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ECONOMIC ANALYSIS FOR BUSINESS
Unit -1
INTRODUCTION
The themes of economics – scarcity and efficiency – three fundamental economic problems –
society’s capability – Production possibility fronties (PPF) – Productive efficiency Vs economic
efficiency – economic growth & stability – Micro economies and Macro economies – the role of
markets and government – Positive Vs negative externalities.
Table of Contents
1.1 Introduction to Economy ........................................................................................................................2
1.1.1 Meaning of Economics ....................................................................................................................2
1.1.2 ECONOMIC GOALS ..................................................................................................................2
1.2 The themes of Economics .......................................................................................................................4
1.3 Three fundamental economic problems: .................................................................................................5
1.4 Types of Economies:...............................................................................................................................5
1.4.1 Market Economy ..............................................................................................................................5
1.4.2 Command Economy.........................................................................................................................6
1.4.3 Mixed Economy ...............................................................................................................................6
1.5 Society’s Capabilities..............................................................................................................................7
1.6 The Production Possibility Frontier (PPF) ..............................................................................................7
1.6.1 Properties of the Production Possibility Frontier .............................................................................9
Productive efficiency Vs economic efficiency ...........................................................................................10
Productive Efficiency..............................................................................................................................10
Economic efficiency ...............................................................................................................................11
1.7 Economic growth & stability ................................................................................................................11
1.7.1 The Record Shows About Our Growth ..........................................................................................11
1.7.2 Factors determining the growth of an Economy ........................................................................12
1.8 Microeconomics and Macroeconomics ................................................................................................12
1.8.1 Microeconomics .............................................................................................................................12
1.8.2 Macroeconomics ........................................................................................................................12
1.10 Externalities ........................................................................................................................................14
1.10.1 Positive Externalities ...................................................................................................................15
1.10.2 Negative Externalities ..............................................................................................................15
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1.1 Introduction to Economy
ECONOMY is the system of trade and industry by which the wealth of a country is
made and used.
An economy is a system that attempts to solve the basic economic problems. The
function of the economy is to allocate scarce resources among unlimited wants.
An economy is an area in which people make and purchase goods and services. It can be
any size and with any number of people involved.

Local economy e.g. small town.

National economy e.g. India

Global economy e.g. the world.
An economy develops as these factors of production are organised to create the necessary
goods and services to satisfy the needs and wants of a society.
Economics is the study of how societies use scarce resources to produce valuable commodities
and distribute them among different people.
1.1.1 Meaning of Economics
Economic systems evolve to help us:
Produce and distribute goods and services to satisfy our needs and wants.
Economics is defined as the study of how individuals and society choose to use scarce
resources. In essence, economics is a study on how individuals make choices.
There are two branches of economics: (1) Microeconomics and (2)Macroeconomics
Microeconomics looks at the decision making behavior of individual decision making
units
Macroeconomics looks at the entire (aggregate) economy.
ECONOMICS is the study or social science of human behaviour in relation to how
scarce resources are allocated and how choices are made between alternative uses Economics
studies mankind’s activities, which are production, distribution (or exchange)
and consumption of goods and services that are capable of satisfying human wants and
desires.
1.1.2 ECONOMIC GOALS
Any science moves with certain goals to be achieved. Economics has become now a
crucial branch of knowledge. Being a social science it keeps on revising its goals from time to
time. The list might be quite large, but we would like to focus only on certain major goals of
economics as given under:
1.
A low rate of unemployment: People willing to work should be able to find jobs
reasonably quickly. Widespread unemployment is demoralising and it represents an economic
waste. Society forgoes the goods and services that the unemployed could have produced.
2.
Price stability: It is desirable to avoid rapid increase or decreases in the average level of
price.
3.
Efficiency: When we work, we want to get as much as we reasonably can take out of our
productive efforts. For this, efficient technology becomes quite useful.
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4.
An equitable distribution of income: When many live in affluence, no group of citizens
should suffer stark poverty. Given this, developing countries are strategizing goals like
participatory growth and inclusive growth.
5.
