Download Session 1 Basic definitions and concepts

Module H4 Session 1
Economic Concepts for Statisticians
Session 1 Basic definitions and concepts
At the end of this session, students will have an understanding of:
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What is economics?
What do economists study? What areas does economics deal with?
Supply, demand and market forces
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Goods, money and foreign exchange markets
The concept of elasticity (especially income elasticity and price elasticity)
Market failure
What is economics?
Economics studies how best to allocate scarce resources, and choices between options
when resources are limited. If resources were not limited, there would be no difficulty –
people could have everything they want, all of the time. But the reality is that most of the
world’s resources are limited, so how do we choose how best to use them?
Economics is sometimes also defined as the study of the “production, distribution and
consumption of goods and services”.
Economics is an applied science not a pure science because it is concerned with practical
matters – understanding choices in the real world. It is a social science, because it looks at
the behaviour of individuals, households, firms and governments; social relations,
institutions, etc – these things affect people’s choices.
What sort of things do economists study?
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Economic growth and productivity
Inflation
Interest rates
Business trends, labour markets and unemployment
Consumption, savings and investment (and links with financial systems)
Public finances and national debt
International trade, capital flows and exchange rates
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… and much more! We will be looking at some of the above topics in Module H4.
What areas does economics cover?
There are two main areas in economics: macroeconomics and microeconomics. Macro
means large and micro means small, so macroeconomics studies the big picture – the
economy as a whole; while microeconomics looks at individual behaviour of ‘agents’ (the
general term for individuals, firms, members of government etc) and how these agents
relate to each other through specific markets.
Most of the topics mentioned in the previous section (What sort of things do economists
study?) are macroeconomic. This is the area of economics which is of most importance to
national statisticians. However, some microeconomic subjects are also relevant to our
work. Examples of microeconomics subjects are: labour markets, firm behaviour,
consumer choice and social welfare.
Do economists agree?
No. There are many schools of thought within economics. The main division is between
orthodox economics, which is based on the neoclassical school of the 19th and 20th
centuries, and Keynesian, heterodox or structuralist economics, which place greater
emphasis on human behaviours, social structures and relationships, politics and
institutions, and which includes – among others – socialist views of economics. Boxes 1
and 2 give examples of famous economists with very different views of the world.
Box 1 John Maynard Keynes
The British economist John Maynard Keynes brought about a revolution in economic
thinking when he published his General Theory of Employment, Interest and Money in 1936.
Previously, ‘classical’ economists believed that the operation of market forces would
inevitably lead to equilibrium in the economy, ensuring that it produced maximum output
and that everybody who wanted to work could do so. Keynes argued that this mechanism
did not work automatically, as classical theory suggested, because of the existence of
market failures. Often there would be recessions, and the government would have to
intervene using economic policy tools to bring the economy back to its maximum
potential level of output and employment.
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Box 2 Milton Friedman
Milton Friedman, an eminent US economist of the second half of the 20th century, was a
firm believer in the free market. He argued that the operation of market forces will produce
the best outcome in economic terms, and that economic freedom will lead to political
freedom. He was strongly against almost all forms of government intervention. His ideas
had a strong influence on political leaders such as Ronald Reagan and Margaret Thatcher.
What tools do economist use?
Most economists use graphs and models. These are just ways of describing relationships.
They aim to make complex things easier to understand, and also to allow us to predict what
will happen if things change. The graph below is an example of how economists work.
Production Possibility Frontier
Shoes
A
100
Thousand
pairs
B
D
50
C
10
Trousers
10
50
100
Thousand pairs
The graph shows the relationship between production of shoes and production of trousers
in an economy. Remember that economics is about the allocation of limited resources to
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different things: in this case, although different raw materials may be needed to produce
shoes and trousers, they compete for similar resources in terms of labour, energy, industrial
installations etc. All along the ‘production possibility frontier’, the economy uses its scarce
resources to the maximum – for example, producing at point A, B or C. There are choices
to be made: at A, the economy can produce some 108,000 pairs of shoes and 40,000 pairs
of trousers, whereas as C, it can produce 25,000 pairs of shoes and 97,000 pairs of trousers.
