Economics and the Problems of Scarcity and Choice

Main body of the report :

The report is about the key economic concepts, evaluating the problem of scarcity and choice, which is mainly caused because of unlimited wants and limited resources. It covers topics such as opportunity cost, explanation of micro and macro economics. The demand and supply curve theory, individual and market demand, the oligopoly market structure, and information about the Keynesian and Monetarist economics.

Task 1 – 18 Marks

1.0 A definition of economics which includes the problems of scarcity and choice.

“Economics is the study of how individuals and groups make decisions with limited resources as to best satisfy their wants, needs and desires.” Reference Desk: online available http://economics.about.com/cs/studentresources/f/whatiseconomics.htm [2011, Feb 27]. Resources are the inputs that society uses to produce goods. The economic resources used to produce goods and services include:

Land – the economy’s natural resources such as land, trees and minerals

Labor – The mental and physical skills of individuals in a society

Capital – Goods such as tools, machines and factories used in production

Examples of goods are food, clothing and housing, whereas services are those provided by doctors, police officers and teachers. The goal is to forecast economic occurrences and to build up policies that might avoid or correct such problems as unemployment, inflation or waste in the economy.

Human wants being always unlimited whereas the resources to satisfy these wants are insufficient, people, therefore, have to make choices because they can’t have everything they want. Whenever a choice is made, something is sacrificed. The opportunity cost of that choice is the value of the best alternative given up.

Scarcity is a major problem for every society. It exists because human wants for goods and services surpass the quantity of goods and services that can be produced using all available resources. Decisions must be made about what to produce, how to produce and for whom to produce. What to produce includes decisions about the kind and quantities of good and services to produce. How to produce includes decisions about the techniques to be used and how the factors of production are to be merged in producing output. For whom to produce involves decisions on the distribution of goods and services among members of a society.

To make efficient decisions – decisions that provide the utmost possible return from the resources available, people and society must consider the benefits and costs of using their resources to do more of some things, and less of others. For example, to use their time effectively, students must think about the additional benefits and costs of studying economics rather than listening to music or going out with friends.

In other words, the economic choices that we make will not always be measured by the amount of money that we spend. Time is also a limited resource and it should be allocated efficiently.

1.1 An explanation of what is meant by the concept of opportunity cost.

All the decisions mentioned above include an opportunity cost. Opportunity cost is what is sacrificed to apply an alternative action, means, what is given up to produce or obtain a particular good or service. For example, I have two alternatives of how to spend my holidays, either I visit my family in England or I stay inland and do some benevolent jobs. If I choose to stay inland, the opportunity cost of my choice will be visiting my family in England. Opportunity costs are found in every situation in which scarcity requires decision making. Opportunity cost is the value, monetary or otherwise, of the next best alternative, or that which is sacrificed.

1.2 An explanation of the difference between micro and macro economics.

Economics is subdivided into two categories: micro-economics and macro-economics.

Micro-economics studies the economic behavior of individual decision makers, such as consumers and business firms, the decision process and the decision impact. The general concern of micro-economics is to allocate efficiently the limited resources between alternative uses and more particularly it implies the determination of the price through the optimizing behavior of economic agents, with consumers maximizing utility and firms raising profits.

In contrast to micro-economics, macro-economics looks at larger economic aggregates, such as national income, consumption and investment. In macro-economics, issues such as inflation, unemployment, recessions, international trade and economic development can be analyzed.

Task 2 – 23 Marks

2.0 Show how an individual demand curve (schedule) is derived and how market demand is derived.

The individual demand is represented by a demand schedule, which lists the amount of a good that a buyer is ready to purchase at different prices. An example of a demand schedule for a certain good X is given in Table 1. It is to be noted that as the price of good X increases, the demand for that good decreases.

Table 1

Demand schedule for good X

Price of good X (in $)

Quantity Demanded

5

2

4

4

3

6

2

8

1

10

It exists an inverse relationship between price and quantity demanded. More units are purchased at lower prices because of a substitution effect and an income effect. As a commodity’s price falls, an individual will buy more of this good since he is more likely to replace it for other goods whose price has remained unchanged.

Also, when a product’s price falls, the purchasing power of an individual with a given income increases, allowing for greater purchases of the good. As stated in the law of demand, people buy more at lower prices and less at higher prices.

