Game Theory - How I Would Define It
Game theory considers economic scenarios with the following properties:
•Two or more 'economic actors' - that is, two or more firms, individuals, political parties, etc.
•Each individual economic actor has a set of decisions they can make - what price to charge, how much to save, whether to move right or left, etc.
•Each individual economic actor has a 'goal' or payoff, such as profit maximization, maximize happiness, minimize loss, etc.
•The decisions made by one economic actor not only affects her payoff, but the payoff of one or more other economic actors
Game theory is a particularly useful tool for understanding why firms and individuals make the decisions they do, and how the decisions made by one individual affects others.
Game Theory - Some Alternative Points of View
Here are a few definitions that should help you answer the question "What are Game Theory and Bargaining Theory?":
The best definition of Game Theory I've seen is contained in the Economists "Dictionary of Economics". In part it states: "Much of economic theory is concerned with the process and conditions under which individuals or firms maximize their own benefits or minimize their own costs in markets in which their individual actions do not materially influence others (perfect competition). There are, however, many cases in which economic decisions are made in situations of conflict, where one party's actions induces a reaction from others. An example is wage bargaining between employers and unions. A more simple case is the of duopoly, in which the price set by one seller will be based on his view of that set by the other in reply. The mathematical theory of games has been applied to economics to help elucidate problems of this kind."
The Game Theory Society
A group of academic game theorists called the Game Theory Society defines game theory as: "Game theory studies strategic interaction in competitive and cooperative environments. Only fifty years old, it has already revolutionized economics, and is spreading rapidly to a wide variety of fields. It develops general mathematical formulas and algorithms to identify optimal strategies and to predict the outcome of interactions."
Bargaining Theory and Evolutionary Game Theory
Bargaining Theory deals with a more narrow class of problems than Game Theory, but many economists tend to use the terms interchangably. Both bargaining theory and game theory can be broken into various subfields, most notably evolutionary game theory. The Economics Glossary gives the following definition for Evolutionary Game Theory: "Evolutionary game theory describes game models in which players choose their strategies through a trial-and-error process in which they learn over time that some strategies work better than others."
Saturday, December 12, 2009
What Is Experimental Economics?
Most applied work in economics is used by collecting 'real world' data from decisions made outside of the economist's control. Suppose we wanted to know how changes in the minimum wage impacts the unemployment rate for young workers. We would look for states, provinces or countries where there was a change in the minimum wage and then examine unemployment data both prior to the minimum wage law and after the minimum wage law. However, there is no possible way to be absolutely certain that any change in the unemployment rate was caused by the change in the minimum wage. We cannot be sure of the causal relationship because there are so many outside factors going on in an economy. Perhaps the unemployment rate rose, not due to the minimum wage cut, but because the Federal Reserve cut interest rates or because of a spike in oil prices.
Experimental economics attempts to eliminate these outside factors by running controlled experiments inside of a laboratory setting. While it is impossible to run a controlled experiment of one million minimum wage workers, experimental economics can give us a better idea of how consumers and firms respond to incentives, which helps economists strengthen their models.
Experimental Economics - Alternative Perspectives
The Economist's "Dictionary of Economics" when it defines "empirical testing" as follows:
"In contrast to the physical sciences, it is rarely possible to conduct controlled experiments in economics, for example to see what would happen to exports if the exchange rate were reduced and all other variables in the international economy remained unchanged. It is possible, however, to test hypotheses with facts, for example to verify historically the extent to which changes in the exchange rate have been associated with changes in exports. In fact, experiments can be and are carried out in economics, for example labratory simulations of market behaviour, and there is a growing interest in experimental economics as an adjunct to historical empiricism and theoretical work."
Experimental Economics - Conducting Economic Experiments
One such group conducting experimental economics is E-Economics. They define what they do as follows: "We conduct online experiments into economic decision making. How do people bid in auctions? What better way than to invite them to participate in a controlled auction with real money and observe their behavior? How do people bargain? We can watch real bargaining to arrive at an answer. Experimental Economics is a field of study that requires economists to confront reality - and that reality is represented by the actual decisions made by our subjects."
Experimental Economics - In Conclusion
While experimental economists study similar phenomena as traditional economists, they differ in methodology. Instead of looking at what has happened in the past, experimental economists take a laboratory approach similar to that used in many of the other social sciences.
Experimental economics attempts to eliminate these outside factors by running controlled experiments inside of a laboratory setting. While it is impossible to run a controlled experiment of one million minimum wage workers, experimental economics can give us a better idea of how consumers and firms respond to incentives, which helps economists strengthen their models.
Experimental Economics - Alternative Perspectives
The Economist's "Dictionary of Economics" when it defines "empirical testing" as follows:
"In contrast to the physical sciences, it is rarely possible to conduct controlled experiments in economics, for example to see what would happen to exports if the exchange rate were reduced and all other variables in the international economy remained unchanged. It is possible, however, to test hypotheses with facts, for example to verify historically the extent to which changes in the exchange rate have been associated with changes in exports. In fact, experiments can be and are carried out in economics, for example labratory simulations of market behaviour, and there is a growing interest in experimental economics as an adjunct to historical empiricism and theoretical work."
Experimental Economics - Conducting Economic Experiments
One such group conducting experimental economics is E-Economics. They define what they do as follows: "We conduct online experiments into economic decision making. How do people bid in auctions? What better way than to invite them to participate in a controlled auction with real money and observe their behavior? How do people bargain? We can watch real bargaining to arrive at an answer. Experimental Economics is a field of study that requires economists to confront reality - and that reality is represented by the actual decisions made by our subjects."
