money supply, thus fiscal contraction was required to reduce the money base. Market failure was placed very much on the shoulders of the government, and being too involved.

The Fisher Equation 

MV = PT

M = money supply
V = velocity/number of times the money changes hands
P = price
T = number of transactions

Seeing as it was believed that V and T were fairly equal/constant, it could be deduced that there was a positive relationship between the money supply and price (or inflation). Thus an increase in the money supply was seen to increase inflation and vice versa. Then the Great Depression hit, and it all changed.

Keynesian Theory Economics

This was the theory developed by John Maynard Keynes, that took force in the 1950s after the Great Depression. This is concerned with the control of aggregate demand within an economy, and that government should act to control this.

AD = C + (I-S) + (G-T) + (X-M)

for a further breakdown of this please read the following (‘How the Great Depression lead to further spending and fiscal stimulus‘).

Keynes argued that through fiscal stimulus; to include government spending and regulation of taxes; an economy could overcome the usual market cycle of boom and bust and maintain a more regular balance of growth and prosperity. It was a system that was not based on full employment, and was aware that the markets more often than not sat in disequilibrium.

After WWII, it was believed that the only road was that of depression economics. This involved currency devaluations, nationalistic agendas, increased tarifs and taxes for foreign imports. But after WWII both Theodor White and Maynard Keynes offered something new. Fixing the US exchange rate to the Gold Standard of $35 per ounce of gold meant, allowed all other nations to peg their currency to the US dollar which in turn offered the stability markets so craved. The International Monetary Fund was established to manage the currency rate and act as market stabiliser and between 1947-1971 the world’s economic waters returned to calm.

During this period it could be said that mixed market economies existed, where there was a carefully managed relationship between public and private sectors that was tied together with a fixed currency exchange rate. However in the 1980’s the exchange rate was allowed to float due to inflexible markets, and so became a floating exchange rate system.

Through this period it was apparent that the Phillips Curve, a correlation between % inflation and unemployment, existed and so fiscal control was an easy way to control the economic machine. However, in the 1980’s Stagflation set in where both stagnation and high rates of inflation were seen. This gave rise to Monetarist Economics. Monetarism was closely linked to classical economics and was  concerned with the control and supply of money. It was believed that inflation was positively correlated with the money supply, and so to reduce inflation a government should choke the money ‘drip’. However Monetarism was concerned with ‘adaptive expectations’, ie that one could look back over years of behaviour and systematically adjust policies. It blamed government intervention for inflation (going back to Fishers Equation).

There was an evolution of this, called the New Classical Economics theory which did not believe one could predict the behaviour of the people, and instead looked at the ‘instinctive adaptation‘ of leaders and building up a wealth of knowledge. This meant that responses were instant and based on principles, and that systematic errors did not occur. There was a firm belief that government spending resulted in inflation, and was an advocate for reduced government and mass privatisation. It was also called the Rational School of Thought.

Keynesian Economics has had to evolve also, and so as to counteract the forces seen in stagflation, suggested that contracts were vital so as to commit people and businesses to certain rates for a period of time. It aimed at focussing on what policies can work for governments and why.

Supply Side Economics, does just that. It returns to Say’s Law regarding supply before demand and looks at providing incentives to get back into work, promoting hard work and risk/investment. However, i have an issue with this, as i believe demand becomes before supply, and that all incentives in the world can be offered but if there is no work, there are no jobs.

In general this debate has been raging for many years, and will continue to do so for many more as there appears to be no right answer or that the right solution has not been found yet. I have not gone into the recent 2008 collapse, but will aim to get something up soon.

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The Phillips Curve and its demise

What Is meant by the Phillips Curve and account for its breakdown in the 1970s. 

The Phillips Curve shows a correlation seen between 1861 and 1950 showing the relationship between % inflation and the rate of unemployment. It shows a negative correlation hyperbola between the two sets of results (ie in general as unemployment rate decreases the % inflation increases).

Definition: Inflation is a persistant tendency for prices to rise.

This was seen to support Keynesian Economics, and was a politicians ‘dream’ scenario as it demonstrated that government intervention through fiscal policy could control inflation. For example through positive fiscal measures (ie reduction in taxes and increased government spending) then unemployment fell, but inflation increased. As the economy ‘heated up’, they could choke off the fiscal stimulis, and this would reduce inflation by increasing unemployment.

This relationship worked very well up until the 1970’s, when stagflation set in. Stagflation was a combination of both stagnation and high inflation and gave way to Monetarism.

Equilibrium, Disequilibrium and cobwebs!!

Distinguish between equilibrium and disequilibrium in the market and explain why equilibrium is so important in classical economics. 