Growth: Continuing growth, which would make possible an even higher standard of
living in the future, is generally considered an important objective.
6.
Economic freedom and choice: Any economy should grow and develop in such a
manner that people should get more choices and there should not be any outside pressure on
their choices.
7.
Economic welfare: Economic policies should be pursued in such a manner that welfare
of the people or the social benefits get maximised.
8.
Sustainable development: It has become a major challenge for economists to carry on
the process of economic growth in such a manner that the resources are optimally utilized not
only for intergenerational equity but also for sustainable development in quite long run.
1.1.3 SCOPE OF ECONOMICS
The horizon of economics is gradually expanding. It is no more a branch of knowledge
that deals only with the production and consumption. However, the basic thrust still remains on
using the available resources efficiently while giving the maximum satisfaction or welfare to the
people on a sustainable basis. Given this, we can list some of the major branches of economics
as under:
1. Microeconomics: This is considered to be the basic economics. Microeconomics may be
defined as that branch of economic analysis which studies the economic behaviour of the
individual unit, may be a person, a particular household, or a particular firm. It is a study of one
particular unit rather than all the units combined together. The microeconomics is also described
as price and value theory, the theory of the household, the firm and the industry. Most
production and welfare theories are of the microeconomics variety.
2. Macroeconomics: Macroeconomics may be defined as that branch of economic analysis
which studies behaviour of not one particular unit, but of all the units combined together.
Macroeconomics is a study in aggregates. Hence it is often called Aggregative Economics. It is,
indeed, a realistic method of economic analysis, though it iscomplicated and involves the use of
higher mathematics. In this method, we study how the equilibrium in the economy is reached
consequent upon changes in the macro-variables and aggregates.The publication of Keynes’
General Theory, in 1936, gave a strong impetus to the growth and development of modern
macroeconomics.
3. International economics: As the countries of the modern world are realising the significance
of trade with other countries, the role of international economics is getting more and more
significant nowadays.
4. Public finance: The great depression of the 1930s led to the realisation of the role of
government in stabilising the economic growth besides other objectives like growth,
redistribution of income, etc. Therefore, a full branch of economics known as Public Finance or
the fiscal economics has emerged to analyse the role of government in the economy. Earlier the
classical economists believed in the laissez faire economy ruling out role of the government in
economic issues.
5. Development economics: As after the second world war many countries got freedom from
the colonial rule, their economics required different treatment for growth and development. This
branch developed as development economics.
6. Health economics: A new realisation has emerged from human development for economic
growth. Therefore, branches like health economics are gaining momentum. Similarly,
educational economicsis also coming up.
7. Environmental economics: Unchecked emphasis on economic growth without caring for
natural resources and ecological balance, now, economic growth is facing a new challenge from
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the environmental side. Therefore, Environmental Economics has emerged as one of the major
branches of economics that is considered significant for sustainable development.
8. Urban and rural economics: Role of location is quite important for economic attainments.
There is also much debate on urban-rural divide. Therefore, economists have realised that there
should be specific focus on urban areas and rural areas. Therefore, there is expansion of
branches like urban economics and rural economics. Similarly, regional economics is also being
emphasised to meet the challenge of geographical inequalities. There are many other branches of
economics that form the scope of economics. There are welfare economics, monetary
economics, energy economics, transport economics, people that are used to create goods and
services.
1.2 The themes of Economics
Scarcity
Scarcity is a relative concept. It can be defined as excess demand i.e., demand
more than the supply. For example, unemployment is essentially the scarcity of jobs. Inflation is
essentially scarcity of goods. Scarcity is the fundamental economic problem of having seemingly
unlimited human wants and needs in a world of limited resources. It states that society has
insufficient productive resources to fulfill all human wants and needs. The production of goods
to satisfy a wants will reduce the amount of the available resources. Resources are limited.There
is only so much land, labour, capital, and entrepreneurship in existence at any point in
time.Resources are therefore scarce because there is not enough of them to go around to produce
all the things that we would like to produce to satisfy all our wants.Hence goods are scarce, too.