Experimental Economics - In Conclusion
While experimental economists study similar phenomena as traditional economists, they differ in methodology. Instead of looking at what has happened in the past, experimental economists take a laboratory approach similar to that used in many of the other social sciences.
What Is Econometrics?
Econometrics is concerned with the tasks of developing and applying quantitative or statistical methods to the study and elucidation of economic principles.Econometrics combines economic theory with statistics to analyze and test economic relationships. Theoretical econometrics considers questions about the statistical properties of estimators and tests, while applied econometrics is concerned with the application of econometric methods to assess economic theories. Although the first known use of the term "econometrics" was by Paweł Ciompa in 1910, Ragnar Frisch is given credit for coining the term in the sense that it is used today.
Although many econometric methods represent applications of standard statistical models, there are some special features of economic data that distinguish econometrics from other branches of statistics. Economic data are generally observational, rather than being derived from controlled experiments. Because the individual units in an economy interact with each other, the observed data tend to reflect complex economic equilibrium conditions rather than simple behavioral relationships based on preferences or technology. Consequently, the field of econometrics has developed methods for identification and estimation of simultaneous equation models. These methods allow researchers to make causal inferences in the absence of controlled experiments. Early work in econometrics focused on time-series data, but now econometrics also fully covers cross-sectional and panel data.
Purpose
The two main purposes of econometrics are to give empirical content to economic theory and to subject economic theory to potentially falsifying tests.
For example, consider one of the basic relationships in economics: the relationship between the price of a commodity and the quantities of that commodity that people wish to purchase at each price (the demand relationship). According to economic theory, an increase in the price would lead to a decrease in the quantity demanded, holding other relevant variables constant to isolate the relationship of interest. A mathematical equation can be written that describes the relationship between quantity, price, other demand variables like income, and a random term ε to reflect simplification and imprecision of the theoretical model:
Regression analysis could be used to estimate the unknown parameters β0, β1, and β2 in the relationship, using data on price, income, and quantity. The model could then be tested for statistical significance as to whether an increase in price is associated with a decrease in the quantity, as hypothesized: β1 < 0.
There are complications even in this simple example, and it is often easy to mistake statistical significance with economic significance. Statistical significance is neither necessary nor sufficient for economic significance.In order to estimate the theoretical demand relationship, the observations in the data set must be price and quantity pairs that are collected along a demand schedule that is stable. If those assumptions are not satisfied, a more sophisticated model or econometric method may be necessary to derive reliable estimates and tests.
Methods
One of the fundamental statistical methods used by econometricians is regression analysis. For an overview of a linear implementation of this framework, see linear regression. Regression methods are important in econometrics because economists typically cannot use controlled experiments. Econometricians often seek illuminating natural experiments in the absence of evidence from controlled experiments. Observational data may be subject to omitted-variable bias and a list of other problems that must be addressed using causal analysis of simultaneous equation models.
Data sets to which econometric analyses are applied can be classified as time-series data, cross-sectional data, panel data, and multidimensional panel data. Time-series data sets contain observations over time; for example, inflation over the course of several years. Cross-sectional data sets contain observations at a single point in time; for example, many individuals' incomes in a given year. Panel data sets contain both time-series and cross-sectional observations. Multi-dimensional panel data sets contain observations across time, cross-sectionally, and across some third dimension. For example, the Survey of Professional Forecasters contains forecasts for many forecasters (cross-sectional observations), at many points in time (time series observations), and at multiple forecast horizons (a third dimension).
Econometric analysis may also be classified on the basis of the number of relationships modeled. Single equation methods model a single variable (the dependent variable) as a function of one or more explanatory (or independent) variables. In many econometric contexts, such single equation methods may not recover the effect desired, or may produce estimates with poor statistical properties. Simultaneous equation methods have been developed as one means of addressing these problems. Many of these methods use variants of instrumental variable to make estimates.
Example
A simple example of a relationship in econometrics from the field of labor economics is:
Economic theory says that the natural logarithm of a person's wage is a linear function of (among other things) the number of years of education that person has acquired. The parameter β1 measures the increase in the natural log of the wage attributable to one more year of education. It should be noted that by using the natural log we have moved away from a simple linear regression model and are now using a non linear model, in this case, a semi-log y model. The term ε is a random variable representing all other factors that may have direct influence on wage. The econometric goal is to estimate the parameters, β0 and β1 under specific assumptions about the random variable ε. For example, if ε is uncorrelated with years of education, then the equation can be estimated with ordinary least squares.
If the researcher could randomly assign people to different levels of education, the data set thus generated would allow estimation of the effect of changes in years of education on wages. In reality, those experiments cannot be conducted. Instead, the econometrician observes the years of education of and the wages paid to people who differ along many dimensions. Given this kind of data, the estimated coefficient on Years of Education in the equation above reflects both the effect of education on wages and the effect of other variables on wages, if those other variables were correlated with education. For example, people born in certain places may have higher wages and higher levels of education. Unless the econometrician controls for place of birth in the above equation, the effect of birthplace on wages may be falsely attributed to the effect of education on wages.
