Unit 2 Lecture - Economic Foundations ( (Inferior goods' demand falls…
Unit 2 Lecture - Economic Foundations
What is Economics?
A social science concerned with the production, disrribution and consumption os goods and services. It shows how entities allocate resources to satisfy wants and needs and determine ways to achieve maximum output
Microeconomics - Analyses decisions made by individual consumers and producers
Managers must udnerstand hos prices are determined from outputs and inputs.
Output prices determine the amount of revenue and profit to be made. Input prices indicate the cost of production.
Many managerial decisions are based on expectated changes to these costs
Decisions influenced by changes in the environment that the business operates in.
Change in economic activity, unemployment, exchange rates etc which pose challenges or opportunities
Managers need to be familiar with economic models to predict changes and how to respond. There is a strong link between micro and macro economic analyses
Economic problem of Scarcity
Limited scarce resource Vs Unlimited demand and needs
Resources are limited in two essential ways
Limited in physical qualtity - eg land
Limited in use - eg machinery which can only be used by one purpose at a time
The Economic problem
Paul Samuelson "In order to solve teprob of scarcity, you need to ask:
What to produce? - How many to capital, how many to schools etc
How to produce? - How much land labour and capital can be ued to produce consumer gods?
For whom to produce? - All societies need to decide who will get the final output from the country's economic activity - who is the consumer? This si the problem of distribution
Rational Decision Making
The most common understanding of decision making is that it is rational, self interested, purposeful and efficient
During Ratonal decision makin, indiciduals will survey alternatives, evanluate consequence and inally do what they believe has the best consqeuence for themselves
The key to decision is the quality of information about alternatives and individual preferences. Modern economics is built on the understnading of how indiciduals make decisions
1940's org theorists began to challenge the assumptions necessary for rational decisions to occur
First - Information is never perfect and decisions are mde on imperfect info
Second - individuals do not evaluate al possible alternatives before making a choice. This is related to the costs of gathering information as it becomes profrssively more difficult and costly to gather
Instead of choosing the best alternative possible, individuals tend to choose the first satisfactory alternative they find -
Objective rationality can lead to one possible rational decision whilst satisficing can lead to several potentially satisfactory outcomes in varying degrees.
One aprty has more or better information than the other when making decisions ans transactions. This causes an imbalance of power. eg salary negotiations - you do not know the max the empoyer will pay whilst the employer does not know what you will accept
This can also lead to adverse selection - a term used that refers to a process in which undesited results occur when buyers and sellers have access to different imperfect info.
One example is the Akerlof research which showed info regarding car prices
Does the internet spell the end of Asymmetric Information?
Some economsts argue that the internet has helped to reduce the incidence of asymmetric information - eg consumers can investigate and read reviews. There is therefore an incentive for producers only produce good products?
This is defined as when the curcumstances of an individual cannot be made better without making the situation worse for another individual.
Pareto optimality takes places when the resources are most optimally used and was theorised by the italian economist and engineer Vilfredo Pareto
Equity versus Efficiency
Many argue that resource allocation should be evaluated in terms of perceived equity
BUT people differ in their perceptions of equity!
Efficiency/Equity trade off**
eg everyone is better off but those with higher salaries will benefit more from a percentage increase
The result is that everyone is better off but there is a rise in inequality
Pareto improvement in economic welfare but an increase in inequality
- the institutions and mechanisms used for the uying and selling of goods and services
An actual por nominal place where the forces of supply and demand operate, where buyers and sellers interact
Inefficiency in Compettive markets
Prices do not always fully reflect marginal social benefits or the costs of output
This means that an institution other than markets is needed to make social benefts of certain good s available
Failure of markets to make available certain goods give rise to demand for government regulation
Examples of market failure
Where free markets fail to allocate resources efficiently
Reduces Market efficiency
Missing markets - markets fail to exist due to high transaction costs - non rival and non excludeable (ie you cannot exclude people from it, like lighting)
As a result the producer cannot impose a cost and therefore there is no incentive. These are pure public goods.
Incomplete Markets - free market fail to produce enough - eg education and healthcare.
A market structure where a single firm provides with no direct substitutes
A monopolist faces a downward demand cyrve because ther firm produces the entire output of the industry
Firms are price setters
Managers must set the optimal prices - which maximises thefirms profit. This depends on the firms costs
This leads to a loss of efficiency due to the monopolistic power.