Scarce resources tield scarce goods. Resources are limited, but n the other hand , human wants
are unlimited.Unlimited wants alone are not a problem, but certainly a problem exists when
unlimited wants are combined with a limited means of satisfying those wants.
Goods (and services) that are scarce are called economic goods (or
simply goods if their scarcity is presumed). Other goods are called free goods if they are desired
but in such abundance that they are not scarce, such as air and seawater. Economists study
(among other things) how societies perform the allocation of these resources — along with how
communities often fail to attain optimality and are instead inefficient. More clearly scarcity is
our infinite wants hitting up against finite resources.
Efficiency
A measure of how well workers, businesse, government or a country produces goods or
services. Efficiency sugests that being able to make a judgement about when resources are, or
are not , being used in this ‘best’ possible way is very important. That is what ‘economic’
efficiency’is about.
In economics, the term economic efficiency refers to the use of resources so as to
maximize the production of goods and services. An economic systemis said to be more
efficient than another (in relative terms) if it can provide more goods and services for society
without using more resources.
Efficiency is also producing at a lower cost or using fewer resources when making a
product or providing a service and also meeting the needs of consumers.
We can become efficient by using fewer raw materials, fewer workers, replacing high
cost labour with low cost technology, lowering waste etc.
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1.3 Three fundamental economic problems:
The fundamental economic problem is how to allocate scare resources amoung unlimited wants,
there are three questions to answer they are
What to produce? - this refers to the types of goods & services should be produced &
their quantities
How to produce? - this refers to the method of production
Whom to produce? - this refers to the national problem of how the national output should
be distributed among the population.
1.
What to produce?
This problem is what should the economy produce in order to satisfy consumer wants (as seen
by demand curves) as best as possible using the limited resources available. If a country
produces goods in a way that maximizes consumer satisfaction then the economy is allocatively
efficient.
2.
How to produce?
This problem is how to combine production inputs to produce the goods decided in
problem 1 as most efficiently as possible. An economy achieves productive efficiency if it
produces goods using the least resources possible. A productively efficient economy is
represented by an economy that is able to produce a combination of goods on the actual curve of
the PPF.
3.
For whom to produce:
‘Who should consume the produced goods and service?’Should the economy produce
goods targeted towards those who have high incomes or those who have low incomes. What sort
of demographic group should the goods in the economy that are produced be targeted towards?
All these problems are focused around the problem of unlimited wants and limited resources.
Where resources are the factors of production (such as labor, capital, technology, land) which
are used to produce the products that satisfy the wants.
The economic problem fundamentally revolves around the idea of choice, which
ultimately must answer the problem. Due to the limited resources available, producers must
determine what to produce first to satisfy demand. Consumers are considered the biggest
influences of this choice, and the goods which they want must also fit within
their budgets and purchasing power parity. Different economic models place choice in different
hands. Want must also fit within their budgets and purchasing power parity. Different economic
models place choice in different hands.
1.4 Types of Economies:
1.4.1 Market Economy
Market Economy In a market economy, demand determines what goods and services are
to be produced and how much of each good and service to be produced. Consumers are assumed
to act in a rational manner so as to maximize their economic welfare. They spend their income
on various products in such a way so as to maximize their economic welfare.
Given the demand, firms decide how to produce the required goods and services
in a most efficient manner so as to maximize their profits. This results in optimum allocation of
scarce resources. The last question i.e., how the goods and services are distributed is resolved by
the ownership pattern of factor inputs and factor prices.
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In the market economy described above, prices assume significance in allocation
of resources and determining factor prices.
Suppose consumer tastes change in favor of product A. In maximizing their
welfare consumer demand for product A goes up. Given the supply, this results in an increased
price for product A. This induces the firms to produce more of product A so as to maximize their
profits. To increase the supply of product A more factor inputs are required for producing
product A i.e., increase in demand for factor inputs used for producing product A. Hence prices
of factor inputs used for producing A also increase. This causes the redistribution of income in
favor of the factor inputs used for producing product A. This way price assumes significance by
providing signals and incentives to the economic agents and co-ordinates their decisions in a
market economy.