Although many econometric methods represent applications of standard statistical models, there are some special features of economic data that distinguish econometrics from other branches of statistics. Economic data are generally observational, rather than being derived from controlled experiments. Because the individual units in an economy interact with each other, the observed data tend to reflect complex economic equilibrium conditions rather than simple behavioral relationships based on preferences or technology. Consequently, the field of econometrics has developed methods for identification and estimation of simultaneous equation models. These methods allow researchers to make causal inferences in the absence of controlled experiments. Early work in econometrics focused on time-series data, but now econometrics also fully covers cross-sectional and panel data.
Purpose
The two main purposes of econometrics are to give empirical content to economic theory and to subject economic theory to potentially falsifying tests.
For example, consider one of the basic relationships in economics: the relationship between the price of a commodity and the quantities of that commodity that people wish to purchase at each price (the demand relationship). According to economic theory, an increase in the price would lead to a decrease in the quantity demanded, holding other relevant variables constant to isolate the relationship of interest. A mathematical equation can be written that describes the relationship between quantity, price, other demand variables like income, and a random term ε to reflect simplification and imprecision of the theoretical model:
Regression analysis could be used to estimate the unknown parameters β0, β1, and β2 in the relationship, using data on price, income, and quantity. The model could then be tested for statistical significance as to whether an increase in price is associated with a decrease in the quantity, as hypothesized: β1 < 0.
There are complications even in this simple example, and it is often easy to mistake statistical significance with economic significance. Statistical significance is neither necessary nor sufficient for economic significance.In order to estimate the theoretical demand relationship, the observations in the data set must be price and quantity pairs that are collected along a demand schedule that is stable. If those assumptions are not satisfied, a more sophisticated model or econometric method may be necessary to derive reliable estimates and tests.
Methods
One of the fundamental statistical methods used by econometricians is regression analysis. For an overview of a linear implementation of this framework, see linear regression. Regression methods are important in econometrics because economists typically cannot use controlled experiments. Econometricians often seek illuminating natural experiments in the absence of evidence from controlled experiments. Observational data may be subject to omitted-variable bias and a list of other problems that must be addressed using causal analysis of simultaneous equation models.
Data sets to which econometric analyses are applied can be classified as time-series data, cross-sectional data, panel data, and multidimensional panel data. Time-series data sets contain observations over time; for example, inflation over the course of several years. Cross-sectional data sets contain observations at a single point in time; for example, many individuals' incomes in a given year. Panel data sets contain both time-series and cross-sectional observations. Multi-dimensional panel data sets contain observations across time, cross-sectionally, and across some third dimension. For example, the Survey of Professional Forecasters contains forecasts for many forecasters (cross-sectional observations), at many points in time (time series observations), and at multiple forecast horizons (a third dimension).
Econometric analysis may also be classified on the basis of the number of relationships modeled. Single equation methods model a single variable (the dependent variable) as a function of one or more explanatory (or independent) variables. In many econometric contexts, such single equation methods may not recover the effect desired, or may produce estimates with poor statistical properties. Simultaneous equation methods have been developed as one means of addressing these problems. Many of these methods use variants of instrumental variable to make estimates.
Example
A simple example of a relationship in econometrics from the field of labor economics is:
Economic theory says that the natural logarithm of a person's wage is a linear function of (among other things) the number of years of education that person has acquired. The parameter β1 measures the increase in the natural log of the wage attributable to one more year of education. It should be noted that by using the natural log we have moved away from a simple linear regression model and are now using a non linear model, in this case, a semi-log y model. The term ε is a random variable representing all other factors that may have direct influence on wage. The econometric goal is to estimate the parameters, β0 and β1 under specific assumptions about the random variable ε. For example, if ε is uncorrelated with years of education, then the equation can be estimated with ordinary least squares.
If the researcher could randomly assign people to different levels of education, the data set thus generated would allow estimation of the effect of changes in years of education on wages. In reality, those experiments cannot be conducted. Instead, the econometrician observes the years of education of and the wages paid to people who differ along many dimensions. Given this kind of data, the estimated coefficient on Years of Education in the equation above reflects both the effect of education on wages and the effect of other variables on wages, if those other variables were correlated with education. For example, people born in certain places may have higher wages and higher levels of education. Unless the econometrician controls for place of birth in the above equation, the effect of birthplace on wages may be falsely attributed to the effect of education on wages.
Market Distortions
Market distortions by governments can come in many varieties, such as taxes and competition law. However, we will concern ourselves with the two most basic forms of market distortions, which are as follows:
•Price Restrictions
•Quantity Restrictions
Market Distortions - Price Restrictions
There are two types of price restrictions we see in government policy:
•A price ceiling - A maximum price that can be charged by a company for a product or service.
•A price floor - A minimum price that can be charged by a company for a product or service.
In order to make the discussion interesting, we will only consider case where the restriction has some 'bite'. A restriction making it illegal to charge more than 1 million dollars for a cup of coffee is not a particularly interesting scenario to analyze.
Price Ceilings - Maximum Prices
Two of the most common types of price ceilings are as follows:
•Rent Control
•Oil in the 1970s
Consider the following Demand and Supply schedules for oil:
Demand
90 cents - 125M gallons
80 cents - 127M gallons
70 cents - 129M gallons
60 cents - 131M gallons
50 cents - 133M gallons
Supply
90 cents - 150M gallons
80 cents - 142M gallons
70 cents - 129M gallons
60 cents - 121M gallons
50 cents - 108M gallons
Without any price controls put into place, thr equilibrium price would be 70 cents and 129M gallons would be sold.
Now suppose the government places a maximum price of 60 cents on oil.