The demand schedule can be represented by a graph called the demand curve in which the inverse relationship between the two variables, price and quantity, is promptly seen. A demand curve for the demand schedule given in Table 1 is presented in Figure 1 .

Figure 1. Demand curve for good X

It is a downward sloping curve showing that the quantity demanded increases as the price falls.

A market demand schedule indicates the units of a particular good or service all individuals in the market are disposed and able to purchase at alternative prices.

Table 2 shows the market schedule of buyer A and buyer B for the good X :

Table 2.

Price ($)

QUANTITY DEMANDED

MARKET DEMAND

BUYER A

BUYER B

10

2

2

8

1

3

4

6

2

4

6

4

3

5

8

2

4

6

10

5

7

12

Figure 2 shows the demand curves of both buyers and the market demand curve.

Figure 2.

2.1 Provide a clear explanation of what a firm’s output decision in the short-run is.

In deciding how much output to supply, the firm’s objective is to increase profits while considering the consumers’ demand for his product and the firm’s costs of production. The price at which a perfectly competitive firm may sell its product is determined on the consumer demand. The costs of production are established by the firm’s expertise used. The firm’s profits are the difference between its total revenues and total costs.

Total revenue is the amount of money that the firm gains in selling its product. If a firm decides to provide the amount B of output and the price in the perfectly competitive market is A, the firm’s total revenue is A x B

A firm’s marginal revenue is the amount by which its total revenue changes following a 1-unit change in the firm’s production. If a firm in a perfectly competitive market increases its output by 1 unit, it increases its total revenue by A Ã- 1 = A. Therefore, in a perfectly competitive market, the firm’s marginal revenue is just equal to the market price, A.

In the short-run a firm increases its profits by choosing to deliver the level of output where its marginal revenue equals its marginal cost. When marginal revenue goes beyond marginal cost, the firm can earn larger profits by adding to its output. When marginal revenue is less than marginal cost, the firm is losing money, and therefore, it must reduce its productivity. Profits are thus increased when the firm chooses the level of output where its marginal revenue equals its marginal cost.

2.2 Provide a clear explanation of what a firm’s output decision in the long-run is.

In the long-run, firms can differ all of their input factors, this eventually allows for the possibility of new firms entering the market and some existing firms leaving the market. In a perfectly competitive market, firms can always join or leave. If some of the existing firms in the market are earning positive economic profits, new firms will be attracted to enter the market too. On the other hand, existing firms may choose to leave the market if they are losing. For these reasons, the number of firms in a perfectly competitive market is unlikely to remain unchanged in the long-run.

The entry and exit of firms being possible in the long-run, will eventually make each firm’s economic profits to reduce to zero. So, in the long-run each firm gains normal profits. If some firms are earning positive economic profits in the short-run, in the long-run the increased competition, caused by the entry of new firms in the market, will reduce all firms’ economic profits to zero. Firms that are earning losses in the short-run will have to either alter their fixed factors of production in the long-run or choose to leave the market in the long-run. A perfectly competitive market attains long-run equilibrium when all firms are earning zero economic profits and when the number of firms in the market remains unchanged.

Task 3 – 14 Marks

Using demand and supply theory show:

3.0 How an equilibrium price and equilibrium quantity is achieved.

Every market consists of both buyers and sellers. The demand for a good is the amount that buyers are willing and able to purchase. Quantity demanded is the demand at a particular price, and is represented as the demand curve. The supply of a product is the amount that suppliers are willing and able to sell in the market. The amount offered for sale at a particular price is the quantity supplied. The main factor that influences supply and demand is the price of the product.

In the market for any particular good X, the buyers’ decisions interact simultaneously with the decisions of sellers. Equilibrium occurs when the demand for good X equals the supply of good X. With any market equilibrium, an equilibrium quantity and an equilibrium price are related. The equilibrium quantity of good X is that quantity for which the quantity demanded of good X exactly equals the quantity supplied of the same good. There is an equilibrium price for good X when the price for which the quantity demanded of good X exactly equals the quantity supplied of good X. There is a surplus at prices higher than the equilibrium price since the quantity demanded is not equal to the quantity supplied. At prices lower than the equilibrium price, there is a shortage of productivity since quantity demanded is more than quantity supplied. Once achieved, the equilibrium price and quantity continues until there is a change in demand and/or supply.

Figure 3

The chart in Figure 3 shows the equilibrium which occurs at the intersection of the demand and supply curve. At this point the price of the good will be P* and the quantity will be Q* and these figures are called the equilibrium price and quantity.