It is understood that in economics there are the supply and demand curves. The demand curve shows a representation of the responsiveness of demand to price change (which with normal goods is a negative correlation ie the lower the price the higher the demand and vice versa). The supply curve demonstrates the willingness for suppliers to supply goods at varying prices, and this relationship is normally seen to be a positive correlation (that meaning the higher the possible price, the more a supplier is willing to supply of that good). The equilibrium point is that where these two lines cross, and can be classed as ‘where supply meets demand’. There is no tendency for change from this point, assuming ceteris paribus (ie no other factors change).

In classical economics, where the markets are the sole driver of economic function it is believed that the market will always strive toward equilibrium and that when the markets are said to be in disequilibrium (ie not sitting at the intersection of supply and demand curves) that they should be left alone and will naturally find the equilibrium point once more.

It is also important to note that the cobweb theory of supply and demand states that as the market strives to settle back into the equilibrium position, then the market can implode (ie the supply and demand fluctuate in ever smaller circles around the equilibrium) or explode (ie the supply and demand will fluctuate around the equilibrium point, in ever widening circles). The imploding model is called stable cobweb theory and results when the demand curve is elastic, and the supply curve is inelastic. The exploding model is called the unstable cobweb theory and results from inelastic demand curve, and the supply curve is elastic.

A quick explanation of GDP, GNP, and National Income

Distinguish between National Income, Gross National Product, and Gross Domestic Product and explain which is best as describing an economies health. 

Gross National Income is the sum of all goods and services sold by firms registered within an economy over a period of time. This value includes all output made by firms, based domestically but working abroad. 

In contrast Gross Domestic Income is the sum of all goods and services sold within the domestic boundaries of an economy over a period of time. This figure includes all outputs made by foreign firms within the domestic economy.

National Income measures the amount of money spent on goods and services within an economy.

National Output = National Expenditure (Aggregate Demand) = National Income

It must be noted that if there is a rise in GDP then Aggregate Demand or National Income has risen above inflation and so this is seen as an indicator for economic health.

 

 

Optimal Scale and X-Inefficiency

Considerable knowledge (aka perfect information) is required to understand/calculate the optimal technical output for a firm, but it must be understood so that a firm can make the best decisions regarding production. It must be noted that sometimes it is not possible for a firm to actually produce on the ‘optimal technical efficiency’ because there is simply not enough demand.

The X-Inefficiency is also known as the ‘production cost gap’ and is found in companies that are producing the maximum output, but are not producing at the optimum technical efficiency. There are several reasons this may occur:

  1. the firm is not producing at the optimal scale of production.
  2. the firm does not function efficiently and wastes resources.

It can be seen from the diagram above that there are several points of interest. These include:

  • X’ is the point where maximum output is reached but the cost of production is too high, as it does not sit in the Average Total Cost Curve.
  • the vertical distance between X’ and the ATC Curve is the X-Inefficiency.
  • X is a poor position for a firm to be producing at, as the cost of production is high (above the ATC Curve) and output is low. This firm would be in danger and would require restructuring.

Organising to avoid Economies of Scope and Scale

Firms can certainly benefit from economies of scope, which is when a firm will produce two or more outputs from one source (or they themselves produce) rather than using two firms for this, and thus save on the cost of production. This is equivalent to sharing production. There are several methods this can be achieved:

  • sharing common inputs over a range of production activities.
  • joint promotion of goods and services.
  • joint distribution of goods and services.

Organising Production to avoid economies of scale

So as to avoid diseconomies of scale, companies can arrange themselves to minimise the bureaucracy & increased decision making time associated with growth. This gives rise to the M-Form (multi-form) structure, where parts of the company operate with independence from one another, giving daily decisions to local managers. An example here might be a holding company such as the News Corporation.

Smaller firms however, tend to be managed through a clear hierarchy with little decentralised decision making. This is referred to as the U-Form (Unitary Form) structure (it must be noted that this is the classical definition and theory of company management although my experience and sentiment is that this is not the best form of company management for small firms, instead i would offer more autonomy and freedom in roles empowering people to make their own decisions – but for now i am revising… so i will stick with the text book – I will return to this i promise and give a decent post on this subject).

There are other ways to avoid diseconomies of scale, and these include:

  • relocation of operations
  • contracting out
  • reorganising the management structure
  • introduction of new and improved technology

Here are some basic ideas for you.

Static Cost reductions occur in the short run, and are associated with improving existing production.

Dynamic Cost Reductions are those alterations that occur in the long run and are associated with efficiency gains through improving production.  These will normally occur through innovation, and are associated with reductions in the average cost per unit (please note the Experience Curve).