At this price, we have a quantity demanded of 131M gallons but a quantity supplied of only 121M gallons - a shortage of 10M gallons. In the 1970s this manifested itself with gas stations 'running out' of gasoline and long lines to buy gas from the stations with remaining stations.
Minimum Price Perspective
These are most commonly encountered as minimum wages for low skilled labor.
To keep the analysis simple, we will use a similar example to the one above. What if, instead the government had set a minimum price of 80 cents a gallon. In that case the quantity supplied of gas is 142M gallons and the quantity demanded is 127M - a surplus of 15M gallons. There would be more gas available on the market than consumers would want to buy. In the minimum wage case, it would mean there are more individuals looking for minimum wage jobs than there are jobs available.
•Price Restrictions
•Quantity Restrictions
Market Distortions - Price Restrictions
There are two types of price restrictions we see in government policy:
•A price ceiling - A maximum price that can be charged by a company for a product or service.
•A price floor - A minimum price that can be charged by a company for a product or service.
In order to make the discussion interesting, we will only consider case where the restriction has some 'bite'. A restriction making it illegal to charge more than 1 million dollars for a cup of coffee is not a particularly interesting scenario to analyze.
Price Ceilings - Maximum Prices
Two of the most common types of price ceilings are as follows:
•Rent Control
•Oil in the 1970s
Consider the following Demand and Supply schedules for oil:
Demand
90 cents - 125M gallons
80 cents - 127M gallons
70 cents - 129M gallons
60 cents - 131M gallons
50 cents - 133M gallons
Supply
90 cents - 150M gallons
80 cents - 142M gallons
70 cents - 129M gallons
60 cents - 121M gallons
50 cents - 108M gallons
Without any price controls put into place, thr equilibrium price would be 70 cents and 129M gallons would be sold.
Now suppose the government places a maximum price of 60 cents on oil.
At this price, we have a quantity demanded of 131M gallons but a quantity supplied of only 121M gallons - a shortage of 10M gallons. In the 1970s this manifested itself with gas stations 'running out' of gasoline and long lines to buy gas from the stations with remaining stations.
Minimum Price Perspective
These are most commonly encountered as minimum wages for low skilled labor.
To keep the analysis simple, we will use a similar example to the one above. What if, instead the government had set a minimum price of 80 cents a gallon. In that case the quantity supplied of gas is 142M gallons and the quantity demanded is 127M - a surplus of 15M gallons. There would be more gas available on the market than consumers would want to buy. In the minimum wage case, it would mean there are more individuals looking for minimum wage jobs than there are jobs available.
Supply - The Economics of Supply
What Supply Is:
Economists have a very precise definition of supply. Economists describe supply as the relationship between the quantity of a good or service consumers will offer for sale and the price charged for that good. More precisely and formally the Economics Glossary defines supply as "the total quantity of a good or service that is available for purchase at a given price."
What Supply Is Not:
Supply is not simply the number of an item a shopkeeper has on the shelf, such as '5 oranges' or '17 pairs of boots', because supply represents the entire relationship between the quantity available for sale and all possible prices charged for that good. The specific quantity desired to sell of a good at a given price is known as the quantity supplied. Typically a time period is also given when describing quantity supplied.
Supply - Examples of Quantity Supplied:
When the price of an orange is 65 cents the quantity supplied is 300 oranges a week.
If the price of copper falls from $1.75/lb to $1.65/lb, the quantity supplied by a mining company will fall from 45 tons a day to 42 tons a day.
Supply Schedules:
A supply schedule is a table which lists the possible prices for a good and service and the associated quantity supplied. The supply schedule for oranges could look (in part) as follows:
75 cents - 470 oranges a week
70 cents - 400 oranges a week
65 cents - 320 oranges a week
60 cents - 200 oranges a week
Supply Curves:
A supply curve is simply a supply schedule presented in graphical form. The standard presentation of a supply curve has price given on the Y-axis and quantity supplied on the X-axis.
The Law of Supply:
The law of supply states that, ceteribus paribus (latin for 'assuming all else is held constant'), the quantity supplied for a good rises as the price rises. In other words, the quantity demanded and price are positively related. Supply curves are drawn as 'upward sloping' due to this positive relationship between price and quantity supplied. Note: There are theoretical instances where the law of supply might not hold, though these are rarely, if ever, seen in the real world.
Price Elasticity of Supply:
The price elasticity of supply represents how sensitive quantity supplied is to changes in price.
Economists have a very precise definition of supply. Economists describe supply as the relationship between the quantity of a good or service consumers will offer for sale and the price charged for that good. More precisely and formally the Economics Glossary defines supply as "the total quantity of a good or service that is available for purchase at a given price."
What Supply Is Not:
Supply is not simply the number of an item a shopkeeper has on the shelf, such as '5 oranges' or '17 pairs of boots', because supply represents the entire relationship between the quantity available for sale and all possible prices charged for that good. The specific quantity desired to sell of a good at a given price is known as the quantity supplied. Typically a time period is also given when describing quantity supplied.
Supply - Examples of Quantity Supplied:
When the price of an orange is 65 cents the quantity supplied is 300 oranges a week.
If the price of copper falls from $1.75/lb to $1.65/lb, the quantity supplied by a mining company will fall from 45 tons a day to 42 tons a day.
Supply Schedules:
A supply schedule is a table which lists the possible prices for a good and service and the associated quantity supplied. The supply schedule for oranges could look (in part) as follows:
75 cents - 470 oranges a week
70 cents - 400 oranges a week
65 cents - 320 oranges a week
60 cents - 200 oranges a week
Supply Curves:
A supply curve is simply a supply schedule presented in graphical form. The standard presentation of a supply curve has price given on the Y-axis and quantity supplied on the X-axis.
