Economic Resources (522)

8/3/2019 Economic Resources (522)

1/28

Question # 1Discusses In Detail The Term Economic Resources With ReferenceTo Service Industry. Explain The Link Between Scarcity, Choice AndOpportunity Cost.

Economic Resources: Microeconomics is the study of the behaviors and decisions of individuals andbusinesses in markets across the economy. We start our study of microeconomics by looking at the

resources which an economy may have available to supply and produce goods and services to meet theever-changing needs and wants of individuals and society as a whole.

In economics we classify goods as tangible products, example might include food and drink, cars,digital televisions, flat-screen televisions, energy products and cricket bats! Services are sometimes

known as intangibles, education and health-care are two important services and tourism, business

consultancy, cleaning and home insurance are all examples of services.

Finite resources: There are only a finite (or limited) number of workers, machines, acres of land andreserves of oil and other natural resources on the earth. Because most of our resources are finite, we

cannot produce an unlimited number of different goods and services and by producing more for an ever-

increasing population we are in real danger of destroying the natural resources of the planet. This hasimportant consequences for the long-term sustainability of economies throughout the world and

potentially huge implications for our living standards and the quality of life.

Tuna reaches the quayside and will soon be supplied to the market but over-fishing may have

destroyed fish stocks and risks the whole future of the tuna fishing industry in the European Union

Tuna at risk of extinction:


2/28

Bluefin tuna are at risk of extinction in the Mediterranean and eastern Atlantic

according to a report from the Worldwide Fund for Nature. They lay the blame on fishermen who havecaught more than the quotas allowed under current European Union rules. Over-fishing has led to a

reduction in stocks of tuna and average catch sizes are declining. The WWF has called for an immediate

halt to bluefin tuna fishing arguing that failure to act now will lead to the complete destruction of whatshould be a renewable resource.

Source: Worldwide Fund for Nature and BBC news reports

Environmental pressure groups such as Friends of the Earth and Greenpeace seek to highlight the

permanent damage to the stock of natural resources available throughout the world and the dangers from

economic development and global warming. One such issue is the huge threat posed by the global

shortage of water as the worlds demand for water for household and commercial use continues to groweach year. At the heart of improving resource sustainability is the idea of de-coupling a process of

trying to increase the efficiency with which resources are used in producing goods and services and

breaking the link between ever-increasing output and resource depletion.

Factors of production:

Factors of production refer to the resources we have available to produce goods andservices. We make a distinction between physical and human resources.

Land:Land includes all of the natural physical resources for example the ability to exploit fertile farm land,

the benefits from a temperate climate or the ability to harness wind and solar power and other forms of

renewable energy. Some nations are richly endowed with natural resources and then specialize in the

extraction and production of these resources for example the development of the North Sea oil andgas in Britain and Norway or the high productivity of the vast expanse of farm land in Canada and the

United States and the oil sands in Alberta, Canada. Other countries have a smaller natural factor

endowment and may be more reliant on importing these resources. Japan for example is the worlds

second largest economy but remains heavily dependent on imported oil.

Labour:Labour is the human input into the production process. It is inevitable that some workers are more

productive than others because of the education, training and work experience they have received.

What matters is the size and quality of the workforce. An increase in the size and the quality of the

labour force is vital if a country wants to achieve economic growth. In recent years the issue of themigration of labour has become important, can migrant workers help to solve some of the labour

shortages that many countries experience? And what of the long-term effects on the countries who suffer

a drain or loss of workers through migration?

Capital: To an economist, investment is not the money that people put into the stock market or into bankand building society accounts. Instead, in economics the term capital means investment in capital goods

that can then be used to produce other consumer goods and services in the future.

Fixed capital includes machinery, plant and equipment, new technology, factories and otherbuildings.

Working capital refers to stocks of finished and semi-finished goods (or components) that will

be either consumed in the near future or will be made into finished consumer goods.


3/28

The global oil and gas industry uses a huge amount of capital equipment to get the product crude oil to the refineries and processing stages.

Capital inputs and productivity:New items of capital machinery, buildings or technology are generally used to enhance the productivity

of labour. For example, improved technology in farming has vastly increased the productivity of our

agricultural sector and allowed people to move out of working on the land into more valuable jobs inother parts of the economy. And, investment in information and communication technology can increase

the efficiency of workers across many industries.

Infrastructure:

Infrastructure is the stock of capital used to support the entire economic system. Examples ofinfrastructure include road & rail networks; airports & docks; telecommunications eg cables andsatellites to enable web access. The World Bank regards infrastructure as an essential pillar for

economic growth in developing countries.


4/28

The Gatwick Express the railway infrastructure is an essential part of our transport network

Entrepreneurship:An entrepreneur is an individual who seeks to supply products to a market for a rate of

return (i.e. to make a profit).

Entrepreneurs will usually invest their own financial capital in a business (for example theirsavings) and take on the risks associated with a business investment. The reward to this risk-taking is the profit made from running the business.

Many economists agree that entrepreneurs are in fact a specialized part of the factor input'labour'.

Renewable resources: Renewable resources are commodities such as solar energy, oxygen, biomass,fish stocks or forestry that is inexhaustible or replaceable by new growth providing that the rateof extraction of the resource is less than the natural rate at which the resource renews itself.

This is becoming an enormously important issue in environmental economics, for example theissue of the over-extraction of fish stocks, and the global risks of permanent water shortagesresulting from rising use of ground water stocks. Finite resources cannot be renewed. Forexample with plastics, crude oil, coal, natural gas and other items produced from fossil fuels,no mechanisms exist replenish them.