So what is the Experience Curve (aka the Learning Curve)?

This reflects the efficiency gains seen in a firm due to becoming more experienced about its production, and thus ‘fine tuning’ its processes.

Economies and Diseconomies of Scale

Economies and diseconomies of scale are concerned with the implications of changes in potential output caused through increasing the scale of production (ie as a firm grows in size). There are many positive affects resulting from this growth, but there are also some interesting negative affects that growth can have on the productivity of the firm. I will aim to summarise some of them here.

  1. Constant Returns of Scale. This arises when the volume of output increases at the same proportion to increases in factor inputs.
  2. Increasing Returns of Scale. This arises when the volume output increases more quickly than the respective increases in factor inputs.
  3. Decreasing Returns of Scale. This arises when the volume of output increases less quickly than the increase in the factor inputs.

In the long run, these forms of economies of scale are associated with constant cost, decreasing cost and increasing cost strategies (respectively).

We can also classify the economies of scale dependant where they are taking place and how.

Internal Economies of Scale

These arise in industries where there is a large output of goods or services, and they minimise long-run average costs (eg chemical, oil, banking). The decrease in average costs of production arise from more effective use of available resources resulting in a higher level of efficiency and therefore productivity at lower costs. We are able to identify these internal economies of scale in the following areas:

  • labour
  • investment
  • procurement
  • R&D
  • capital
  • diversification
  • product promotion
  • transport & distribution
  • by-products

A definition to note – Monopsony is the ability/power to drive down prices from a supplier due to being the only output to that supplier.

External Economies of Scale

These relate to the operations and management of the individual firms, and therefore are directly under the control of the business managers. These will relate to:

  • labour
  • suppliers
  • social infrastructure

Internal Diseconomies of Scale

As a company increases in size it may reach a point where diseconomies of scale occur, and therefore a decision is required as to whether to increase output. These diseconomies of scale occur in the following:

  • Management – As a firm grows, so does its management structure and it can often become complex and bureaucratic in nature. It can develop something called ‘organisational slack’.
  • Labour – As companies grow industrial disputes are more likely. As a labour force grows in size the apparent gap between management and workforce increases, unionisation increases, perhaps a lower individual productivity can emerge, absenteeism, and slacking all increase as individual responsibility ‘appears’ to decrease.
  • Other inputs – As demand for inputs increases, these inputs may very well increase in cost if the input is limited. This can also apply to skilled labour.

External Diseconomies of Scale

As a sector of an industry increases in size and demand rises, the costs of this sector may well rise as s whole. An example would in Silicon Valley, through the 1980 as the personal computer industry grew there would have been an increased demand for housing and transport, which would have led to both increases in living and transport costs. This would have resulted in higher wage expectations/demands.

There is another form of external diseconomies of scale in that there can be environmental hazards and thus costs as a sector/business grows.

Long Run Average Costs

As a firms grows, if internal and external economies of scale exist, then we can expect unit costs to decrease as the volume of output increases. This represents increasing returns to scale, or decreasing production costs.

Once the unit cost levels out, the company is said to be operating under constant cost production. Companies will always want to operate at the level of output which corresponds to the minimum unti cost over the long run, or the Minimum Efficient Scale.

E-Commerce and costs of production

The internet has revolutionised the business world, as B2B online sales have increased. The internet has allowed companies to reduce the transaction/admin charges surrounding business exchange and this has in turn been passed onto the customer. However, this reduction in transaction charges has effectively reduced the Minimum Efficient Scale for entry into the market. This means a company requires less capital to begin to trade which results in more firms entering the given market. This means a higher level of competition, quality and customer service.

Production jargon & relationships between cost and output

Long and Short Run are terms that can be confusing from an economics perspective, as they are not based on a time dimension.

The Short Run is a period where at least one input is fixed (eg personell employed), and this is also known as the operating period.

The Long Run is a period where are inputs are seen to vary, and is also known as the planning horizon. 

Diminishing Returns of Production

ASsuming that the firm is using all existing resources efficiently, then the extent to which the firm can alter its output depends on the extent to which the firm can vary its inputs.

The Law of Diminishing (Marginal) Returns

In the short run, when one or more factors are held fixed, there will come a point beyond which the additional output from using extra units of the variable inputs will diminish.

There will be an output beyond which the addition of units of variable factors such as labour, against a fixed input such as capital will result in a decline in output per employee. This is known as the Average Physical Product of labour.

Marginal Physical Product

This is the change in total output seen from employing each additional unit of variable factor input.

The Relationship between Production and Costs

The output at which the average cost per unit is at its lowest is known as the Technically Optimum Output.

