Thursday, 6 August 2009

Features of Capitalist economics: trade and specialization, money and capital.

This article presents the three distinct features of any capitalist economy. Furthermore it explains the role of government in capitalist economies, which can be considered to be either fiscal policy or monetary policy.

Trade and specialization

  • specialization occurs, when people and countries concentrate their efforts on a particular set of tasks – it permits each person and country to use its best advantage its specific skills and resources
  • division of labor – dividing the production into a number of small specialized steps or tasks, this leads to division of labor and specialization which increases productivity
  • Individuals and countries then voluntarily trade goods in which they specialize for others’ products. This increases the range and quantity of consumption and has the potential to raise everyone’s living standards.
  • is the medium of exchange; proper management of the money supply is one of the major issues for government macroeconomic policy in all countries
  • specialization permits people to concentrate on particular tasks; money allows people to trade their specialized outputs
  • Capital is a produced factor of production, a durable input which is itself an output of the economy
  • Capital is major factor of production; land and labor also called primary factors of production; their supply is mostly determined by noneconomic factors. It is important to note that capital itself has to be produced, before using it!
  • Economic activity involves forgoing current consumption to increase our capital; every time an investment is made, the future productivity and consumption is enhanced. By sacrificing current consumption, a society can push its PPF outward
  • Market economy , capital is typically privately owned; income from capital goes to individuals à the ability of individuals to own and profit from capital is what gives capitalism its name!
    • Property rights define the ability of individuals or firms to own, buy, sell and use the capital goods and other property in a market economy; these rights are enforced through the legal framework
The economic role of government
  1. Governments increase efficiency by promoting competition (imperfect competition, Monopolies, Market power), curbing externalities (involuntary imposition of costs and benefits on others outside an exchange relationship) and providing public goods.
    • Extreme example of positive externality is a public good
      Private provision of public goods will be insufficient; government is necessary to produce sufficient quantities
    • Public goods are commodities for which the cost of extending the service to an additional person is zero and which is impossible to exclude individuals from enjoying.
      Private goods: exclusion and competition from/in consumption
      Common good: competition but no exclusion from consumption
      Club goods (e.g. tollbridge): exclusion but no competition
      Public good: no competition no exclusion
    • Public goods are paid for by taxes; taxes are not prices, since everybody has to pay them, even if one cares about that good or not!
    • A public good is hard or impossible to produce for a private profit
  2. Governments promote equity, by using tax and expenditure programs to redistribute income toward particular groups.
    à markets do not necessarily produce a fair distribution of income; it might produce inequalities in the “for whom”, that are not acceptable
    • Progressive taxation
    • Transfer payments
  3. Governments foster macroeconomic stability and growth through fiscal policy and monetary regulation.
    • Fiscal policy: power to tax and the power to spend
    • Monetary policy: determining the supply of money and interest rates; these affect investment in capital goods

Monday, 3 August 2009

What is a market? Who solves the three fundamental questions?

A market is a mechanism through which buyers and sellers interact to set prices and exchange goods and services à in a market system, there are gains from trade! Through trade, one attains a good because he imposes a higher value on the good!

Prices coordinate the decisions of producers and consumers in a market. Higher prices tend to reduce consumer purchases and encourage production. Lower prices encourage consumption and discourage production. Prices are the balance wheel of the market mechanism.

Market equilibrium: At market equilibrium everybody who was willing to exchange goods has done so. Markets are steadily solving the three fundamental questions! 
--> they balance all the forces operating on the economy, markets are finding a market equilibrium of supply and demand.

How are the fundamental questions solved?
  • What
    - Through the daily consumption decisions, the kind of goods and services, that will be produced is determined
    - Firms are motivated by the desire to maximize profits by producing the desired goods
  • How
    - determined by the competition among the producers; best way for producers to meet price competition and maximize profits is to keep costs at a minimum by adopting the most efficient methods of production
  • For whom (who is consuming and how much)
    - depends in large part on the supply and demand for the factors of production à they determine the wage rates, land rents, interest rates and profits; by adding up the all revenues a individual receives for his factors of production, one attains the persons market income

Core determinants of the shape of our economy are the dual monarchs of tastes and technology

  • Tastes determine to a large extent the point on the PPF
  • Technology limits the choices of the consumers to the points within and on the PPF
Adam Smiths discovery
  • „by pursuing his own interest, he frequently promotes that of soceity more effectually than when he really intends to promote it“
  • under limited conditions, a perfectly competitive economy is efficient
  • however, there are market failures
    - Monopolies and other forms of imperfect competition
    - spillovers and externalities outside the marketplace

Wednesday, 1 July 2009

What is Economics? The three fundamental questions of Economics.

Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. It rests on two notions: (1) goods are scarce, i.e. they are limited relative to the desires and (2) efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs à absence of waste. Economists work with a different notion of efficiency, namely “Pareto efficiency“: An allocation is efficient, when it cannot make anyone economically better off without making someone else worse off

Two fields of economics studies

  • Microeconomics: branch of economics which today is concerned with the behaviour of individual entities such as markets, firms and households
  • Macroeconomics, concerned with the overall performance of the economy

Common fallacies in economic reasoning:

  • Post-hoc fallacy occurs when we assume that, because one event occurred before another event, the first event caused the second event.
  • Failure to hold other things constant
  • Fallacy of composition; assumption that what is true for the part is also true for the whole à e.g. Farmer with bumper crop, he enjoys higher income; all farmers with bumper crop, the income is likely to fall

Positive economics describes the facts of an economy, while normative economics involves value judgements

Ways for answering the three problems of economic organisation

A Market economy is one, in which most decisions about production and consumption are made by individuals and private firms. There exists a system of prices, markets, profits and losses, incentives and rewards determines what, how and for whom. Firms produce the commodities that yield highest profits (the what), by using techniques of production that are least costly (how);  consumption is determined by individuals decisions about how to spend the wages and property incomes generated by their labor and property ownership (the for whom). The free interaction of firms supplying and households demanding goods in markets determines the major economic decisions in the society

  • Laissez-faire economy: government keeps hands of any economic decision
  • Command economy: most decisions about production and distribution are made by the government; government owns most means of production; it owns and directs the operation of enterprises in most industries, it’s the employer of most workers, decides on the distribution of goods
    à the government answers the major economic questions through its ownership of resources and its power to enforce decisions
  • Most societies are thus mixed economies, with elements of market and command.
Economic organization

There are several ways economic activity may be organized:

  • Command economy à government makes most economic decisions
    - government owns means of production
    - directs the productive facilities
    - employs most people
    - decides how output is to be distributed
  • Market economy à individuals and private firms make the major decisions regarding consumption and production
    - system of prices, which are determined by supply and demand
    - production decisions made by firms, that are motivated by profits
    - individuals supply labor services (and other means of production) to privately owned firms
    - households use earned income to demand goods in consumption markets
    - free interaction of firms supplying and households demanding goods in markets determines the major economic decisions in the society

Society’s technological possibilities

Goods are scarce relative to wants, an economy must decide how to cope with limited resources. A socieity must choose between different potential bundles of goods (the what), select from different techniques of production (the how) and decide in the end who will consume the goods (the for whom).

Inputs and Outputs

Inputs (or factors of production)  are commodities or services that are used to produce goods and services; an economy uses the existing technology to combine inputs, to produce outputs
can be classified in three broad categories:

  • Land : natural resources
  • Labor : consists of the human time spent in production
  • Capital :  forms the durable goods of an economy; they are produced in order to produce yet other goods

Outputs are the various useful goods or services that result from the production process and are either consumed or employed in further production.

Production possibility frontier shows the maximum amounts that can be obtained by an economy, given its technological knowledge and the quantity of inputs available (scarcity). Points inside the PPF are attainable but inefficient, points on the PPF are attainable and efficient, points outside are not attainable

Production Possibilities Frontier - A key economic principle

Production Possibilities Frontier - A key economic principle

e.g. PPF of Capital Investment or Current Consumption. A society has to decide on whether to invest in the future or whether to spent everything right away for consumption goods à more investment in capital goods is likely to push the PPF outward

Economic growth entails moving the PPF outward with
… technological knowledge and/or
… the quantity of available inputs

Factors of economic growth
… human resources
… natural resources
… capital formation (productive equipment, infrastructure)
… technology

Trade-off line

PPF shows the notion of trade-offs à a trade-off usually refers to losing one quality or aspect of something in return for gaining another quality or aspect. It implies a decision to be made with full comprehension of both the upside and downside of a particular choice.

Opportunity costs

In a world of scarcity, choosing one thing means giving up something else. The opportunity cost of a decision is the value of the good or service forgone.

Productive Efficiency occurs, when an economy cannot produce more of one good without producing less of another good; this implies that the economy is on its PPF. This shows that productive efficiency is one important aspect of overall economic efficiency