Adam Smith proclaimed that through the functioning of the invisible hand, those
who pursue their own self-interest in a competitive economy would most effectively promote the
public interest. The tendency of the market prices to direct individuals pursuing their own
interests into productive activities that also promote the economic well being of the society, is
referred to as the invisible hand principle. It has been proved that under restrictive assumptions,
a perfectly competitive economy is efficient. It should be noted that an economy is said to be
producing efficiently when it cannot increase the economic welfare of anyone without making
someone else worse off. According to Adam Smith, under perfect competition and with no
market failures, markets will squeeze as many useful goods and services out of the available
resources as possible. However, where monopolies or other sorts of market imperfections or
market failures become pervasive, the remarkable efficiency properties of the invisible hand may
be destroyed.
1.4.2 Command Economy
A command mechanism is a method of determining what, how, when, where and
for whom goods and services are produced, using a hierarchical organization structure in which
people carry out the instructions given to them. The best example of a hierarchical organization
structure is the military. Commanders make decisions requiring actions that are passed down a
chain of command. Soldiers and mariners on the front line take the actions they are ordered.
The economic system that prevailed in the former Soviet Union and the former
communist nations of Eastern Europe was called a command economy because under that
system central planning authorities determined resource allocation, production goals, and prices.
A command economy differs from a market economy in two important ways:
firstly, in a command economy the state owns all the productive resources,
like land, factories, financial institutions, retail stores, and the bulk of the housing stock.
Government enterprise and government ownership of resources are the rule rather than the
exception in a command economy.
secondly, in a command economy, authoritarian methods are used to
determine resource use and prices.
A centrally planned economy is one in which politically appointed
committees plan production by setting target outputs for factory and enterprise managers and in
general manager the economy to achieve political objectives.
1.4.3 Mixed Economy
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An economy that uses a market co-ordinating mechanism is called a market economy.
However, most of the real world economies use both markets and commands to co-ordinate
economic activity. An economy that relies on both markets and command mechanism is called a
mixed economy.
In most modern nations, governments control many resources, and criteria other
than personal gain and business profit are used to decide how resources will be employed. Most
of modern nations have a mixed economy, where governments as well as business firms provide
goods and services. In such economies government supplies roads, defense, pensions, and
sometimes even schooling directly to the citizens. In modern economies, governments also
commonly intervene in the markets to control prices and correct the shortcomings of a system in
which prices and the pursuit of personal gain influence resource use and incomes.
1.5 Society’s Capabilities
We need many goods and services. We like to consume goods including basic
necessities like food, clothes, house, water and luxuries like diamonds, cars and huge bungalows
and also needs services education, health and social security’s, etc. All these goods and services
are together called commodities;millions of commodities are produced and distributed all over
the world. Millions of decisions are being made in the production and distribution of all such
commodities. Commodities satisfy human wants and give pleasure or utility to individuals.
• Takes the initiative in combining the resources of land, labour, and capital
• Makes strategic business decisions
• Is an innovator
• Commercializes new products, new production techniques, and even new forms of business
organization
• Takes risk to get profits
1.6 The Production Possibility Frontier (PPF)
The production possibility frontier shows all the combinations of two goods
that can be produced if all of society’s resources are used efficiently.
Figure 1 shows the production possibility frontier for consumption and capital goods.
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Point A represents a point where all the resources in the economy are being used to produce
capital goods. In this case only capital goods are produced and no consumption goods are
produced.
Point B represents the opposite case where all the resources in the economy are being used to
produce consumption goods. In this case only consumption goods are being produced and no
capital goods are produced.
There are any number of combinations in between these two extremes, and any point on the
curve in Figure 1 are possible production points for the economy. Points E and F are points
along the PPF, which means that an economy utilizing all its resources efficiently can produce at
those points.
Point C is another point that is obtainable in this economy. In fact any point inside the
production possibility frontier is obtainable. However, Point C is not desirable since it implies
that the economy is not using its resources efficiently. We can see that, because the economy can
go to another point which would be able to produce more capital goods and more consumption
good. Thus the economy doesn’t want to remain at a point inside its PPF. How does an economy
get to be at a point inside its PPF? There are two possibilities:
1.