Factor Rewards:Factors of production are used to create output to be sold in markets. Each factor

used in production can expect some reward.

High oil prices help Shell to record profits

Soaring crude oil prices are boosting oil companies' profits around the world. Royal DutchShell has announced record annual profit for a UK stock market listed company. Shellgenerated profits of 13.12bn in 2005 up nearly a third on the 2004 level. Most of Shellsprofits come from finding and extracting oil, and then selling it on to the worlds oil markets.

Income:Income represents a flowofearnings from using factors of production to produce an output ofgoods and services which are then sold in markets. The main sources of income for individualsand households are:

1. Wagesandsalariesfromwork often supplemented by overtime and productivitybonuses.

2. Interestfromsavingsheld in banks, building societies and other accounts.3. Dividendsfrom share ownership.4. Rentincome from the ownership of property.

For the majority of people, most of their weekly or monthly income comes from their job. Thegovernment cans also affect peoples disposable (or post-tax) income by taxing incomes andby giving welfare benefits to households on low incomes or to people who are out of work.


5/28

Wealth:Wealth is defined as a stockofassets that creates a flow of income and it can be

held in a variety of forms by individuals, firms and also the nation as a whole: Financial wealth- stocks and shares, bonds, savings in bank and building society

accounts and contributions to pension schemes. Marketable wealth - consumer durables that can be sold for a price e.g. rare antiques. Social capital including social infrastructure such as transport systems, schools and

hospitals.It is important to distinguish between income and wealth. For example, if you receive a higherwage or salary from your job then this adds to your monthly income and if this is saved in abank, or by making contributions to a pension fund then you are adding to your financialwealth.

Being wealthy can also generate income for if you own shares in companies listed on the stockmarket then you expect to receive dividend incomeonce or twice a year. And if you havemoney in a savings account, you will be paid interest on your savings balances. Likewise, if

you own properties, then you can earn some income from renting it out to tenants. There hasbeen a huge expansion in recent years in the buy-to-let sector of the housing market withhundreds of thousands of people buying properties and then letting them out. By the summerof 2006 in the UK there were over 700,000 people who had bought property and then let it outto tenants as part of the buy-to-let sector of the housing market.

Of course the value of financial wealth can fluctuate over time. In the UK in recent years wehave seen aboom in the UK housing marketleading to sharp rises in average house prices,particularly in London and the South East. The result has been a jump in housing wealth forpeople with mortgages, but a growing problem ofaffordability for people looking to enter thehousing market for the first time on relatively low incomes. Share prices have also been

volatile with a collapse in prices from 2000-2003 and then a recovery in the stock market overthe last three years.

Inequality in the distribution of income and wealth:Factor incomes or factor rewards are rarely if ever distributed equitably in

any country. Indeed it is a fact of life that the distribution of income and wealth in the UK ishighly unequal there is a huge gap between the richest and poorest households in our society.For example, the latest available data shows that 94% of the total wealth in this country is heldby 50% of the population. Put another way, the other half of our population can lay claim toonly 6% of total wealth. Millions of people must rely on relatively low incomes with littleopportunity to accumulate wealth. Is this fair? What are the consequences of a high level of

inequality? Should the government intervene to change the distribution of income? And whatmight be some of the effects of such policies? These are important questions and we willreturn to them when we consider the issue ofmarket failure.

Income of the richest UK families is sixteen times that of the poorestIn 2004-05, the average gross (pre-tax) income of the richest 20% of

families in Britain was 66,300, more than 16 times that of the poorest 20% who earned4,300 on average. After adjusting for taxes and welfare benefits such as income support and


6/28

the state pension, however, this ratio fell to four-to-one. For direct taxes, the top fifth ofhouseholds pay 25% of their gross income in direct taxes such as income tax while for thepoorest households the figure is 10%. Levels of inequality are little changed from that seenduring the years of the Thatcher government.

Labour and Wages

Most people have the ability to do some form of work. If they are of working age and activelyseeking a job then they are included in the working population. In industries and jobs wherelabour is not particularly scarce, wages tend to be lower. Millions of workers in the UK are paidhourly wages well below the national average. The minimum wage(currently 5.05 for all adultworkers it rises to 5.35 in October 2006) seeks to address some of the problems associatedwith low pay. On the other hand, some people have skills that are quite rare, and these peoplewill command high salaries in the labour market.

Capital and InterestBusinesses often need to borrow money to fund capital investment. The reward for investingmoney is called interest. Interest rates can of course go up or down. If the interest rate is high,

it becomes less worthwhile to borrow money because any project will have to make moremoney than before to be profitable since more interest is now being paid.

Enterprise and ProfitIn return for having innovative business ideas and taking the risk in putting funds into abusiness the entrepreneur takes any money that the business has left after the other factors ofproduction have received their rewards. This is called gross profit. Taxes then have to be paidto the government, and the entrepreneur takes what is left. This after-tax profit is called netprofit.

Profits flow from increased passenger numbers

The low-cost airline EasyJet is reaping the benefits of higher sales and it is forecasting thatpre-tax profits in 2006 will be up by as much as 50 per cent. The business is creating higherprofits by increasing passenger revenue per seat and achieving extra sales and income fromancillary revenues. EasyJet has managed to overcome the challenge of higher oil prices partlyby making cost savings in other parts of their business. EasyJet said it carried 2.6 millionpassengers in June 2006, up 15.6 percent from a year earlier, while its load factor, a measureof how efficiently it is filling seats on each flight, was 87.6 percent, 2 per cent higher than at thesame time in 2005. EasyJet is part of the Easy Group of companies.