This occurs when a firm influences the price of a product by reducing output to a level where the price set exceeds the marginal costs of production
Customer sovereignty is constrained
Causes failure of markets to result in inefficient levels of output
This leads economists to call on the government to intervene
Essentially a monopolist will produce less to control the market, leading to an inefficienct market as compared to what it would be in a competitive state
Reasons for market failure
Monopoly power in the market
Effects of transactions on 3rd parties
Lack of a market for a good with a marginal social benefit that exceeds its marginal social cost
Negative externalities - costs to third parties such as pollution or similar are not reflected in the price
Positive externalities - benefits are not reflected inthe price, eg smoke alarms
Pecuniary externalities -
MEC - marginal exterals cost. Cost to third parties resulting from the productui of another unit of another good.
MEB - Marginal external benefit
Consumers base decsiios on marginal personal benefit - only thinking of their selves
Markets in action
Demand - the functional relationship between the price of a good or service and the quamtity demanded by customers in a period of time, all else held constant (centeris parabus)
Supply Functional relationship between the prices of a good or service and the qutity supplied
Demand and suply provide the frameworks for analusing consumer behaviour and producers in economy
As managers we need to understand this
Demand incorporates the customers willingness and ability to buy
Demand relationship is between the quantity purchased and its price
There are non price factors that determeine demand. income, prices of competitors, expectations of future goods, changes in fashion.
However to analyse we hold these factors as constant.
Demand curves are usually downward sloping showing a negative relationship between the price of a good and the qualtity bought.
Shift in the demand curve:
A change in demand is the change in quantity purchased when one or more of the shifters change
The distinction is important in economics and can be for example a change in income causing a surge in demand at the same price
Changes in any of the variables in demand function other than price will affect the curve.in one direction or the other.
The relationship between q demanded and the price determines the slope of the curve whilst other factors cause it to shift. Increase in income or quality would increase demand and a rightward shift on the curve. The opposite is also true with a left shift.
External factors can be the prices of substitute or complentary products, for example cars where a rival price increase would increase demand for yours, but a rise in petrol costs would mean a shift to the left.
Functional relationship between the price of a good or service and the quantity supplied by producers in a time period.
Factors the influence supply
State of tech - or the body of knowledge about how to combine the inputs of production affects output through costs.
Input prices - prices of all the inputs or factors, such as capital of labour, materials, etc
Prices of goods related in production - prices of other goods related in production can also affect the supply of a particular good. Two goods are substitutes in production if the same inputs can be used to produce either good - eg land for farming
Future expectations - play a role on the supply side of the market. Suppliers may supply less of a resource if they expect the prices to rise in the future
Change in aupply
In developing a competitive strategy managers must analyse the factors that affect supply as dscussed.
In a competitive market the interacton of demand and supply determines the equlibrium price - the price that exists in the market or twards where the market is heading.
At any other price there will be an imbalance in the quantity of the good and the amoint supplied and forces will be set in motion to correct the imbalance and restore equilibrium
Equilibrium price is the price set which establishes the supply being equal to demand.
A below Eq price will create a shortage, whilst a price above eq will create a surplus.
Demand and elasticity
Consumer responsiveness to a company price changes reated to:
Tastes and pref for quality characteristics as opposed to the concept of price.
Consumer income and the amount spent on a product in relation to inome
Availability of substitute goods and perception of what is an adequate substitute
Ammount of time needed to adjust to the changes
Demand Elasticity is the quantitive measurement showin the percentage change in the quantity demanded of a paerticular product relatiev to the percentage change in one of the variavles.
Elasticity can be calc'd in relation to incomes etc
Price elasticity of demand (eP) is the percentage change in the quantity demanded of a given good (x) relative to a % change in its own pice, all other factors assumed constant.
A % change in a variable is the ratio of the absolute change in that variable to a base value of the variable
If the % Quantity demanded changes by more than th % change in price then demand is price elastic. The opposite is also true
Cross price elasticity of demand
Measures the demand for one good and how it varies with changes in the price of another good.
Elasticity coefficient measures how the quantity demand of good x divided by the price 5 change of good Y. So eg a price change in good Y causes a demand increase for good X.
2 x goods with cross price elasticity are said to be substitute goods - tea and coffee for example.
If they have a negative cross price elasticity, they are said to be complementary goods. For example coffee and cream, where an increase in the price of coffee may affect the quantity ordered of cream.
Inferior goods' demand falls as consumer income increases.
A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes.
A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.
A zero income elasticity of demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.