The Law of Supply:
The law of supply states that, ceteribus paribus (latin for 'assuming all else is held constant'), the quantity supplied for a good rises as the price rises. In other words, the quantity demanded and price are positively related. Supply curves are drawn as 'upward sloping' due to this positive relationship between price and quantity supplied. Note: There are theoretical instances where the law of supply might not hold, though these are rarely, if ever, seen in the real world.
Price Elasticity of Supply:
The price elasticity of supply represents how sensitive quantity supplied is to changes in price.
Demand - The Economics of Demand
Economists have a very precise definition of demand. For them demand is the relationship between the quantity of a good or service consumers will purchase and the price charged for that good. More precisely and formally the Economics Glossary defines demand as "the want or desire to possess a good or service with the necessary goods, services, or financial instruments necessary to make a legal transaction for those goods or services."
What Demand Is Not:
Demand is not simply a quantity consumers wish to purchase such as '5 oranges' or '17 shares of Microsoft', because demand represents the entire relationship between quantity desired of a good and all possible prices charged for that good. The specific quantity desired for a good at a given price is known as the quantity demanded. Typically a time period is also given when describing quantity demanded.
Demand - Examples of Quantity Demanded:
When the price of an orange is 65 cents the quantity demanded is 300 oranges a week.
If the local Starbucks lowers their price of a tall coffee from $1.75 to $1.65, the quantity demanded will rise from 45 coffees an hour to 48 coffees an hour.
Demand Schedules:
A demand schedule is a table which lists the possible prices for a good and service and the associated quantity demanded. The demand schedule for oranges could look (in part) as follows:
75 cents - 270 oranges a week
70 cents - 300 oranges a week
65 cents - 320 oranges a week
60 cents - 400 oranges a week
Demand Curves:
A demand curve is simply a demand schedule presented in graphical form. The standard presentation of a demand curve has price given on the Y-axis and quantity demanded on the X-axis.
The Law of Demand:
The law of demand states that, ceteribus paribus (latin for 'assuming all else is held constant'), the quantity demanded for a good rises as the price falls. In other words, the quantity demanded and price are inversely related. Demand curves are drawn as 'downard sloping' due to this inverse relationship between price and quantity demanded.
Price Elasticity of Demand:
The price elasticity of demand represents how sensitive quantity demanded is to changes in price. Further information is given in the article Price Elasticity of Demand.
What Demand Is Not:
Demand is not simply a quantity consumers wish to purchase such as '5 oranges' or '17 shares of Microsoft', because demand represents the entire relationship between quantity desired of a good and all possible prices charged for that good. The specific quantity desired for a good at a given price is known as the quantity demanded. Typically a time period is also given when describing quantity demanded.
Demand - Examples of Quantity Demanded:
When the price of an orange is 65 cents the quantity demanded is 300 oranges a week.
If the local Starbucks lowers their price of a tall coffee from $1.75 to $1.65, the quantity demanded will rise from 45 coffees an hour to 48 coffees an hour.
Demand Schedules:
A demand schedule is a table which lists the possible prices for a good and service and the associated quantity demanded. The demand schedule for oranges could look (in part) as follows:
75 cents - 270 oranges a week
70 cents - 300 oranges a week
65 cents - 320 oranges a week
60 cents - 400 oranges a week
Demand Curves:
A demand curve is simply a demand schedule presented in graphical form. The standard presentation of a demand curve has price given on the Y-axis and quantity demanded on the X-axis.
The Law of Demand:
The law of demand states that, ceteribus paribus (latin for 'assuming all else is held constant'), the quantity demanded for a good rises as the price falls. In other words, the quantity demanded and price are inversely related. Demand curves are drawn as 'downard sloping' due to this inverse relationship between price and quantity demanded.
Price Elasticity of Demand:
The price elasticity of demand represents how sensitive quantity demanded is to changes in price. Further information is given in the article Price Elasticity of Demand.
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 quantity consumed or quantity purchased/sold on the X-axis. An easy way to remember how to label each axis is to 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.
The Demand Curve
A 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 particular price (such as 145 units @ $20) is known as a quantity demanded.
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 the problem from the point of view of the seller the quantity level associated with a particular price is known as quantity supplied.
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 to sell, then equilibrium occurs. Consider the following demand and supply schedules:
Demand Schedule
$10 - 200 units
$20 - 145 units
$30 - 110 units
$40 - 100 units
Supply 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. Thus quantity 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 a price 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 and must be lowered in order for the market to reach equilibrium.
Shortage
A shortage is simply the flip-side of a surplys. It is a situation where, at the current price, quantity demanded exceeds quantity supplied. At a price of $10, quantity supplied is 100 units and quantity demanded is 200 units, leading to a shortage of 100 units (200-100=100). Our market, then, is out of equilibrium. The current price is unsustainable and must be raised in order for the market to reach equilibrium.
Friday, May 1, 2009
What is Economics ?
Economics is the social science that studies the production, distribution, and consumption of goods and services.
The term economics comes from the Ancient Greek οἰκονομία(oikonomia, "management of a household, administration") from οἶκος(oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)".
Current economic models developed out of the broader field of political economy in the late 19th century, owing to a desire to use an empirical approach more akin to the physical sciences. A definition that captures much of modern economics is that of Lionel Robbins in a 1932 essay: "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." Scarcity means that available resources are insufficient to satisfy all wants and needs. Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.