Passenger data and passenger revenue for Easy Jet

12 months toJune 2006 12 months toJune 2005

Change over theyear

Passengers 32,122,137 28,291,843 +13.5%

Load Factor 84.4% 85.1% -0.7%

Total Revenue 1,535m 1,261m +21.8%

Source: EasyJet Investor Relations web site, accessed July 2006


7/28

Economists often assume that one of the main objectives of a business is to achieve maximumprofits. But this is not always the case! Some businesses are looking to achieve a rising marketshareand increasing market share might mean having to sacrifice some profits in the short runby cutting prices and under-cutting rival suppliers in the market.There is also a growing interest in the concept ofethical businessesand corporate socialresponsibility where the traditional assumption of businesses driven solely by the profit motive

is being challenged and where businesses are encouraged to take account of their economic,social and environmental impacts.

Factor Description Reward

Land all natural resources (gifts of nature)including fields, mineral wealth, andfishing stocks

The reward for landlords for allowing firmsto use their property is rent

Labour The physical and mental work of peoplewhether by hand, by brain, skilled orunskilled

The reward for workers giving up time tohelp create products is wagesor salaries

Capital Man made goods used to producemore goods including factories (plant),machines and roads.

The reward for creditors lending money tofirms to invest in buildings and capitalequipment is interest

Enterprise An entrepreneurrisks financial capitaland organizes land labour & capital toproduce output in the hope of profit

The reward for individuals risking fundsand offering products for sale is profit.Unsuccessful firms make losses.

Source: Richard Young, Markets Question and Answer, Tutor2

LINK BETWEEN SCARCITY, CHOICE AND OPPORTUNITY COST

The purpose of economic activityRoad space throughout the world is becoming increasingly scarce as

the demand for motor transport increases each year what do you think are some of the bestsolutions to reducing the problem of congestion on our roads?

It is often said that the central purpose of economic activity is the production of goods and

services to satisfy consumers needs and wants i.e. to meet peoples need for consumptionboth as a means of survival but also to meet their ever-growing demand for an improvedlifestyle or standard of living.The basic economic problemis about scarcity and choicesince there are only a limited amountof resources available to produce the unlimited amount of goods and services we desire.All societies face the problem of having to decide:

What goods and services to produce: Does the economy uses its resources to operatemore hospitals or hotels? Do we make iPod Nanos or produce more coffee? Does theNational Health Service provide free IVF treatment for thousands of childless couples?


8/28

Or, do we choose instead to allocate millions of pounds each year to providing beta-interferon to sufferers of multiple sclerosis?

How best to produce goods and services: What is the best use of our scarce resourcesof land labour and capital? Should school playing fields be sold off to provide more landfor affordable housing? Or are we contributing to the problem of obesity by selling offthese playing fields?

Who is to receive goods and services: What is the best method of distributing productsto ensure the highest level of wants and needs are met? Who will get expensivehospital treatment - and who not? Should there be a minimum wage? If so, at what levelshould it be set?

Scarcity Water, water everywhere:We use an average of 158 liters of water a day in Britain, for which we pay a

price of 28p per liter but much of it is just cash down the drain, according to watercompanies. Most are campaigning to cut the amount we use. And the front-line weapon in theircampaign is the water meter. They want us all to have one and one company is seekingpowers to make them compulsory. When a meter is installed, in most homes, consumptiondrops by 20 per cent and, in some, it goes down by a third. According to Ofwat, the water

industry regulator, the average water and sewerage bill for homes with a meter is 248compared with 289 for those with flat-rate bills. At present only 25 per cent of householdshave meters and most of those are in East Anglia. They are installed free by water companiesbut households then have about 43 added to each bill to cover the cost of installing andreading the meter. Unsurprisingly, we use more water in summer. Peak demand on hot dayscan be 50 to 70 per cent above average. Most of this is for lawns, flowers, paddling pools andextra showers and baths.Source: Adapted from an article by Valerie Elliott, the Times, 9 July 2005

If something is scarce - it will have a market value!If the supply of a good or service is low, the market price will rise, providing

there is sufficient demand from consumers. Goods and services that are in plentiful supply willhave a lower market value because supply can easily meet the demand from consumers.Whenever there is excess supply in a market, we expect to see prices falling. For example, theprices of new cars in the UK have been falling for several years and there have been huge fallsin the prices of clothing as supply from countries such as China and Vietnam has surged.

Insatiable human wants and needs


9/28

The Swedish furniture giant IKEA sells to millions of consumers throughout the world

Human beings want better food; housing; transport, education and health services. Theydemand the latest digital technology, more meals out at restaurants, more frequent overseastravel, more leisure time, better cars, cheaper food and a wider range of cosmetic health caretreatments.Opinion polls consistently show that the majority of the electorate expect government policiesto deliver improvements in the standard of education, the National Health Service and ourtransport system. (Whether voters are really prepared to pay for these services through highertaxes is of course another question!)Economic resources are limited, but human needs and wants are infinite. Indeed thedevelopment of society can be described as the uncovering of new wants and needs- whichproducers attempt to supply by using the available factors of production. For a perspective onthe achievements of countries in meeting peoples basic needs, the Human DevelopmentIndex produced annually by the United Nations is worth reading. Data for each country can beaccessed and cross-country comparisons can be made.