Resources such as labor are not being fully utilized. If there is unemployment,then the
economy is not producing at its full potential. As workers get hired, the economy will be able to
produce more.
2.
Resources are wasted or mismanaged. Even if workers and capital are fully employed,
there can be ways in which the economy produces below full potential. Suppose a new law was
put into effect saying that all college educated individuals could only work as janitors, while
those only with a high school education would be allowed to run corporations and factories.
Although labor might be fully utilized, it is clear that it is being mismanaged as jobs are not
matched with the skill sets. As a result production will be less.
Point D represents a point that is unattainable. Given the level of technology in the
economy, there is no method which will allow the economy to reach that level of consumption
and capital goods.
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1.6.1 Properties of the Production Possibility Frontier
PPFs are not just useful in examining the tradeoffs between consumption and
capital goods, they can be used to examine the tradeoffs between any two goods. For example
the table below shows an economy with fixed resources is able to produce the following
combinations of grapes and apples.
POINT
GRAPES
APPLES
A
75
0
B
60
12
C
45
22
D
30
30
E
15
36
F
0
40
Figure 2 uses the data in the table to graph the PPF between apples and grapes.
Using Figure 2 we can illustrate several properties of PPF.
Property 1: To be efficient and economy must also produce what consumers want.
This is called output efficiency. We talked earlier about how an economy is efficient if it uses all
of its resources (production inefficiencies). Any of the Points A-F uses its
resources efficiently. However, if the economy is producing at Point F, but everyone in the
economy hates apples then the result is a waste of resources (we have output
inefficiency). The point of output efficiency is determined by consumer preferences.
Property 2: PPF have negative slope.
The slope of the PPF is called the marginal rate of transformation (MRT). Note that
throughout the curve, the slope is negative. For example as we move from Point C to Point D,
the number of grapes decreases by 15 while the number of apples increases by 8. The slope from
C to D is -15/8. The reason for the negative slope is quite straightforward. Because resources are
limited, in order to produce more apples, the other product (grapes) must be sacrificed. Thus
between C and D, in order to produce 8 more apples, the economy has to sacrifice 15 grapes.
Property 3: The Law of Increasing Opportunity Costs implies that PPF is bowed.
Notice in Figure 2 that opportunity cost is increasing as we shift production from grapes
to apples. For example, as we move from A to B, in order to get 12 apples we have to sacrifice
15 bushels of grapes. The opportunity cost per apple is 15/12 = 1.25 grapes.
Now as we move from E to F, if we sacrifice 15 bushels of grapes we only get 4 more apples.
The opportunity cost per apple is 15/4 = 3.75 grapes. Why does the opportunity cost increase?
It’s reasonable to assume that apples and grapes require different land to grow best. As we shift
production more and more away from grapes, we are increasingly taking away land that is best
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suited towards grape production and shifting it to apple production. As a result we are sacrificing
more grapes to get less apples. This idea of increasing opportunity cost explains why the PPF
curve is bowed. If the opportunity cost was constant (like in our island example) then the PPF
would simply be a straight line.
Property 4: Economic growth is characterized by the PPF shifting outwards to the right.
Economic growth can occur if:
(1) There are more resources such as more labor or more capital or
(2) There is new technology that allows producers to produce more output with the
same level of inputs.
Figure 3 shows how economic growth can be represented by our PPF. Suppose that the
economy was fully utilizing its resources at Point D. With new technology, with the same
amount of capital and labor it can produce both more apples and more grapes and will move to a
higher point such as Point G. This will be true at every other old combination and thus the curve
will shift to the right.
Figure 3: Economic Growth
Productive efficiency Vs economic efficiency
Efficiency is one of the most important concepts to use in you're A Level Economics course.