3.1 The effects of excess supply on market equilibrium.

When the quantity supplied is more than the quantity demanded, it is called excess supply, which results in surpluses at the current price. In cases of excess supply the following points can be observed:

Price is too high to be at equilibrium

Suppliers find that inventories increase

Suppliers react by lowering prices

This continues until price falls to equilibrium

If the price is set too high, it will create excess supply in the market and therefore will result in a disequilibrium as the quantity demanded for the good will fall. Figure 4 shows an example of the demand and supply curve for the quantity of goods that the suppliers wish to produce at price P1 and the quantity the buyers are willing to buy.

Figure 4

Q2 indicates the quantity of goods that suppliers are willing to produce at price P1. Whereas Q1 indicates the quantity that buyers are willing to consume at P1, which is much less than Q2. Q2 being greater than Q1, clearly shows that too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, with the hope of selling them to increase profits, but the consumers will find the good less attractive and purchase less because the price is too high.

3.2 The effects of excess demand on market equilibrium.

Excess demand occurs when price is set below the equilibrium price and therefore results in quantity demanded being greater than quantity supplied. This creates shortages and consumers cannot buy all what they want at the current price, as the suppliers won’t be producing enough of the good when the price is too low.

Figure 5 shows an example of the excess demand.

In this case, Q2 indicates the quantity of goods the consumers are willing to buy at price P1. Whereas the quantity of goods that suppliers are willing to produce at this price is Q1. Therefore, too few goods are being produced to satisfy the demand of the consumers. Yet, as consumers have to compete with one other to buy the good at this price, the demand will push the price up. This will therefore encourage the suppliers to produce more and bring the price closer to its equilibrium.

Task 4 -15 Marks

Using both words and diagrams :

4.0 Explain clearly what is meant by perfect competition.

“When economists analyze the production decisions of a firm, they take into account the structure of the market in which the firm is operating. The structure of the market is determined by four different market characteristics: the number and size of the firms in the market, the ease with which firms may enter and exit the market, the degree to which firms’ products are differentiated, and the amount of information available to both buyers and sellers regarding prices, product characteristics, and production techniques.” Reference Desk: online available http://www.cliffsnotes.com/study_guide [2011, March 22]

For a perfectly competitive market structure to exist, four characteristics or conditions are essential. First, many firms must be there in the market, which are small in terms of their sales. Second, firms should be able to enter and exit the market easily. Third, each firm in the market produces and sells an identical product. Fourth, all firms and consumers in the market are well informed about prices, product quality, and production techniques.

A firm that is running in a perfectly competitive market will be a price-taker. A price-taker has no control over the price of the good it sells; it just takes the market price as given. The conditions that cause a market to be perfectly competitive also cause the firms in that market to be price-takers. When there are many firms, all manufacturing and selling the same good using the same inputs and technology, competition compels each firm to sell their good at the same market price. The fact that each firm in the market sells the same, identical product, doesn’t allow any single firm to increase the price that it charges above the price charged by the other firms in the market without losing business. As it is assumed to have many firms, each small in size, it is therefore impossible for a single firm to affect the market price by changing the quantity of output it supplies.

4.1 Explain clearly what is meant by oligopoly.

“Oligopoly is the form of market organization in which there are few sellers of a product. If the product is homogenous, there is a pure oligopoly. If the product is differentiated, there is a differentiated oligopoly. Since there are only a few sellers of a product, the actions of each seller affect others. That is, the firms are mutually interdependent.” Dominick Salvatore, Schaum’s Easy Outlines, 2nd edition. McGraw-Hill: USA, p.127

An oligopoly is a market condition in which a few large firms focus in the production of the same or similar products. Examples of oligopolies include the steel, aluminum, automobile, petroleum, tire, and beer industries. The launching of new products and processes can establish new oligopolies, as in the computer or synthetic fiber industries. Oligopolies exist as well in service industries, such as the airlines industry.

An oligopoly may be classified as either a homogeneous oligopoly or a differentiated oligopoly. When the major firms produce identical products, such as steel bars or aluminum ingots, it is called the homogeneous oligopoly. In homogeneous oligopolies, prices are likely to be the same. In a differentiated oligopoly, the goods produced are similar but not identical. Some examples are the automobile industry, the cigarette industry, and the soft drink industry. In differentiated oligopolies companies try to distinguish their products from those of their competitors. To the extent that they are able to create differentiated products, companies may be able to maintain price differences.