Economics aims to explain how economies work and how economic agents interact. Economic analysis is applied throughout society, in business and finance but also in crime, education, the family, health, law, politics, religion, social institutions, and war. This dominating effect of economics on the social sciences has been described as economic imperialism
The term economics comes from the Ancient Greek οἰκονομία(oikonomia, "management of a household, administration") from οἶκος(oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)".
Current economic models developed out of the broader field of political economy in the late 19th century, owing to a desire to use an empirical approach more akin to the physical sciences. A definition that captures much of modern economics is that of Lionel Robbins in a 1932 essay: "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." Scarcity means that available resources are insufficient to satisfy all wants and needs. Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.
Economics aims to explain how economies work and how economic agents interact. Economic analysis is applied throughout society, in business and finance but also in crime, education, the family, health, law, politics, religion, social institutions, and war. This dominating effect of economics on the social sciences has been described as economic imperialism
Markets
production possibilities, opportunity cost
In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a "rate of output per period of time". There are three aspects to production processes, including the quantity of the commodity produced, the form of the good created and the temporal and spatial distribution of the commodity produced.
Opportunity cost expresses the idea that for every choice, the true economic cost is the next best opportunity. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.
factors of production
The inputs or resources used in the production process are calledfactors of production. Possible inputs are typically grouped into six categories. These factors are:
Raw materials
Machinary
Labour services
Capital Goods
Land
Enterprise
In the short-run, as opposed to the long-run, at least one of these factors of production is fixed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the "long-run", all of these factors of production can be adjusted by management. In the short run, a firm's "scale of operations" determines the maximum number of outputs that can be produced, but in the long run, there are no scale limitations. Long-run and short-run changes play an important part in economic models.
economic efficiency
Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if:
No one can be made better off without making someone else worse off.
More output cannot be obtained without increasing the amount of inputs.
Production ensures the lowest possible per unit cost.
These definitions of efficiency are not exactly equivalent. However, they are all encompassed by the idea that nothing more can be achieved given the resources available.
specialization, division of labour, and gains from trade
Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful. According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be:
a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort,
correspondingly different types of capital equipment and differentiated land uses
Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.
In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation of factors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by productor by design.Such specialization of production creates opportunities forgains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplus and producer profits) from specialization in production and resulting trade
In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a "rate of output per period of time". There are three aspects to production processes, including the quantity of the commodity produced, the form of the good created and the temporal and spatial distribution of the commodity produced.
Opportunity cost expresses the idea that for every choice, the true economic cost is the next best opportunity. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.
factors of production
The inputs or resources used in the production process are calledfactors of production. Possible inputs are typically grouped into six categories. These factors are:
Raw materials
Machinary
Labour services
Capital Goods
Land
Enterprise
In the short-run, as opposed to the long-run, at least one of these factors of production is fixed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the "long-run", all of these factors of production can be adjusted by management. In the short run, a firm's "scale of operations" determines the maximum number of outputs that can be produced, but in the long run, there are no scale limitations. Long-run and short-run changes play an important part in economic models.
economic efficiency
Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if:
No one can be made better off without making someone else worse off.
More output cannot be obtained without increasing the amount of inputs.
Production ensures the lowest possible per unit cost.
These definitions of efficiency are not exactly equivalent. However, they are all encompassed by the idea that nothing more can be achieved given the resources available.
specialization, division of labour, and gains from trade
Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful. According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be:
a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort,
correspondingly different types of capital equipment and differentiated land uses
Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.
In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation of factors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by productor by design.Such specialization of production creates opportunities forgains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplus and producer profits) from specialization in production and resulting trade
Market failure
Pollution can be a simple example of market failure. If Cost of production are not borne by producers but are by the environment, accident victims or others, then prices are distorted.
The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently, the following categories emerge in the main texts.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, involves a failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the greater the returns are. This means it only makes economic sense to have one producer.
Information asymmetric arise where one party has more or better information than the other. The existence of information asymmetry gives rise to problems such as moral hazard, and adverse selection, studied in contract theory. The economics of information has relevance in many fields, including finance, insurance, contract law, and decision-making under risk and uncertainty.
Incomplete markets is a term used for a situation where buyers and sellers do not know enough about each others positions to price goods and services properly. Based on George Akerlof's Market of Lemon article, the paradigm example is of a dodgy second hand car market. Customers without the possibility to know for certain whether they are buying a "lemon" will push the average price down below what a good quality second hand car would be. In this way, prices may not reflect true values.
Public Goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities. Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply.In many areas, some form of is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics. Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition.
Macroeconomic instability, addressed below, is a prime source of market failure, whereby a general loss of business confidence or external shock can grind production and distribution to a halt, undermining ordinary markets that are otherwise sound.
Some specialised fields of economics deal in market failure more than others. The economics of the public sector is one example, since where markets fail, some kind of regulatory or government programme is the remedy. Much environmental economics concerns externalities or "public bads". Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights Environmental economics is related to ecological economics but there are differences.
