Notes - Economics, Business and Sustainability PDF

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Economics, Business andSustainabilityChapter 1: What is economics?1 What economists studyEconomics — the study of how society decides what, how and for whom to produce.Economics is the study of how society decides: What goods and services should an economy produce? How should goods and services be p...

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Economics, Business and Sustainability Chapter 1: What is economics? 1.1 What economists study Economics — the study of how society decides what, how and for whom to produce. Economics is the study of how society decides: • What goods and services should an economy produce? • How should goods and services be produced? • Who should get the goods and services produced? Economics is a science, and just like other sciences, it deals with a fundamental problem of nature. For example; Aerospace Engineering — a science which struggles to overcome a basic problem of nature, that of gravity. Aerospace Engineers are scientists whose research and life’s work is aimed at overcoming the problem of gravity and putting a man in space. Society has to resolve the conflict between people’s limitless desire for goods and services, and the scarcity of resources (labour, machinery, raw materials) with which goods and services are made. Economics is the analysis of these human decisions, about which we aim to develop theories and test them against facts. As a student, you can afford the necessities of life — a place to live, food to eat, a brilliant textbook — and some extras, e.g. holidays. You are richer than some people, poorer than others. Income distribution across people is closely linked to the ‘what’, ‘how’ and for ‘whom’ questions. The large differences in incomes between groups reflect how goods are made. Poor countries have little machinery, and their people have less access to health and education. Workers in poor countries are less productive because they work in less favourable conditions. Income is unequally distributed within each country as well as between countries, and this affects what goods and services are produced. In Brazil, where income is unequally distributed, rich people can afford domestic servants who work for low wages. In egalitarian Denmark, few people are sufficiently rich to afford to hire servants.

Scarcity and opportunity cost Economics is the study of scarcity. When something is so abundantly available that we all get what we want, we don't waste time worrying about what, how and for whom it should be produced. For example, in the Sahara, there is no need to worry about the production of sand. Scarcity — the condition of not being able to have all of the goods and services one wants. Scarcity arises where ‘demand for goods and services is infinite, yet resources to supply and satisfy demand are finite’. When resources are scarce, society can get more of some things by having less of other things. We must close between different outcomes, or make trade-offs between them.

For a scarce resource, the quantity demanded at a zero price would exceed the available supply. Like individual, governments and societies experience scarcity… • Overfishing can result in a scarcity of a type of fish • Those without access to clean water are experiencing a scarcity of water • Coal is used to create energy; the limited amount of this resource that can be mined is another example of scarcity • Each year limited amount of the flu vaccine is available to the population, meaning there is not enough for each individual to be vaccinated. This is scarcity. Many of the natural resources are scarce, but also labour, land, capital, etc… Opportunity cost — the quantity of other goods sacrificed to get another unit of this good.

People have different opportunity costs

Effective decision making requires comparing the additional costs of alternatives with the additional benefits. It is important to optimise your resource allocation and find the efficient resource allocation. Examples of opportunity cost in business/society: • How much you spend on advertising instead of product development • Employ more people or buy more equipment • Invest on healthcare or national defence • Incentivising production of factories or preventing the climate

The role of the market A market — uses prices to reconcile decisions about consumption and production.

Markets and prices are one way in which society can decide what, how and for whom to produce. During the British beef crisis, caused by fears about ‘mad cow disease’, pork prices rose 30% while beef prices fell. This provided the incentive to expand pig farming, and stopped many shoppers switching to pork until the new piglets were ready for market. Oil prices have risen rapidly in the last few years. In order to remove the effect of inflation, we adjust oil prices for changes in the prices of goods and services as a whole, isolating how oil prices have moved relative to other goods and services. Oil prices are currently higher than ever before. We can learn from what happened last time oil prices were higher, in the early 1980s. These high prices induced changes in people’s behaviour. Consumers found ways to economise on expensive energy (smaller cars, more insulation, etc.) and producers looked harder for new sources of oil and to invent alternative energy sources. The market ‘solved’ the problem of high oil prices in the early 1980s. As behaviour changed, demand for oil fell and supply increased. The price came down again. With booming demand from China and India, oil prices are unlikely to remain above $100/barrel indefinitely. Many new energy sources become profitable if they are competing with oil prices over $50/barrel. It may take time to get these on stream, but the more confident people are that high oil prices are going to last, the greater will be the incentive to discover and introduce alternative forms of energy, thereby reducing the price of oil again. It is this self-correcting feature of markets that is their greatest strength. Types of economies Command economy — where government planners decide what, how and for whom goods and services are made. Households, firms and workers are then told what to do. Here, the state owned land and factories, and made key decisions about what people should consume, how goods should be made and how much people should work. This occurred in China, Cuba and the former Soviet bloc in the past. A command economy slows little individual economic freedom, since decisions are taken by the state. Free market economy — here prices adjust to reconcile desires and scarcity. In this type of economy, the state does not interfere while the market allocates resources. In a free market, people pursue their self-interest without government restrictions. For example, you might invent a mobile phone hoping to become a millionaire. In turn this can make society better off by creating new jobs and using existing resources more productively. Mixed economy — where the government and private sector interact in solving economic problems. This type of market lies between the two previous extremes. The government affects economic activity by taxation, subsidies and the provision of services such as defence and the police force. It

also regulates the extent to which individuals may pursue their own self-interest. All countries are mixed economies, though some have freer markets than others.