These combinations are both on the ‘frontier’, and therefore represent efficient use of
scarce resources. Producing at D, however, would be an inefficient use of resources, as the
economy could produce more by moving from D to B.
Exercise 1
The production possibility frontier graph helps us to think about our choices in use of
resources. For instance, if we are at C and want to produce more shoes, we can calculate
the ‘opportunity cost’ of producing more shoes in terms of lost trouser production.
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Roughly what is the opportunity cost (in pairs of trousers) of producing 45,000
more pairs of shoes by moving from C to B?
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What is the implication of the fact that the production possibility frontier is
concave (in terms of the opportunity costs of production)?
Some economists tend to be more comfortable than others with data and with complex
quantitative models. At the extreme, those who spend their time using quantitative
methods (e.g. regression models) applied to economic problems are involved in
econometrics, which means economic measurement.
Models are useful, and most economists use them, but it is important to be careful! If you
get the model wrong – in other words, the model does not show what is happening in
reality, or predict properly what is likely to happen – then the results will be useless. Even a
good model will be of no use unless:
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The data that you put into it is relevant and reliable; and
You understand how to manipulate the model and interpret the results.
The problem is – as the saying goes – “rubbish in, rubbish out”. In other words, if you put
bad or irrelevant data into a model, the result will be rubbish!
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Supply, demand and market forces
A long time ago, human beings all lived in small family groups. They survived by hunting
and gathering, and later by farming – but all communities were self-sufficient. They found
or grew their own food and made their own clothes, and they did not have much else. Still,
today, some communities are largely self-sufficient, producing almost everything that they
consume. However, most communities have evolved (in economic terms). First, people
specialised in producing different things, which they exchanged with others in nearby
communities through barter. Then, as trade became more widespread, money was
invented, allowing goods to be exchanged over longer distances.
Specialised production, trade and payment with money represent a big step forward from the
economics point of view… Why? Because they allow much more efficient use of resources than
before. One of the earliest economists, Adam Smith, writing in Scotland in 1776, gave the
example of pin manufacturing. He pointed out that there are several different processes
involved in manufacturing pins. If one man tries to do all of them, he may succeed in
producing 20 pins in a day – so ten men could make 200 pins. But a team of ten men
working together, each specialising in one part of the manufacturing process, could make
around 48,000 pins a day. This is called ‘division of labour’.
The problem, of course, is that men cannot eat or wear pins. So they need to find others
who want pins and are prepared to buy them with money (need plus money to buy =
demand). The pin sellers will then supply the pins in return for money, which they can
use to buy food, clothes and the other things they need and want. Everyone specialises in
producing something that they can sell, in order to get money to buy what they need and
want.
How does the buying and selling take place? Economists describe all the millions of
individual buying and selling transactions as happening in a market. This could be a simple
market, such as a trading centre in a remote rural area, where people come to buy and sell
food, clothes and other basic needs items. Some have a shop, others set up a stall, and
some sit by the roadside. Perhaps there is also an auction for particular products such as
tobacco or cattle. The market is a meeting place for buyers (who demand goods) and
sellers (who supply goods). The transaction will take place when the price is agreed – i.e.
when the buyer has agreed to buy the item for a certain amount of money, and the seller is
willing to sell for this amount. Many individual bargaining processes take place, and
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probably prices vary a little from one transaction to another. But in general, prices will be
determined by the balance between quantities supplied and quantities demanded: if many
buyers are demanding maize, but there is not much available, the price will rise; if many
sellers have maize to sell but few people want to buy it, the price will fall.
Economists see the same mechanism operating in the simplest market as in the most
complex market (e.g. a high-tech market like the NASDAQ – the largest US stock market,
where all the trading is done on computers). Market forces operate, allowing people to
exchange goods and services at mutually agreed prices, which will depend on the balance
between quantities supplied and quantities demanded.
Orthodox economists believe that if individuals and companies are allowed to operate
freely, without interference from governments, the operation of market forces will bring
about the best possible allocation of scarce resources.