Making choices:Because of scarcity, choices have to be made on a daily basis by all consumers, firms andgovernments. For a moment, just have a think about the hundreds of millions of decisions thatare made by people in your own country every single day.Take for example the choices that people make in the city of London about how to get to work.Over six million people travel into London each day, they have to make choices about when totravel, whether to use the bus, the tube, to walk or cycle or indeed whether to work fromhome. Millions of decisions are being taken, many of them are habitual (we choose the samepath each time) but somehow on most days, people get to work on time and they get hometoo! This is a remarkable achievement, and for it to happen, our economy must provide theresources and the options for it to happen.

Trade-offs when making choices:Making a choice made normally involves a trade-off- in simple terms,

choosing more of one thing means giving up something else in exchange. Because wants areunlimited but resources are finite, choice is an unavoidable issue in economics.For example:


10/28

1. Housing: Choices about whether to rent or buy a home a huge decision to make andone full of uncertainty given the recent volatility in the British housing market! There arecosts and benefits to renting a property or choosing to buy a home with a mortgage.Both decisions involve a degree of risk.

2. Working: Choosing between full-time or part-time work, or to take a course in highereducation lasting three years how have these choices and commitments been

affected by the introduction of university tuition fees?3. Transport and travel: The choice between using Euro-Tunnel, a speedy low-cost ferry or

an airline when traveling to Western Europe. Your choices about which modes oftransport to use to get to and from work or school each day.

Consumer welfare and rationality:What makes people happy? Why despite several decades of rising

living standards do surveys of happiness suggest that people are not noticeably happier thanprevious generations? When we study the decisions of consumers in different markets, we canstart to consider and explore what their aims are. Our working assumption for the moment isthat consumers make choices about what to consume based on the aim ofmaximizing their

own welfare.They have a limited income (i.e. a limited budget) and they seek to allocate theirfunds in a way that improves theirstandard of living.

Of course in reality consumers rarely behave in a perfectly informed and rational way. We willsee later that often decisions by people are based on imperfect or incompleteinformation which can lead to a loss of satisfaction and welfare not only for people themselvesbut which affect other and our society as a whole. As consumers we have all made poorchoicesabout which products to buy. Do we always learn from our mistakes? To what extentare our individual choices influenced and distorted by the effects of persuasive advertising?Multinational companies have advertising and marketingbudgets that often run into hundredsof millions of pounds. We are all influenced by them to a lesser or greater degree and there is

always the risk that advertising can be misleading.

Economic Systems:An economic system is best described as a network of organizations used by

a society to resolve the basic problem of what, how and for whom to produce.There are four categories of economic system.

Traditional economy: Where decisions about what, how and for whom to produce arebased on custom and tradition. Land is typically held in common ie private property isnot well defined.

Free market economy: Where households own resources and free markets allocate

resources through the workings of the price mechanism. An increase in demandraises price and encourages firms to switch additional resources into the production ofthat good or service. The amount of products consumed by households depends ontheir income and household income depends on the market value of an individualswork. In a free market economy there is a limited role for the government. Indeed in ahighly free market system, the government limits itself to protecting the propertyrights of people and businesses using the legal system, and it also seeks to protect thevalue of money or the value of a currency.


11/28

Planned or command economy: In a planned or command system typicallyassociated with a socialist or communist economic system, scarce resources are ownedby the state (i.e. the government). The state allocates resources, and sets productiontargets and growth rates according to its own view of people's wants. The final incomeand wealth distribution is decided by the state. In such a system, market prices play littleor no part in informing resource allocation decisions and queuing rations scarce goods.

Mixed economy: In a mixed economy, some resources are owned by the public sector(government) and some resources are owned by the private sector. The public sectortypically supplies public, quasi-public and merit goods and intervenes in markets tocorrect perceived market failure. We will come back to all of these concepts later on inour study of microeconomics.

Opportunity Cost:There is a well known saying in economics that there is no such thing as a

free lunch! Even if we are not asked to pay a price for consuming a good or a service, scarceresources are used up in the production of it and there must be an opportunity cost involved.Opportunity costmeasures the cost of any choice in terms of the next best alternativeforegone. Many examples exist for individuals, firms and the government.

Work-leisure choices:The opportunity cost of deciding not to work an extra ten hours a weekis the lost wages foregone. If you are being paid 6 per hour to work at the local supermarket,if you choose to take a day off from work you might lose 48 from having sacrificed eight hoursof paid work.

Government spending priorities:The opportunity cost of the government spending nearly10 billion on investment in National Health Service might be that 10 billion less is availablefor spending on education or the transport network.Investing today for consumption tomorrow: The opportunity cost of an economy investingresources in new capital goods is the current production of consumer goods given up. We mayhave to accept lower living standards now, to accumulate increased capital equipment so thatlong run living standards can improve.

Making use of scarce farming land:The opportunity cost of using arable farmland to produce wheat is that the land cannot be usedin that production period to harvest potatoes.

Sectors of production in the economy Primary sector: This involves extraction of natural resources e.g. agriculture, forestry,

fishing, quarrying, and mining Secondary sector: This involves the production of goods in the economy, i.e.

transforming materials produced by the primary sector e.g. manufacturing and theconstruction industry

Tertiary sector: the tertiary sector provided services such as banking, finance,insurance, retail, education and travel and tourism


12/28

Quaternary sector: The quaternary sector is involved with information processing e.g.education, research and development

Manufacturing industry in the United Kingdom only accounts for 18 per cent of national output.The bulk of our income and employment comes from the service sector.