The change seen in total costs of production as output is changed incrementally is referred to as the marginal cost. Where the total cost curve is linear, the marginal cost is constant, and it is easier to refer to this as the marginal cost of output.

The Incremental cost per unit is the total change in costs caused by the output increment. in other words  the incremental cost equals the average marginal cost over the range of outputs.

Classification of Profits

Normal profits are made when profits ‘just’ cover the opportunity cost of investing this capital elsewhere. It is the minimum level of profits required for a firm to continue trading.

In incorporated companies this is equal to the ‘cost of capital’, which would include interest on loans and returns to investors.

In non-corporate entities this is the amount of profit required to persuade investors to invest money into a company to undertake production risks in an industry.

Supernormal Profit is seen to be all profit made above this normal profit.

Concepts of Elasticity… and i don’t mean rubber bands!!

There are many forms of Elasticity of Demand, and the basic mathematical formula is:

Coefficient of Elasticity = % change in quantity demanded / % change in relevant variable

The Price Elasticity of Demand

The price elasticity of demand is the amount at which consumer demand for a product or service will vary with price, ie the responsiveness of demand to changes in Po.

Based on general formula, the own price (Po) elasticity of demand for a product, denoted as Ed, may be calculated as such:

Ed = % change in quantity demanded / % change in Po

Cross Price Elasticity of Demand

The Cross Price Elasticity of Demand (aka cross elasticity) is also seen as the measure of responsiveness of product demand when there is a change in price of either complimentary or substitution products. An example here, might well be the change in demand for butter if there is a decrease in the price for margarine (ie the responsiveness of demand to changes in Ps and Pc.

This can be calculated as follows:

A = product of interest
B = complimentary/substitue product

cross price elasticity = % change in demand for A / % change in the price of B

It should be obvious that in substitute products the cross price elasticity will be a positive number, ie a rise in price of a substitute good will likely raise the demand seen for interested product. And vice versa, in complimentary products the cross price elasticity will be a negative value. If the goods are unrelated then the value will be negligible or zero. Thus a CPE of:

‘1’ would mean a unitary CPE.
<1 would mean an inelastic CPE.
>1 would mean an elastic CPE.

Income Elasticity of Demand

It should be understood that the price elasticity of demand is variable due to factors other than Po. One very important factor is ‘real income’ (nominal income adjusted for inflation). Therefore Income Elasticity of Demand is important. This measures the responsiveness of demand due to a change in the income of consumers. A simple example here would what would happen to the demand for housing if average salaries were increased by £500 per month.

We can calculate this mathematically:

Income Ed = % change in demand / % change in income

For normal goods the Income Ed is seen as a positive value, ie the more earned the more bought. But there are casses when the value is negative and so can be used to classify products. Normal goods can be split into two more further categories; Necessities and Luxuries.

  • Necessities are goods such as bread, milk and flour and the Income Ed will be <1, which means that the demand will increase at a slower proportion than increases in salary.
  • Luxuries will see a varied Income Ed, with little or no demand below a certain income level, but thereafter there will be a disproportionate rise in demand for these goods. These goods will be Veblen Goods such as luxury cars, luxury houses and luxury holidays.

Inferior goods have a negative Income Ed. This means less is bought as income increases, which could be goods such as junk foods, or non branded clothing.

In times of boom, luxury products will see a disproportionate rise in demand, and offer great returns to savvy investors. However, necessities offer a more stable market, as there is demand through recessions etc as the Income Ed is <1 and are there said to have an inelastic Income Ed.

Arc Elasticity of Demand

This measures the responsiveness of demand between two points on a demand curve. It must be noted that the Arc Of Elasticity is measured at the midpoint between these two points, say X and Y. Arc Elasticity is therefore always expressed as an average of quantity and price.

Point Elasticity of Demand

This is not commonly used by businesses, as no one is particularly interested in what an infinitesimally small change in price would have on demand, but it does have a role in mathematical demand forecasting.

It should be noted, that products with:

  • a price elasticity of <1 are said to be fairly ‘inelastic’ (thus as the price changes there will be little affect to the demand for that product. An example would be bread, because if the price of bread went up people would still need to eat and would thus purchase the bread but if the price went down people would not really look to buy more bread as they would be unable to consume before it went stale).
  • a price elasticity of >1 are said to be fairly ‘elastic’ (thus there would be considerable change in the demand for the product as the price of that product changes)
  • a price elasticity equal to 1 are said to have a ‘unitary’ elasticity of demand. This means that the change in demand is perfectly correlated to the change in price.
  • It should be noted that the correlation is ‘usually’ a negative number (-) but this is ignored and always referred to as positive.