Being part of an oligopoly affects a company’s competitive behavior. In a competitive market situation that is not an oligopoly, firms compete freely to increase profits without regard to the reactions of their competitors. In an oligopoly, a firm must consider the effects of its actions on others in the industry. While smaller firms may operate at the border of an oligopoly without affecting the other firms in the industry, a major firm’s actions in the oligopoly typically cause reactions in the other firms in the industry. For example, if one company in the oligopoly tries to sell at a lower price than others, then the other firms will react by lowering prices too. As a result, price cuts in oligopolies tend to result in lower profits for all of the firms involved.

Task 5 – 20 Marks

5.0 An explanation and evaluation of what is meant by Keynesian economics.

“Keynesian economics is a theory of total spending in the economy (called aggregate demand) and its effects on output and inflation.” Reference Desk : online available http://www.econlib.org/library/Enc/KeynesianEconomics.html [2011, March 23].

In Keynes’ theory, one person’s expenses go towards another’s earnings, and when that person spends his earnings he is eventually supporting another’s earnings. This continuous circle helps in sustaining a normal functioning economy. When the Great Depression hit, people’s natural reaction was to collect their money. Under Keynes’ theory this stopped the circular flow of money, causing the economy to be idle.

A Keynesian believes that aggregate demand is influenced by a number of economic decisions, both public and private, and sometimes behaves unsteadily. The public decisions include, most significantly, those on monetary and fiscal policies, that is, spending and tax. According to Keynesian theory, changes in aggregate demand, whether foreseen or unpredicted, have their utmost short-run effect on real productivity and employment, not on prices. Keynesians believe that what is true about the short run cannot necessarily be deduced from what must happen in the long run, and we live in the short run.

Monetary policy can have a real impact on output and employment only if some prices are inflexible, if nominal wages, for example, do not adjust instantly. Else, an addition of new money would change all prices by the same percentage. So Keynesian models normally either assume or try to explain rigid prices or wages. Reducing inflexible prices is a difficult theoretical problem because, according to standard microeconomic theory, real supplies and demands should not change if all nominal prices rise or fall comparatively.

It is believed that, because prices are fairly rigid, fluctuations in any part of spending consumption, investment or government expenditures, cause output to rise and fall. For example, if government costs increase and all other factors of spending remain stable, then output will increase. Keynesians believe that prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.

5.1 An explanation and evaluation of what is meant by Monetarist economics.

Monetarist economics is an economic theory advocating that governments use interest rates and control of the supply of money for the purpose of economic regulation. It is in contrast to Keynesian economics which supports taxation and fiscal policy. Using monetary instruments for economic regulation causes an effect on macro-economic cycles in the economy, while avoiding bureaucratic regulation or alterations of market forces.

Monetarism is the economic doctrine established by Milton Friedman, that the money supply, that is, the total amount of money circulating in an economy, whether as currency or bank balances, is the chief controller of the level of economic activity.  Monetarism has become the dominant framework of theory in both academic economics and public policy. It is closely linked with neo-conservatism, a version of liberalism that strains free markets and individualism rather than the ‘welfare state’ vision that had become dominant in most western societies.

The idea of monetarism is that if the money supply is limited, then prices must fall and/or the rate of circulation of money must go down, that is, the government can restrict the supply of money and credit to reduce inflation and increase unemployment. This, it was said, would take effect more quickly than fiscal measures like reducing government expenditure or increasing taxes, which Friedman claimed were unsuccessful in controlling the business cycle and could weaken the economy. Instead, Friedman advocated a gradual expansion of the money supply at an annual rate equal to the expected growth in the gross national product. 

Monetarists are particularly concerned with the prospective for abuse of monetary policy and deterioration of the price level. They often mention the contractionary monetary policies of the Fed during the Great Depression, policies that they blame for the great depression of that period. Monetarists believe that persistent inflations (or deflations) are purely monetary phenomena brought about by constant expansionary monetary policies. As a means of fighting persistent periods of inflation or deflation, monetarists argue in favor of a fixed money supply rule. They believe that the Fed should carry out monetary policy so as to keep the growth rate of the money supply fixed at a rate that is equal to the real growth rate of the economy over time. Thus, monetarists believe that monetary policy should serve to accommodate increases in real GDP without causing either inflation or deflation.