Question # 2Why Do Consumers, Producers And Governments Have ToMake Choices?

The invisible hand the workings of the price mechanism

Adam Smith

Adam Smith, one of the Founding Fathers ofeconomics famously wrote of the invisible hand of theprice mechanism. He described how the invisible orhidden hand of the market operated in a competitivemarket through the pursuit of self-interest to allocate

resources in societys best interest. This remains thecentral view of all free-market economists, i.e. thosewho believe in the virtues of a free-market economywith minimal government intervention.

Theprice mechanismis a term used to describe themeans by which the many millions of decisions takeneach day by consumers and businesses interact todetermine the allocation of scarce resources betweencompeting uses. This is the essence of economics!

Theprice mechanism plays three important functions in any market-basedeconomic system:

The signaling function


13/28

The price of digital printing is comingdown this will have an effect on thedemand for substitute forms of imageprinting. How will traditional photoimaging retailers respond?

Firstly, prices perform a signaling function. This means that market prices willadjust to demonstrate where resources are required, and where they are not.Prices rise and fall to reflect scarcities and surpluses. So, for example, if marketprices are rising because of high and rising demand from consumers, this is a

signal to suppliers to expand their production to meet the higher demand.Consider the left hand diagram on the next page. The demand for computer gamesincreases and as a result, producers stand to earn higher revenues and profitsfrom selling more games at a higher price per unit. So an outward shift of demandought to lead to an expansion along the market supply curve.

In the second example on the right, an increase in market supply causes a fall inthe relative prices of digital cameras and prompts an expansion along the marketdemand curveConversely, a rise in the costs of production will induce suppliers to decreasesupply, while consumers will react to the resulting higher price by reducingdemand for the good or services.

The Transmission of preferencesThrough the signaling function, consumers are able through

their expression of preferences to send important information toproducers about the changing nature of our needs and wants. When demandis strong, higher market prices act as an incentive to raise output (production)


14/28

because the supplier stands to make a higher profit. When demand is weak, thenthe market supply contracts. We are assuming here that producers do actuallyrespond to these price signals!One of the features of a free market economy is that decision-making in themarket is decentralized in other words, the market responds to the individualdecisions of millions of consumers and producers, i.e. there is no single body

responsible for deciding what is to be produced and in what quantities. This is aremarkable feature of an organic market system.

The Rationing FunctionPrices serve to ration scarce resources when demand in a market

outstrips supply. When there is shortage of a product, the price is bid up leaving onlythose with sufficient willingness and ability to pay with the effective demandnecessary to purchase the product. Be it the demand for tickets among Englandsupporters for the 2006 World Cup or the demand for a rare antique, the market price actsrationing device to equate demand with supply.

The prices for using the M6 Toll Road are a good example of the rationing function of theprice mechanism. A toll road can exclude those drivers and vehicles that are not willing orable to pay the current toll charge. In this sense, motorists and road haulage businessesand other road users are paying for the right to use the road, road space has a marketprice instead of being regarded as something of a free good. The current charges arebelow:

Prices on the M6 Toll RoadJune 2006

Day(06:00 - 23:00)

Night(23:00 - 06:00)

Class 1 (e.g. motorbike) 2.50 1.50

Class 2 (e.g. car) 3.50 2.50

Class 3 (e.g. car & trailer) 7 6Class 4 (e.g. van/coach) 7 6

Class 5 (e.g. HGV) 7 6

What would happen if the day-time charges increased to 5 for cars?

The growing popularity ofauctions as a means of allocating resources is worthconsidering as a means of allocating resources and clearing a market. Thephenomenal success of EBAY is testimony to the power of the auction process as arationing and market clearing mechanism as internet usage has grown.

The price mechanism is the only allocate mechanism solving the economicproblem in a free market economy. However, most modern economies are mixedeconomies, comprising not only a market sector, but also a non-market sector,where the government (or state) uses the planning mechanism to providepublic goods and services such as police, roads and merit goods such aseducation, libraries and health.

In a state run command economy, the price mechanism plays little or no activerole in the allocation of resources. Instead government planning directs resources


15/28

to where the state thinks there is greatest need. The reality is that state planninghas more or less failed as a means of deciding what to produce, how much toproduce, how to produce and for whom. Following the collapse of communism inthe late 1980s and early 1990s, the market-based economy is now the dominanteconomic system even though we are increasingly aware ofimperfections inthe operation of the market i.e. the causes and consequences of market

failure.

Prices and incentives Incentives matter enormously in our study of microeconomics, markets and

instances of market failure. For competitive markets to work efficiently alleconomic agents (i.e. consumers and producers) must respondto appropriate price signals in the market.

Market failure occurs when the signaling and incentive function of the pricemechanism fails to operate optimally leading to a loss of economic and socialwelfare. For example, the market may fail to take into account the externalcosts and benefits arising from production and consumption. Consumerpreferences for goods and services may be based on imperfectinformation on the costs and benefits of a particular decision to buy andconsume a product. Our individual preferences may also be distorted andshaped by the effects of persuasive advertising and marketing to createartificial wants and needs.

Government intervention in the marketOften the incentives that consumers and producers

have can be changed by government interventional markets. For example achange in relative prices brought about by the introduction ofgovernmentsubsidies and taxation.Suppose for example that the government decides to introduce a new tax onaviation fuel in a bid to reduce some of the negative externalities created by theair transport industry.