Most environmental economists have been trained as economists. They apply the tools of economics to address environmental problems, many of which are related to so-called market failures—circumstances wherein the "invisible hand" of economics is unreliable.[ Most ecological economists have been trained as ecologists, but have expanded the scope of their work to consider the impacts of humans and their economic activity on ecological systems and services, and vice-versa. This field takes as its premise that economics is a strict subfield of ecology. Ecological economics is sometimes described as taking a more pluralistic approach to environmental problems and focuses more explicitly on long-term environmental sustainability and issues of scale. Agricultural economics is one the oldest and most established fields of economics. It is the study of the economic forces that affect the agricultural sector and the agricultural sector's impact on the rest of the economy. It is an area of economics that, thanks to the necessity of applying microeconomic theories to complex real world situations, has given rise to many important advances of more general applicability; the role of risk and uncertainty, the behaviour of households and links between property rights and incentives. More recently policy areas such as international commodity trade and the environment have been stressed.
Firms
One of the assumptions of perfectly competitive markets is that there are many producers, none of whom can influence prices or act independently of market forces. In reality, however, people do not simply trade on markets, they work and produce through firms. The most obvious kinds of firms are corporations, partnerships and trusts. According to Ronald Coase people begin to organise their production in firms when the costs of doing business becomes lower than doing it on the market. Firms combine labour and capital, and can achieve far greater economies of scale (when producing two or more things is cheaper than one thing) than individual market trading.
Labour economics seeks to understand the functioning of the market and dynamics for labour. Labour markets function through the interaction of workers and employers. Labour economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attempts to understand the resulting patterns of wages and other labour income and of employment and unemployment, Practical uses include assisting the formulation of full employment of policies
Public sector
Public finance is the field of economics that deals with budgeting the revenues and expenditures of a public sector entity, usually government. The subject addresses such matters as tax incidence (who really pays a particular tax), cost-benefit analysis of government programs, effects on economic efficiency and income distribution of different kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory, models public-sector behavior analogously to microeconomics, involving interactions of self-interested voters, politicians, and bureaucrats.
Much of economics is positive, seeking to describe and predict economic phenomena. Normative economics seeks to identify what is economically good and bad.
Welfare economics is a normative branch of economics that uses microeconomic techniques to simultaneously determine the allocative efficiency within an economy and the income distribution associated with it. It attempts to measure social welfare by examining the economic activities of the individuals that comprise society
The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently, the following categories emerge in the main texts.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, involves a failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the greater the returns are. This means it only makes economic sense to have one producer.
Information asymmetric arise where one party has more or better information than the other. The existence of information asymmetry gives rise to problems such as moral hazard, and adverse selection, studied in contract theory. The economics of information has relevance in many fields, including finance, insurance, contract law, and decision-making under risk and uncertainty.
Incomplete markets is a term used for a situation where buyers and sellers do not know enough about each others positions to price goods and services properly. Based on George Akerlof's Market of Lemon article, the paradigm example is of a dodgy second hand car market. Customers without the possibility to know for certain whether they are buying a "lemon" will push the average price down below what a good quality second hand car would be. In this way, prices may not reflect true values.
Public Goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities. Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply.In many areas, some form of is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics. Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition.
Macroeconomic instability, addressed below, is a prime source of market failure, whereby a general loss of business confidence or external shock can grind production and distribution to a halt, undermining ordinary markets that are otherwise sound.
Some specialised fields of economics deal in market failure more than others. The economics of the public sector is one example, since where markets fail, some kind of regulatory or government programme is the remedy. Much environmental economics concerns externalities or "public bads". Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights Environmental economics is related to ecological economics but there are differences.
Most environmental economists have been trained as economists. They apply the tools of economics to address environmental problems, many of which are related to so-called market failures—circumstances wherein the "invisible hand" of economics is unreliable.[ Most ecological economists have been trained as ecologists, but have expanded the scope of their work to consider the impacts of humans and their economic activity on ecological systems and services, and vice-versa. This field takes as its premise that economics is a strict subfield of ecology. Ecological economics is sometimes described as taking a more pluralistic approach to environmental problems and focuses more explicitly on long-term environmental sustainability and issues of scale. Agricultural economics is one the oldest and most established fields of economics. It is the study of the economic forces that affect the agricultural sector and the agricultural sector's impact on the rest of the economy. It is an area of economics that, thanks to the necessity of applying microeconomic theories to complex real world situations, has given rise to many important advances of more general applicability; the role of risk and uncertainty, the behaviour of households and links between property rights and incentives. More recently policy areas such as international commodity trade and the environment have been stressed.
Firms
One of the assumptions of perfectly competitive markets is that there are many producers, none of whom can influence prices or act independently of market forces. In reality, however, people do not simply trade on markets, they work and produce through firms. The most obvious kinds of firms are corporations, partnerships and trusts. According to Ronald Coase people begin to organise their production in firms when the costs of doing business becomes lower than doing it on the market. Firms combine labour and capital, and can achieve far greater economies of scale (when producing two or more things is cheaper than one thing) than individual market trading.
Labour economics seeks to understand the functioning of the market and dynamics for labour. Labour markets function through the interaction of workers and employers. Labour economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attempts to understand the resulting patterns of wages and other labour income and of employment and unemployment, Practical uses include assisting the formulation of full employment of policies
Public sector
Public finance is the field of economics that deals with budgeting the revenues and expenditures of a public sector entity, usually government. The subject addresses such matters as tax incidence (who really pays a particular tax), cost-benefit analysis of government programs, effects on economic efficiency and income distribution of different kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory, models public-sector behavior analogously to microeconomics, involving interactions of self-interested voters, politicians, and bureaucrats.
Much of economics is positive, seeking to describe and predict economic phenomena. Normative economics seeks to identify what is economically good and bad.