Positive and normative Positive economics — deals with the scientific explanation of how the economy works. Positive economics aims to explain how the economy works, and thus how it will respond to changes. It formulates and tests propositions of the form: If cigarettes are taxed, then their price will rise. In this sense, positive economics is like natural sciences such as physics, geology and astronomy. Many propositions in positive economics are widely agreed to be correct. As in any science, there are some unresolved questions where disagreement remains. Research in progress will resolve some of these issues, but new issues will arise, providing scope for further research. Normative economics — offers recommendations based on personal value judgements. Normative economics is based on subjective value judgements, not on the search for objective truth. For example, should resources be switched from health to education? The answer is a subjective value judgement, based on the feelings of the person making the statement. Economics cannot show that health is more or less desirable than education. However, it can answer the positive question of what quantity of extra health could be achieved by giving up a particular quantity of education.

Micro and macro Microeconomics — makes a detailed study of individual decisions about particular commodities (at firm/consumer level). For example, we can study why individual households prefer cars to bicycles and how firms decide whether to make cars of bicycles. Comparing the markets for cars and for bicycles, we can study the relative price of cars and bicycles and the output of these two goods. However, in studying the whole economy, such detailed analysis gets very complicated. We need to simplify to keep the analysis manageable. Microeconomics offers a detailed treatment of one part of the economy — for example what is happening to cars — but ignores interactions with the rest of the economy in order to keep the analysis manageable. Macroeconomics — analyses the interactions in the economy as a whole. To be able to study the economy as a whole deliberately simplifies the individual building blocks of the analysis. Macroeconomists don't divide consumer goods into cars, bicycles, TVs and iPods. Rather, they study a single bundle called ‘consumer goods’ in order to focus on the interaction between house-hold shopping sprees and firms’ decisions about building new factories.

Microeconomics • Individual markets • The behaviour of firms and consumers • The allocation of land, labour and capital resources • Supply and demand • The efficiency of markets • Product markets • Product maximisation • Utility maximisation • Competition • Resource markets • Market failure

Macroeconomics • • • • • • • • •

National markets Total output and income of nations Total supply and demand of the nation Taxes and government spending Interest rates and central banks Unemployment and inflation Income distribution Economics growth and development International trade

1.2 How economists think A model or theory makes assumptions from which it deduces how people behave. It deliberately simplifies reality. Models omit some details of the real world in order to focus on the essentials. An economist would use a model just as a traveller would use a map — it is a simplified picture which is easy to follow yet provides a good guide to actual behaviour. Data are pieces of evidence about economic behaviour. They are the economist’s link with the real world and are used to explain what is happening and why. The data or facts interact with models in two ways: • It helps to quantify theoretical relationships. To choose the best route we need some facts about where delays may occur, and therefore the model is useful as it tells us which facts to collect. • The data helps us to test our models. Like all careful scientists, economists must check that their theories square with the relevant facts.

Economic data To gather evidence, we can study changes across groups or regions at the same point in time; or for a single group or region over time. These are classified into cross section data and time series data. Cross section deals with one period in time

Cross section data As seen in table 1-4, the average price of a new house rose from £3,100 in 1963 to £200,000 in 2007. Are houses really 50 times as expensive as in 1960? Not once we allow for inflation, which also raised incomes and the ability to buy houses. Nominal values measure prices at the time of measurement. Real values adjust nominal values for changes in the general price level. In the UK the consumer price index (CPI) measures the price of a basket of goods bought by a typical household. Inflation caused a big rise in the CPI during 1963-2007.The third row of table 1-4 calculates an index of real house prices, expressed as if the CPI had always been at the lee lit attained in the year 2007. It shows how house prices would have changed if there had been no general inflation in the prices of goods as a whole. An index number expresses data relative to a given base value. Comparing 1963 and 2007, allowing for inflation, real house prices rose sixfold, from £33,800 to £200,000. Most of 59-fold rise in nominal house prices in the top row of table 1.4 was actually caused by inflation.

Economic models A scatter diagram plots pairs of values simultaneously observed for two different variables.

The data can be simplified with an ‘average’ line according to the pattern.

The other data can be removed and only the average line left to represent the overall data.

Even though a clear correlation can be seen on the graph, it is important to note that other factors affect the data. For example, the subject studied hasn't been described, but if it were to be taken into consideration, the graph would then have a different interpretation.

These diagrams demonstrate that for having good grades in Finance you have to study more (higher slope in the finance model). Once again, it is important to take into account other parameters which could change the interpretation of these diagrams, for example: • Being good at math • Ability to concentrate • Language skills, etc Most economic data are collected while many of the relevant factors are simultaneously changing. We need to disentangle their separate influences. To make a start, we can pick out two of the variables in which we are interested, pretending the other variables remain constant.