How will airlines respond?a. Will they pass on the tax to consumers?b. Can they absorb the tax and seek cost-savings elsewhere in their

operations? If the tax raises price for air travelers, will they change their behavior in the

market? Is an aviation tax the most effective way of controlling pollution? Or could

incentives for producers and behavior by consumers wanting to travel by airbe changed through other more effective and efficient means?


16/28

Agents may not always respond to incentives in the manner in which textbookeconomics suggests.The law of unintended consequences encapsulates the idea that governmentpolicy interventions can often be misguided of have unintended consequences!See the revision focus article on government failure.

Question # 3What Is Meant By A Production Possibility Frontier? Illustrate Your

Answer. What Other Names Are Used Instead Of ProductionPossibility Frontier?

Production Possibility Curve

DefinitionGraphical representation of the alternative combinations of the amounts of two goods orservices that an economy can produce by transferring resources from one good or service tothe other. This curve helps in determining what quantity of a non-essential good or a service


17/28

an economy can afford to produce without jeopardizing the required production of an essentialgood or service. Also called transformation curve

The Production Possibility Frontier

Consider the case of an island economy that produces only two goods: wine and grain. In a

given period of time, the islanders may choose to produce only wine, only grain, or acombination of the two according to the following table:

Production Possibility Table

Wine(thousands of bottles)

Grain(thousands of bushels)

0 15

5 14

9 12

12 9

14 5

15 0

Theproduction possibility frontier(PPF) is the curve resulting when the above data is graphed,as shown below

Production Possibility Frontier

The PPF shows all efficient combinations of output for this island economy when the factors ofproduction are used to their full potential. The economy could choose to operate at less thancapacity somewhere inside the curve, for example at point a, but such a combination of goodswould be less than what the economy is capable of producing. A combination outside thecurve such as point b is not possible since the output level would exceed the capacity of theeconomy.


18/28

The shape of this production possibility frontier illustrates the principle of increasing cost. Asmore of one product is produced, increasingly larger amounts of the other product must begiven up. In this example, some factors of production are suited to producing both wine andgrain, but as the production of one of these commodities increases, resources better suited toproduction of the other must be diverted. Experienced wine producers are not necessarilyefficient grain producers, and grain producers are not necessarily efficient wine producers, so

the opportunity costincreases as one moves toward either extreme on the curve of productionpossibilities.Suppose a new technique was discovered that allowed the wine producers to double theiroutput for a given level of resources. Further suppose that this technique could not be appliedto grain production. The impact on the production possibilities is shown in the followingdiagram:

Shifted Production Possibility Frontier

In the above diagram, the new technique results in wine production that is double its previouslevel for any level of grain production.Finally, if the two products are very similar to one another, the production possibility frontier

may be shaped more like a straight line. Consider the situation in which only wine is produced.Let's assume that two brands of wine are produced, Brand A and Brand B, and that these twobrands use the same grapes and production process, differing only in the name on the label.The same factors of production can produce either product (brand) equally efficiently. Theproduction possibility frontier then would appear as follows:

PPF for Very Similar Products


19/28

Note that to increase production of Brand A from 0 to 3000 bottles, the production of Brand Bmust be decreased by 3000 bottles. This opportunity cost remains the same even at the otherextreme, where increasing the production of Brand A from 12,000 to 15,000 bottles stillrequires that of Brand B to be decreased by 3000 bottles. Because the two products arealmost identical in this case and can be produced equally efficiently using the same resources,

the opportunity cost of producing one over the other remains constant between the twoextremes of production possibilities.

Question # 4

Discuss the Contrasting Features of A Market Based Economyto A Command Economy and Give Their Advantages and

Disadvantages.

A market economy is, strictly speaking, an economy in which prices of things are freely set

based on the laws of supply and demand, unfettered by interference from a government or other outsidebody. A market economy is, at its most basic, an economy run entirely by the market itself. In the realworld, however, there is no such thing as a truly unfettered market economy, and so the term is used todescribe economies which are largely dictated by market forces. As a result, whether or not a giveneconomy is actually a market economy can be open to some debate.

A market economy can be contrasted by a command economy, where the prices for things are setby a force outside the market, such as a government. Strict Communist economies, for example, do notallow the market to dictate prices, making them command economies. In recent years, however, manyCommunist states have begun incorporating aspects of a market economy into their systems. China is agood example of this model, often called market socialism or the socialist market economy. Under

market socialism, many key industries are actually owned and operated by the government rather thanprivate industry, but the government allows the prices of goods and services to fluctuate based on themarket, rather than using their monopoly to set the prices as they choose.

A related type of market economy is known as Anarcho-capitalism, in which all governmentinterference in the market is removed entirely. Under Anarcho-capitalism all involvement in largerprojects, such as defense spending or infrastructure, is on a voluntary basis. The government does notregulate any sales or ownership in any way, shape, or form, and the market is regulated only to theextent that individuals choose to limit their own actions. This has a great deal in common with the ideal,strictly laissez-faire market economy, but is markedly different in its rejection of all apparatuses of thestate as a necessary pre-condition to a truly free market.


20/28

Most economies in the West are defined as mixed economies, incorporating some elements of asocialist command economy and some elements of a market economy. These economies can be seen asfalling along a spectrum, with varying degrees of market freedom. The United States, for example, canbe seen as falling fairly far on the side of a true market economy, with steady deregulation of industriesand privatization of even once government-owned industries. In contrast, many nations in WesternEurope can be seen as falling more on the socialized end of the spectrum, with fairly substantialregulation of industries, and government ownership of some key businesses, such as prisons, watersystems, telecommunications systems, health-care systems, and others.