There are several meanings of the term - but they generally relate to how well an economy
allocates scarce resources to meets the needs and wants of consumers. Make sure you know your
definitions well, can illustrate them using appropriate diagrams and can apply them to particular
situations
Productive Efficiency
Productive efficiency refers to a firm's costs of production and can be applied both to the short
and long run. It is achieved when the output is produced at minimum average total cost (AC).
For example we might consider whether a business is producing close to the low point of its long
run average total cost curve. When this happens the firm is exploiting most of the available
economies of scale. Productive efficiency exists when producers minimise the wastage of
resources in their production processes.
Trade-offs between efficiency and equity
There is often a trade-off between economic efficiency and equity. Efficiency means that all
goods or services are allocated to someone (there’s none left over). When a market equilibrium
is efficient, there is no way to reallocate the good or service without hurting
someone. Equity concerns thedistribution of resources and is inevitably linked with concepts of
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fairness and social justice. A market may have achieved maximum efficiency but we may be
concerned that the "benefits" from market activity are unfairly shared out.
Economic efficiency
Efficiency is about a society making optimal use of scarce resources to satisfy wants & needs.
Economic Efficiency is the wise use of available resources so that costs do not exceed benefits.
There are several meanings of efficiency but they all link to how well a market allocates our
scarce resources to satisfy consumers
Normally the market mechanism is good at allocating these inputs, but there are occasions when
the market can fail
Allocative efficiency
Allocative efficiency is concerned with whether we are producing the goods and services that
match our changing needs and preferences and which we place the greatest value on.
Allocative efficiency is reached when no one can be made better off without making someone
else worse off. This is also known as Pareto efficiency.
1.7 Economic growth & stability
Economic growth is an increase in the total output of the economy. It occurs when a
society acquires new resources, or when it learns to produce more using existing resources.
The main sources of economic growth are capital accumulation and technological advances.
Economic growth can be and is measured by various yard- sticks, none of which is
satisfactory. Some people focus attention on Gross National Product or its rate of increase.
Others more properly take account of the increasing population and use per capita GNP as a
growth indicator. Both measures have disadvantages, however. GNP data are crude, vague, and
difficult to compare over time. Therefore, some people concentrate on industrial production, a
less broad measure, but more accurate in its limited area. A common tendency is to shift from
what we want to know to what we can find out.
The big drawback with all three measures is that they leave out the really important
quality aspects of growth, such as leisure, for example. One of the most striking changes of the
past forty years or so has been the great increase in leisure, coupled with a great reduction in
brutal physical toil. To the extent people demand leisure instead of additional goods and
services, they hold down the numbers that purport to measure improvement in economic wellbeing.
1.7.1 The Record Shows About Our Growth
In spite of these difficulties, how does the record look?
1.
GNP grew at an average annual compound rate of 2.9 percent from 1909 to 1957. During
the period from 1948 to 1957 it grew at 3.8 percent per year. If we take non-overlapping periods
the difference would be even greater.
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2.
Per capita GNP shows much the same story. The long-term rate has been 1.5 percent per
year; the postwar rate has been 2.0 percent.
3.
Data on industrial production go back to 1919. From 1919 to 1957 the average annual
rate of increase was 3.7 percent, whereas in the postwar period (1948-57), it was 4.4 percent.
4.
Output per man hour has grown over the long term since about 1880, at 2 percent per
year. Since World War II (1948-57) it has gone up 3.1 percent per year-about 50 percent higher
than the long term.
5.
Output per unit of labor and capital combined shows a long-run growth rate of about 1.7
percent per year. Our postwar rate has been 2.2 percent.
6.
Disposal per capita real income increased at an annual rate of 1.6 percent from 1929 to
1958. This rate was pushed down by the depression and pushed up by the war. But the postwar
annual rate, even with very high personal taxes, has been 1.9 percent.