Other things equal Other things equal is a device for looking at the relation between two variables, but remembering other variables also matter. Moreover, when one output is affected by many inputs, a two-dimensional diagram can always be drawn relating an output to only one of the inputs, and treat all the other inputs as given. Moving along this line shows how the highlighted input affects the output. However, if any other input changes, we need to show this as a shift in the relationship between output and our highlighted input. For example, figure 1-3 can be interpreted as saying that higher tube fares cause higher revenue only if no other important input to the passenger decision was changing. One the congestion charge was introduced, being an input that affects the diagram, behaviour then altered. Figure 1-4 reinterprets the previous data as showing two parallel lines, one before the introduction of the congestion charge and the other, further to the right, after the introduction of the charge. Now the observed data fit the theory much more neatly. Other things equal, higher fares go with higher revenue. Changing the congestion charge alters one of these things, and we have to show this as a shift in the entire relationship between fares and revenue.

1.3 How markets work Market — a mechanism which brings buyers and sellers together to allow them to interact/trade goods or services. Buyers require goods and services and sellers offer them. Markets bring together: • Households’ decisions about consumption of alternative goods • Firms’ decisions about what and how to produce Some markets physically bring together the buyer and seller, for instance shops and fruit stalls. Other markets, for example the Stock Exchange, operate through intermediaries (stockbrokers) who transact business on behalf of clients. Some markets can also be conducted on the Internet, which is also known as E-business. To think about a typical market we need demand — the behaviour of buyers — and supply — the behaviour of sellers. Then we can study how a market works in practice: Demand — the quantity buyers wish to purchase at each conceivable price. Demand is not a particular quantity but a full description of the quantity buyers would purchase at each and every possible price. Supply — the quantity sellers wish to sell at each conceivable price. Again, supply is a full description of the quantity that sellers would like to sell at each possible price. Equilibrium price — the price at which the quantity supplied equals the quantity demanded. It is when demand = supply and the market clears. Disequilibrium price Suppose the price is below the equilibrium price. With a low price, the quantity demanded is high but the quantity supplied is low. There is a shortage, or excess demand, a shorthand for the more accurate statement: ‘the quantity demanded exceeds the quantity supplied at this price.’

Conversely, at any price above the equilibrium price, the quantity supplied is high but the quantity demanded is low. Sellers have unsold stock. To describe this surplus, economists use the shorthand excess supply, meaning ‘excess quantity supplied at this price’. Quantity demanded and supplied are only the same at the equilibrium price.

Is the market automatically in equilibrium? Measures are constantly taking place so that there is no unsold stock. Suppose the price is initially too high, this would signify unsold stock and excess supply. Hence, sellers would need to cut the price to clear their stock. Cutting the price in turn has two effects: • It raises the quantity demanded • It reduces the quantity supplied As a result, both effects reduces the excess supply and price cutting continues until the equilibrium price is reached and excess supply is eliminated. Conversely, if the price is too low, the quantity demanded is large, but the quantity supplied is small. With excess demand, sellers run out of stock and have to charge higher prices. Prices rise until the equilibrium price is reached, excess demand is eliminated and the market clears. Prices adjust until equilibrium is reached, after which things settle down at that level. This is also known as the ‘invisible hand of the market’. Summary • The upward-sloping curve SS shows how much sellers wish to sell at each price • The downward-sloping curve DD shows how much consumers wish to purchase at each price Market is in equilibrium at point E, where the two • curves intersect • The equilibrium price is P*, at which a quantity Q* is supplied and demanded At any price P’ above P*: • The quantity supplied exceeds the quantity demanded • There is excess supply at this price and suppliers have unsold stock • To sell this unsold stock, suppliers have to reduce the price • This occurs until the market returns to equilibrium at point E. At any price P” below P*: • The quantity demanded exceeds the quantity supplied • There is excess demand at this price, and buyers cannot find all the goods they would like to purchase Buyers offer to pay more than suppliers are asking for • The price is steadily bid upwards until the equilibrium price is restored at point E • Shift in demand A shift in demand (to the right) results in a new (higher) equilibrium price. E.g. nowadays, the price for healthy food is higher (change of taste and habit)

A shift in demand (to the left) results in a new (lower) equilibrium price. E.g. in a financial crisis (lower income) situation, price of jewellery decreases/goes down.

Shift in supply A shift in supply (to the right) results in a new (lower) equilibrium price. E.g. laptops are cheaper now because of technology advancement.

A shift in supply (to the left) results in a new (higher) equilibrium price. E.g. when price of electricity rises the price of products goes up in general.

Price controls Price control — a government regulation to fix the price. Price controls can be floor prices (minimum prices) or ceiling prices (maximum prices). Price ceilings many be introduced when a sharp fall in supply occurs. Wartime scarcity of food would mean high prices and hardship for the poor. Hence, governments may impose a price ceiling (a maximum price) on food so that poor people would also be able to afford some food in case of a national food shortage. Example: Suppose, due to a shortage of wheat and flour, the equilibrium price of a loaf of bread would have been £15. To try to help out, the government imposes a price ceiling of £2 a loaf. Compared with the equilibrium, the quantity demanded is now much higher, but, at £2 a loaf rather tha...