Price Elasticity should also be calculated for each change in price. This theory, although impossible to calculate in reality, should be understood because understanding price changes has a very real affect on sales revenue.

The Analysis of Consumer Demand

again…. some more of my notes & revision from the Principles of Business Economics by Joseph G. Nellis and David Parker.

The Analysis of Consumer Demand is a crucial aspect of successful business management. Without an understanding of this, and its implications it is unlikely that a firm will be around for very long.

Consumer demand is affected by many things, some within the control of the managers, and some not. Uncontrollable conditions are those things that affect consumer demand, but that are not under the control of the firm itself such as the weather.

It is also understood that sometimes, consumers can act as theorised to maximise utility, but with imperfect information. A great example of this, would be an individual buying a car who later regretted his/her choice as the car was unreliable. If the consumer had had perfect information regarding the car’s engine it would be safe to say he/she would not have purchased it. This is known as Boundless Rationality.

The Market Demand Curve

Economist use the term ‘demand’ to mean the ‘effective demand‘ for a product in the market place. This is the amount consumers are willing to buy at a given price and over a given period of time. We can aim to visualise this with the use of a ‘Consumers Demand Curve’, which relates the quantity an individual consumer is willing to buy of a certain product over a range of conceivable prices.

We can then build the more useful Aggregate/Market Demand Curve for a good/service which shows the ‘total’ effective demand for a product over a given period of time. This can be achieved by summing the individual demand curves of consumers horizontally for any given price.

At any given price : Adam’s demand + Eve’s demand = Market Demand

The Law of Demand

As stated the Demand Curve shows the relationship between the Market Demand over a range of prices for the good/service, and thus the amount a company can expect to sell. It is understood that in general there is an inverse relationship between an increase in price and the aggregate demand for that product in the market place, assuming ceteris paribus (all other factors are held constant).

So why do people consume more of something the cheaper it becomes? Well, when people consume more of something in a given time period the total utility will tend to rise. However it should be noted that the marginal utility will tend to decrease with each purchase. This decline of marginal utility as units purchased increases can be attributed to the Law of Diminishing Marginal Utility. Therefore, we can assume that consumers will tend to maximise their utility buy spreading their purchases over many products (how much more can you get from your 10th car, than you got from your 9th?).

At some point the consumer will reach what is known as Consumer Equilibrium, that is to the say, the point where they are unable to redistribute their spending to acquire a higher utility.

Let us assume two goods, a and b and that consumer Equilibrium has been reached:

MUa/Pa =  MUb/Pb

If the price of a increases then

MUa/Pa < MUb/Pb

Therefore the consumer will purchase more of b so as to restore to Consumer Equilibrium. This will result in the Marginal Utility of ‘a’ will increase and the Marginal Utility of ‘b’ will decrease (Law of Diminishing Marginal Returns in effect) until once again

MUa/Pa = MUb/Pb

The Paradox of Values is seen when the cost of goods/services that are seen as necessary are actually lower than those that are not vital. A good example is how expensive diamonds are, but water is cheap.

Consumer Surplus

This is the increase in the price a consumer would be willing to pay for a good, rather than go without the good, than is actually paid for by the consumer. This can also be referred to as the ‘consumers rent’. However, in an auction based market place, where each person can bid to the maximum price he/she gives marginal utility of owning that product, eliminates Consumer Surplus, and gives rise to a Discriminating Monopolist.

As mentioned above it is vital for a business to understand the behaviour of demand, and there are some other determinants of demand that should be looked at. These include:

  • the ‘own’ price – Po (as stated above the price is one of the major determinants)
  • the price of substitute goods – Ps
  • the price of complimentary goods – Pc
  • levels of advertising – Aa,b,c,d….
  • levels of disposable taxes – Yd
  • wealth affects caused by stock market booms, rising house prices, windfall gains etc – W
  • changes in consumer trends, tastes and preferences- T
  • cost and availability of credit – C
  • consumers expectations concerning future price changes and availability of prices – E
  • changes in total population – POP

The conditions of demand are seen as those conditions, other than Po, that affect the demand curve.

The demand function is as follows:

Qd = f(Po, Ps, Pc, Aa,b,c, Yd, W, T, C, E, POP)

When Po changes it is expected that demand will move along the demand curve. However, when any other determinants of demand are altered, we would see a movement OF the demand curve.

It should also be noted….

The Income Effect

As Own Price (Po) of a product decreases, the consumer’s purchasing power increase as though their income was increasing. The opposite effect also applies, even though their income in unchanged.

The Substitution Effect

As Po falls, this product becomes cheaper than many competitors, and so consumers will begin to choose this over other products. This is know to the Substitution Effect.

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