The idea of the market economy is intricately connected with larger political ideals as well.Many theorists, most notably Milton Friedman, one of the great proponents of the market economy,have posited that a free-market economy is a necessary pre-condition for a truly free political system.They hold that the degree to which a nation embraces a free market correlates over time to the degree towhich that nation will provide civil and political freedoms to its citizens, with command economieseventually stripping away individual rights.

A Mixed Economy: The Role of the Market

The American free enterprise system emphasizes private ownership. Privatebusinesses produce most goods and services, and almost two-thirds of the nation's total economic outputgoes to individuals for personal use (the remaining one-third is bought by government and business).The consumer role is so great, in fact, that the nation is sometimes characterized as having a "consumereconomy."

This emphasis on private ownership arises, in part, from American beliefs about personal freedom.From the time the nation was created, Americans have feared excessive government power, and theyhave sought to limit government's authority over individuals -- including its role in the economic realm.In addition, Americans generally believe that an economy characterized by private ownership is likelyto operate more efficiently than one with substantial government ownership.


21/28

Why? When economic forces are unfettered, Americans believe,supply anddemanddetermine theprices of goods and services. Prices, in turn, tell businesses what to produce; if people want more of aparticular good than the economy is producing, the price of the good rises. That catches the attention ofnew or other companies that, sensing an opportunity to earn profits, start producing more of that good.On the other hand, if people want less of the good, prices fall and less competitive producers either go

out of business or start producing different goods. Such a system is called a market economy. A socialisteconomy, in contrast, is characterized by more government ownership and central planning. MostAmericans are convinced that socialist economies are inherently less efficient because government,which relies on tax revenues, is far less likely than private businesses to heed price signals or to feel thediscipline imposed by market forces.

A Mixed Economy - The Limits to Free Enterprise

There are limits to free enterprise, however. Americans have always believed that

some services are better performed by public rather than private enterprise. For instance, in the UnitedStates, government is primarily responsible for the administration of justice, education (although thereare many private schools and training centers), the road system, social statistical reporting, andnational defense. In addition, government often is asked to intervene in the economy to correct

situations in which the price system does not work. It regulates "natural monopolies," for example, andit uses antitrust laws to control or break up other business combinations that become so powerful thatthey can surmount market forces. Government also addresses issues beyond the reach of market forces.It provides welfare and unemployment benefits to people who cannot support themselves, either becausethey encounter problems in their personal lives or lose their jobs as a result of economic upheaval; itpays much of the cost of medical care for the aged and those who live in poverty; it regulates privateindustry to limit air and water pollution; it provides low-cost loans to people who suffer losses as a


22/28

result of natural disasters; and it has played the leading role in the exploration of space, which is tooexpensive for any private enterprise to handle.

In this mixed economy, individuals can help guide the economy not only through the choices they makeas consumers but through the votes they cast for officials who shape economic policy. In recent years,consumers have voiced concerns about product safety, environmental threats posed by certain industrial

practices, and potential health risks citizens may face; government has responded by creating agenciesto protect consumer interests and promote the general public welfare.

The U.S. economy has changed in other ways as well. The population and the labor force have shifteddramatically away from farms to cities, from fields to factories, and, above all, to service industries. Intoday's economy, the providers of personal and public services far outnumber producers of agriculturaland manufactured goods. As the economy has grown more complex, statistics also reveal over the lastcentury a sharp long-term trend away from self-employment toward working for others.

Question # 5According To The Central Deduction Of Economic Theory, Under

Certain Conditions Markets Allocate Resources Efficiently.Efficiency Has A Special Meaning In This Context. This TheorySuggests That Markets Will Produce An Outcome Such That, GivenThe Economys Scarce Resources, It Is Impossible To Make AnybodyBetter Off Without Making Somebody Else Worse Off. EconomicTheory, In Other Words, Offers A Proof Of Adam Smiths Big Idea: In

A Market Economy, If Certain Conditions Are Met, An Invisible Hand

Guides Countless Apparently Un Co-Coordinated Individuals To AResult That Is, In One Plausible Sense, The Best That Can Be Done.In rich countries, markets are too familiar to attract attention. Yetcertain awe is appropriate. When soviet planners visited avegetable market in London during the early days of perestroika,they were impressed to find no queues, shortages, or mountains ofspoiled and unwanted vegetables. They took their hosts aside andsaid: we understand, you have to say its all done by supply anddemand. But can you tell us what is really going on? Where youre

planners and what are their methods?

1. Explain What Is Meant By Efficiency.2. Market Economy.3. Comment on Two Conditions Which Have To Be Met For a MarketEconomy to Work Efficiently.

4. Explain What Is Meant, in the Context of the Extract, By Its alldone By Supply And Demand.5. What Was The Role Of Soviet Planners In The Former SovietUnion?


23/28

EXPLAIN WHAT IS MEANT BY EFFICIENCY

Economic efficiency is a term typically used in microeconomics when discussingproduct. Production of a unit of good is considered to be economically efficient when that unit of goodis produced at the lowest possible cost. Economics by Perkins and Bade give a useful introduction to thedifference between economic efficiency and technological efficiency:

There are two concepts of efficiency: Technological efficiency occurs when it is not possible toincrease output without increasing inputs.Economic efficiency occurs when the cost of producing a

given output is as low as possible.