1.7.2 Factors determining the growth of an Economy
Economic Measures:

GDP

Inflation

Unemployment

Balance of Payments

Exchange Rate
1.8 Microeconomics and Macroeconomics
1.8.1 Microeconomics
Microeconomics looks at the behavior of individual people and companies within
the economy. It is based on the idea of a market economy, in which consumer demand is the
driving force behind the prices and production levels of goods and services.Microeconomics is
interested in how specific parties choose to use the limited resources that are available to them. It
focuses on what drives them to make their decisions, as well as the ways in which their decisions
affect the supply and demand of particular goods and services. In turn, these choices influence
the price levels of various commodities. Microeconomics also examines how the decisions of
individuals impact specific industries. For example, economists studying at the micro level
might be interested in discovering how current consumer demand is affecting the well-being of
the oil industry. Another basic principle of microeconomics is the "theory of the firm." This
studies the actions of businesses as they strive to increase their profits. It looks at which
resources they choose to utilize as inputs, how much they produce, and what they charge for
their goods or services. In summary, microeconomics concerns itself with the human beings
whose purchasing and production-related decisions come together to form the backbone of a
given economy. Even when it involves companies, the focus of microeconomics is always at the
personal level.
1.8.2 Macroeconomics
The most concrete definition of macroeconomics is that it is a study of "the big
picture" in the economy. Instead of focusing on individual households and firms, it examines
conditions within the economy as a whole. This is the most vital difference of micro and
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macroeconomics. In more technical terms, macroeconomics looks at the factors that influence
aggregate supply and demand. Since it is associated with the conditions of national economies, it
deals with such statistics as unemployment rates, gross domestic product (GDP), overall price
levels, and inflation. Its general nature makes it closely associated with public policy. Most
nations around the world have their own central banks; in the United States, this is the Federal
Reserve. In any class about macroeconomics, the actions of a given country's central bank
(known collectively as monetary policy) will be a major topic of discussion. Those studying
economics at the macro level will learn about the factors that drive a central bank to manipulate
the interest rates and money supply of its respective nation at any given time. They will also
learn about the ways in which the decisions of the national government can affect the overall
economy. These governmental actions are known collectively as fiscal policy. Although
macroeconomics has a much broader focus than microeconomics does, many macroeconomic
factors are essential to making predictions and conclusions at the microeconomic level. For
instance, knowing what the unemployment rate is at the national level can help a micro
economist predict future layoffs in a specific industry.
1.8.3 Differences between Macro and Microeconomics
Both macro and microeconomics look at supply and demand, as well as price
levels. However, each field views these factors from a different standpoint. To better grasp the
meaning of macroeconomics, it might be helpful to think of it as a "top-down approach" toward
understanding the economy. Macroeconomics paints a picture of the economic conditions in a
particular country as a whole; however, knowledge of macroeconomic principles can be used to
develop an understanding of conditions for the individual players in the economy. Likewise,
microeconomics looks at the economy from the bottom up, but the information it gathers about
individual households and businesses is helpful in gaining an understanding of general economic
conditions. The difference of micro and macroeconomics may seem well-defined on the surface,
but these two categories of study can overlap in significant ways. In fact, no student of the
economy can truly comprehend the meaning of macroeconomics without comprehending the
meaning of microeconomics as well.
Microeconomics is generally the study of individuals and business decisions,
macroeconomics looks at higher up country and government decisions. Macroeconomics and
microeconomics, and their wide array of underlying concepts, have been the subject of a great
deal of writings. The field of study is vast; here is a brief summary of what each covers:
- Microeconomics is the study of decisions that people and businesses make regarding
the allocation of resources and prices of goods and services. This means also taking into account
taxes and regulations created by governments. Microeconomics focuses on supply and demand
and other forces that determine the price levels seen in the economy. For example,
microeconomics would look at how a specific company could maximize it's production and
capacity so it could lower prices and better compete in its industry.
- Macroeconomics, on the other hand, is the field of economics that studies the behavior
of the economy as a whole and not just on specific companies, but entire industries and
economies. This looks at economy-wide phenomena, such as Gross National Product (GDP) and
how it is affected by changes in unemployment, national income, rate of growth, and price
levels. For example, macroeconomics would look at how an increase/decrease in net exports
would affect a nation's capital account or how GDP would be affected by unemployment rate.