Modelling goods markets
Demand curves
A non-economist might talk of someone having demand for a product even if they did
not have the money to buy it, but an economist would call this needing or wishing to buy the
product – not demand. Demand only occurs when we have the money to realise our need
or our wish to buy, i.e. we have “purchasing power”.
The concept of demand in economics is linked to the concept of price. It can be defined
as the quantity which will be bought at a given price. For instance, we may estimate that if
a particular type of shoes cost $20 a pair, demand for this type of shoes in the economy will
be 50,000 pairs. The demand curve shows the relationship between quantity (Qd)
demanded and price (P). The demand curve for goods is downward sloping (see Demand
curve for shoes graph, page 7).
Discussion 1
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Why is the demand curve downward sloping?
Do you think the curve will always be a straight line?
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Demand curve for shoes
Price
(US$)
100
50
10
10
Quantity
(1000 pairs)
50
Supply curves
Economists also draw supply curves for goods. We assume that there are many producers
who produce things competitively, motivated by profit. In general, this is a useful
assumption, although there are exceptions (can you think of any?). On the basis of this
assumption, the relationship between quantity supplied (Qs) and price (P) can be drawn as
an upward sloping curve, where higher prices lead to greater quantities supplied.
Supply curve for maize
Price
(US$/tonne)
400
300
200
100
100
200
300
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400
500
Quantity
(1000 tonnes)
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Note: This graph shows the supply curve for maize in the whole economy. This is just the
sum of the individual producers’ supply curves (in a competitive market). Each producer
faces a set of costs, such as the cost of raw materials and labour, and works with a given
technology. To draw the curve, we assume that these factors remain constant.
Drawing the curves
In reality, the exact position and shape of the supply curve may not be like this – it could be
curved rather than straight, or further to the right, for instance. To draw the curve exactly,
we would have to collect the data. But this would be difficult:
First:
Because we cannot conduct an ‘experiment’, artificially varying the price to
see what quantities producers supply!
Because the exact shape of the curve changes with changes in production
costs, technology, and prices of similar goods which are seen as alternatives
(substitutes). These changes can be rapid.
Second:
In reality, these curves are mainly used either to understand the concept of supply and
demand, or to suggest roughly what is the pattern of supply and demand at a given point in
time based on the available evidence.
Equilibrium price and market clearing
Supply and demand for maize
Price
(US$/tonne)
Supply
400
300
Pe
200
Demand
100
100
200
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300
400
500
Quantity
(1000 tonnes)
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One of the main reasons for drawing supply and demand curves for goods is to study the
equilibrium price (Pe) in the goods market. This is the price at which supply equals
demand (Qs = Qd) and the market clears (i.e. everything that is produced is sold). On the
graph, it is the point at which the supply and demand curves cross. On the above graph
(Supply and demand for maize), Pe is $245/tonne.
Discussion 2
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What happens to Pe if the factors affecting supply change, so that supply increases
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(producers can supply more goods at each price level)?
What happens to Pe if the factors affecting demand change, so that demand
increases (people want to – and can afford to – buy more at each price level)?
Discussion 3
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Is Pe the same as the market price?
Is Pe the most efficient price for the economy?
Does Pe imply a fair or just distribution of resources (equity)?
Modelling money and foreign exchange markets
Goods markets are not the only markets which can be modelled. The other key markets
which economists model are: money, foreign exchange and labour markets.
Supply and demand for money
Interest
rate
Supply
Demand
Quantity of
money
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Discussion 4
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What is the ‘price’ of money?
What happens to the interest rate if supply of money increases?
Exercise 2: The foreign exchange market
Draw a graph showing theoretical supply and demand curves for foreign exchange,
assuming a free market (i.e. a freely floating exchange rate without any restrictions).
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What is the ‘price’ of foreign exchange?
What happens to the exchange rate if demand for foreign exchange increases?
Demand elasticity
When economists talk about ‘elasticity’, they normally mean elasticity of demand (unless they
specify another type). Demand elasticity is defined as the change in quantity demanded
when there is a change in another factor, e.g. price.