Technological efficiency is an engineering matter. Given what is technologically feasible, somethingcan or cannot be done. Economic efficiency depends on the prices of the factors of production.Something that is technologically efficient may not be economically efficient. But something that iseconomically efficient is always technologically efficient.A key point to understand is the idea that economic efficiency occurs "when the cost of producing agiven output is as low as possible". There's a hidden assumption here, and that is the assumptionthat all else being equal. A change that lowers the quality of the good while at the same time lowers the


24/28

cost of production does not increase economic efficiency. The concept of economic efficiency is onlyrelevant when the quality of goods being produced is unchanged.

MARKET ECONOMYA system of allocating resources based only on the interaction of market forces, such as supply

and demand. A true market economy is free of governmental influence, collusion and other externalinterference.

The questions "What is a market economy?" "What is a standard market economy?" or rather "Whatare the standards for a market economy?" would naturally pop up when people are talking about somecountries being market economy countries and some enterprises being market economy enterprises.For if not so, how come the conclusion as to whether a country is or is not a market economy country?

As a matter of fact, the existence of criteria of a market economy is controversial. Each one gets areason to support his or her own idea. We hereby accept a proposition, i.e., criteria of market economydo exist, put forward due to anti-dumping cases involved in international trade, but also believe that the

criteria are established on a relative basis.Some well-recognized market economy countries, we have discovered, practice various economicsystems. It is difficult to say, therefore, that certain country is a standard market economy country,while any other country not exactly the same cannot be regarded as a market economy country. Due todifferent traditions and development phases, countries inevitably differ in the form, even the contents oftheir market economy to a certain extent. The existence of differences does not mean there are nomarket economy criteria, however, and it is unacceptable to deny the existence of market economycriteria due to such differences. As an economic system in human history, the market economy cameinto being in modern times and is flourishing nowadays. It differs from either historical self-sufficienteconomy or planned economy, and certainly has its intrinsic definition that refers to the commonness ofvarious market economy countries at different development stages. The commonness, being sorted out

from various market economy countries, shapes a framework, which will facilitate us to judge acountry's status of market economy in anti--dumping cases. While it is reasonable to admit that thereare certain criteria of market economy, it is incorrect to rigidly apply such criteria in an arbitrary way.The framework of market economy criteria is a range of fundamental characteristics of marketeconomy, a status section with certain allowable differences and variations, and a varied status sectionof market economy taking the commonness of different countries' market economy as a dominant factorand supplemented with variations, rather than an absolute concept, a point or a line.


25/28

Supply and Demand - The Basics

Supply and Demand analysis is relatively straight-forward once the terminology is understood. The

important terms are as follows: Price Quantity Demand and Demand Curve Quantity Demanded Supply and Supply Curve Quantity Supplied Equilibrium Surplus Shortage

Basic supply and demand analysis is done one of two ways - either graphically or numerically. If done

graphically, it is important to set up the graph in the 'standard' form.

The Graph

Traditionally economists have placed price (P) on the Y-axis and quantity (Q), as in quantityconsumed or quantity purchased/sold on the X-axis. An easy way to remember how to label each axis isto remember 'P then Q', since the price (P) label occurs above and to the left of the quantity (Q) label.Next there are two curves to understand - the demand curve and the supply curve.


26/28

The Demand CurveA demand curve is simply a demand function or demand schedule represented graphically.

Note that demand is not simply a number - it is a one-to-one relationship between prices and quantities.

The following is an example of a demand schedule:

Demand Schedule

$10 - 200 units$20 - 145 units$30 - 110 units$40 - 100 units

Note that demand is not simply a number such as '145'. The quantity level associated with a particularprice (such as 145 units @ $20) is known as a quantity demanded.

A more detailed description of the demand curve can be found at: The Economics of Demand.

The Supply Curve

Supply curves, supply functions and supply schedules are not conceptually different than their

demand counterparts. Once again, supply is never represented as a number. When considering theproblem from the point of view of the seller the quantity level associated with a particular price is


27/28

known as quantity supplied. A more detailed description of the supply curve can be found at: TheEconomics of Supply.

Equilibrium

Equilibrium occurs when at a specific price P', quantity demanded = quantity supplied. In other words,if there is some price where the amount buyers wish to buy is the same as the amount sellers wish tosell, then equilibrium occurs. Consider the following demand and supply schedules:

Demand Schedule

$10 200 units$20 - 145 units$30 - 110 units$40 - 100 unitsSupply Schedule

$10 - 100 units

$20 - 145 units$30 - 180 units$40 - 200 units

At a price of $20, consumers wish to purchase 145 units and sellers which to provide 145 units. Thusquantity supplied = quantity demanded and we have an equilibrium of ($20, 145 units)

Surplus

A surplus, from the supply and demand perspective, is a situation where, at the current price,quantity supplied exceeds quantity demanded. Consider the demand and supply schedules above. At aprice of $30, quantity supplied is 180 units and quantity demanded is 110 units, leading to a surplus of

70 units (180-110=70). Our market, then, is out of equilibrium. The current price is unsustainable andmust be lowered in order for the market to reach equilibrium.Shortage

A shortage is simply the flip-side of a surplus. It is a situation where, at the current price,quantity demanded exceeds quantity supplied. At a price of $10, quantity supplied is 100 units andquantity demanded is 200 units, leading to a shortage of 100 units (200-100=100). Our market, then, isout of equilibrium. The current price is unsustainable and must be raised in order for the market toreach equilibrium.


28/28

Economic Resources (522)

Documents

Transcript of Economic Resources (522)