While these two studies of economics appear to be different, they are actually
interdependent and complement one another since there are many overlapping issues between
the two fields. For example, increased inflation (macro effect) would cause the price of raw
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materials to increase for companies and in turn affect the end product's price charged to the
public.
The bottom line is that microeconomics takes a bottoms-up approach to analyzing the
economy while macroeconomics takes a top-down approach. Regardless, both micro- and
macroeconomics provide fundamental tools for any finance professional and should be studied
together in order to fully understand how companies operate and earn revenues and thus, how an
entire economy is managed and sustained.
1.9 The Role Of Governments
The government provides the legal framework and the services needed for a market
economy to operate effectively. The legal framework sets the legal status of business enterprises,
ensures the rights of private ownership, and allows the making and enforcement of contracts.
Government also establishes the legal "rules of the game" that control relationships among
business, resource suppliers, and consumers. Discrete units of government referee economic
relationships, seek out foul play, and impose penalties. Government intervention is presumed to
improve the allocation of resources. By supplying a medium of exchange, ensuring product
quality, defining ownership rights, and enforcing contracts, the government increases the volume
and safety of exchange. This widens the market and fosters greater specialization in the use of
property and human resources. Such specialization promotes a more efficient allocation of
resources.
The government improves the operation of a market system by maintaining competition.
Competition is the basic regulatory mechanism in the market system. It is the forcer that subjects
producers and resource suppliers to the dictates of consumer sovereignty. With competition,
buyers are the bosses, the market is their agent, and businesses are their servants. On the other
hand, if a monopoly takes place, the monopolist is able to charge a higher-than-competitive
price. Producer sovereignty then supplants consumer sovereignty. In the United States, the
government has attempted to control monopoly through regulations and through antitrust.
However, a few natural monopolies exist; for instance, some firms that provide local electricity,
telephone, and transportation services are considered regulated monopolies.
1.10 Externalities
Adam Smith‘s ―invisible hand‖ of the marketplace leads self-interested buyers and
sellers in a market to maximize the total benefit that society can derive from a market.
1. An externality refers to the uncompensated impact of one person‘s actions on the wellbeing of
a bystander.
2. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. When a
person engages in an activity that influences the well-being of a bystander and yet neither pays
nor receives any compensation for that effect.
3. When the impact on the bystander is adverse, the externality is called a negative externality.
4. When the impact on the bystander is beneficial, the externality is called a positive externality.
Externality: a by-product of a transaction that affects someone not immediately involved in the
transaction.
• Imply that the competitive equilibrium will not result in the social optimum
• Imply that the competitive equilibrium will result in a dead weight loss
• Create a role for government intervention
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1.10.1 Positive Externalities
Unintended external effects do not automatically lead to greater cost for society
as a whole. A positive externalities in that it enhances labour participation, and therefore reduces
demand for social security provisions.
• Immunizations
• Restored historic buildings
• Research into new technologies
1.10.2 Negative Externalities
Whole range of industrial and commercial activities can give rise to negative
externalities. Negative externalities was significant to economic arguments about the strengths
and weaknesses of the market system because their existence places additional costs on other
members of society.
• Automobile exhaust
• Cigarette smoking
• Barking dogs (loud pets)
• Loud stereos in an apartment building
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
Externalities, which occur in cases where the "market does not take into account the impact of an
economic activity on outsiders." There are positive externalities and negative externalities.
Positive externalities occur in cases such as when a television program on family health
improves the public's health. Negative externalities occur in cases such as when a company‘s
process pollutes air or waterways. Negative externalities can be reduced by using government
regulations, taxes, or subsidies, or by using property rights to force companies and individuals to
take the impacts of their economic activity into account.
EXTERNALITIES: impacts on third parties besides the buyer and seller.
Consumption Externalities: impacts on third parties as a result of the consumption of a good.
Eg. Each infected person who takes Drugs eliminates disease helps all of society, not Just the
drug company which provides the medicine.
Production Externalities: impacts on third parties as a result of the production of a good. Eg.
New discoveries & innovations impact all of Society, not just the scientist who disovers them
and the firm who employs the Scientist.
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