Price elasticity of demand1
Defined as:
Percentage change in quantity demanded (Qd )
Percentage change in price ( P)
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If price of shoes increases by 10% and quantity demanded increases by 20%, the
price elasticity of demand is 2. This is called elastic demand (when elasticity of
demand is greater than 1)
If price of shoes increases by 10% and quantity demanded increases by 5%, the
price elasticity of demand is 0.5. This is called inelastic demand (when elasticity of
demand is less than 1)
1
Trainers please see note on demand elasticity in Guidance for Trainers.
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If price of shoes increases by 10% and quantity demanded increases by 10%, the
price elasticity of demand is 1. This is called ‘unitary elasticity’.
Income elasticity of demand
Defined as:
Percentage change in quantity demanded (Qd )
Percentage change in income (Y )
For example, if household income of workers in manufacturing increases by 10% and
purchases of shoes increase by 15%, then we would say that manufacturing workers’
income elasticity of demand for shoes is 1.5 (demand for shoes is income elastic).
In practice, income elasticity of demand for different goods will vary according to factors
like the type of goods being purchased, and the starting level of income. For instance, in a
poor country with low income levels, we might expect demand for basic foods like maize
to be income elastic, so that if household income increases by, say, 5%, demand for maize
might increase by 10%. As the country becomes wealthier, the demand for maize might
become income inelastic because households are starting from a point where their maize
needs are almost satisfied, so they will spend a smaller proportion of any extra income they
receive on maize.
At some point, income elasticity of demand for basic foods may even become negative: an
increase in income leads to a fall in demand for basic foods! This is because people switch
to meat and other luxury foods and away from basic foods:
change in Y
(%)
Change in Qd
(%)
Poor country
5
Middle income country
5
2.5
0.5
Wealthy country
5
-2.5
-0.5
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10
Income elasticity of
demand
2
When income elasticity of demand for something is positive, economists call it a
‘normal good’ (elastic, unitary or inelastic income elasticity of demand).
When income elasticity of demand for something is negative, economists call it an
‘inferior good’.
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Discussion 5
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Which food items in the basket of goods which is used to calculate the consumer
price index (CPI) in your country are likely to be normal goods?
Which food items are likely to be inferior goods?
Exercise 3 (optional)
Check your hypotheses about which are normal and which are inferior goods in your
country. You can only do this if you have data on income (Y) (or household expenditure as
a proxy for income) and on quantities of food consumed (Qd) for a period of several years.
Income/expenditure data might come from an national household survey, while data on
quantities of food consumed might come from a national food survey. Calculate percentage
increases in each over the same period and work out elasticities using the equation:
Percentage change in quantity demanded (Qd )
Percentage change in income (Y )
Market failure
Orthodox economists believe that if market forces are allowed to operate freely, then
eventually markets will clear. Even if market prices are not Pe at the moment, they are
moving towards Pe. This leads to the most efficient position for the economy.
Heterodox or structuralist economists say there are many obstacles which prevent this
happening. In theory, some of the obstacles could be removed – although in practice this
would be very difficult. Some obstacles are so ingrained in the structure of particular
economies that it would be impossible to remove them.
Orthodox view of market forces
Structuralist view of market forces
Market mechanism operates, based on
perfect competition among producers.
Markets clear at Pe. The outcome is
economically efficient.
Market failure is widespread, and imperfect
competition is the norm, not the exception.
Often there is excess supply and/or
demand and market forces alone cannot
bring about equilibrium.
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Examples of market failures, i.e. obstacles which hinder the operation of the market
mechanism and prevent markets from clearing at Pe, are:
1. Firms which operate as monopolies or oligopolies2 (imperfect competition).
2. Markets not operating properly, e.g. because producers do not have information
about where to sell their products.
3. Government interventions.
Discussion 6
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Do any of these examples of market failure (1-3) exist in your country?
Can you think of any other examples based on your experience/observation?
In general, do you think markets operate freely and efficiently in your country?
If not, how should this affect your economic analyses?
2
A monopoly means that there is only one producer or buyer in the market. An oligopoly
occurs when a small number of firms work together to create the effect of a monopoly.
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