Welfare economics is a normative branch of economics that uses microeconomic techniques to simultaneously determine the allocative efficiency within an economy and the income distribution associated with it. It attempts to measure social welfare by examining the economic activities of the individuals that comprise society
Supply and demand, prices and quantities
The supply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).
The theory of demand and supply is an organizing principle to explain prices and quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it refers to price and output determination in a perfectly competitive market. This has served as a building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective buyers would be prepared to purchase at each unit price of the good. Demand is often represented using a table or a graph relating price and quantity demanded (see boxed figure). Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income as the constraint on demand). Here, utility refers to the (hypothesized) preference relation for individual consumers. Utility and income are then used to model hypothesized properties about the effect of a price change on the quantity demanded. The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy of it (other things unchanged). As the price of a commodity rises, overall purchasing power decreases (the income effect) and consumers move toward relatively less expensive goods (the substitution effect). Other factors can also affect demand; for example an increase in income will shift the demand curve outward relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied. Producers are hypothesized to be profit-maximizers, meaning that they attempt to produce the amount of goods that will bring them the highest profit. Supply is typically represented as a directly proportional relation between price and quantity supplied (other things unchanged). In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the graph above, market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the value, or marginal utility to consumers for that unit of output. It measures what the consumer would be prepared to pay for the corresponding unit of the good. The price point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply and demand equate cost and value at equilibrium.
Demand and supply can also be used to model the distribution of income to the factors of production, including labour and capital, through factor markets. In a labour market for example, the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the demand for labour (from business firms etc. for production) and supply of labour (from workers).
Demand and supply are used to explain the behavior of perfectly competitive markets, but their usefulness as a standard of performance extends to any type of market. Demand and supply can also be generalized to explain variables applying to the whole economy, for example, quantity of total output and the general price level, studied in macroeconomics.
Diminishing marginal utility, given quantification
In supply-and-demand analysis, the price of a good coordinates production and consumption quantities. Price and quantity have been described as the most directly observable characteristics of a good produced for the market. Supply, demand, and market equilibrium are theoretical constructs linking price and quantity. But tracing the effects of factors predicted to change supply and demand—and through them, price and quantity—is a standard exercise in applied microeconomics and macroeconomics. Economic theory can specify under what circumstances price serves as an efficient communication device to regulate quantity. A real-world application might attempt to measure how much variables that increase supply or demand change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are associated with a specific change in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassical tradition that emerged from Britis marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental rôle in analysis
The theory of demand and supply is an organizing principle to explain prices and quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it refers to price and output determination in a perfectly competitive market. This has served as a building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective buyers would be prepared to purchase at each unit price of the good. Demand is often represented using a table or a graph relating price and quantity demanded (see boxed figure). Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income as the constraint on demand). Here, utility refers to the (hypothesized) preference relation for individual consumers. Utility and income are then used to model hypothesized properties about the effect of a price change on the quantity demanded. The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy of it (other things unchanged). As the price of a commodity rises, overall purchasing power decreases (the income effect) and consumers move toward relatively less expensive goods (the substitution effect). Other factors can also affect demand; for example an increase in income will shift the demand curve outward relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied. Producers are hypothesized to be profit-maximizers, meaning that they attempt to produce the amount of goods that will bring them the highest profit. Supply is typically represented as a directly proportional relation between price and quantity supplied (other things unchanged). In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the graph above, market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the value, or marginal utility to consumers for that unit of output. It measures what the consumer would be prepared to pay for the corresponding unit of the good. The price point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply and demand equate cost and value at equilibrium.
Demand and supply can also be used to model the distribution of income to the factors of production, including labour and capital, through factor markets. In a labour market for example, the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the demand for labour (from business firms etc. for production) and supply of labour (from workers).
Demand and supply are used to explain the behavior of perfectly competitive markets, but their usefulness as a standard of performance extends to any type of market. Demand and supply can also be generalized to explain variables applying to the whole economy, for example, quantity of total output and the general price level, studied in macroeconomics.
Diminishing marginal utility, given quantification
In supply-and-demand analysis, the price of a good coordinates production and consumption quantities. Price and quantity have been described as the most directly observable characteristics of a good produced for the market. Supply, demand, and market equilibrium are theoretical constructs linking price and quantity. But tracing the effects of factors predicted to change supply and demand—and through them, price and quantity—is a standard exercise in applied microeconomics and macroeconomics. Economic theory can specify under what circumstances price serves as an efficient communication device to regulate quantity. A real-world application might attempt to measure how much variables that increase supply or demand change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are associated with a specific change in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassical tradition that emerged from Britis marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental rôle in analysis
Microeconomics
A common distinction is between positive economics (describing "what is") and normative economics (advocating "what ought to be") or mainstream economics (more "orthodox") and heterodox economics (more "radical"). The primary textbook distinction is between microeconomics ("small" economics), which examines the economic behavior of agents (including individuals and firms) and "macroeconomics" ("big" economics), addressing issues of unemployment, inflation, monetary and fiscal policy for an entire economy. Microeconomics looks at interactions through individual markets, given scarcity and government regulation. A given market might be for a product, say fresh corn, or the services of a facter of production, say bricklaying. The theory considers aggregates ofquantity demanded by buyers and quantity supplied by sellers at each possible price per unit. It weaves these together to describe how the market may reach equilibrium as to price and quantity or respond to market changes over time. This is broadly termed demand-and-supply analysis. Market structures, such as perfect competition and monopoly, are examined as to implications for behavior and economic efficiency. Analysis of change in a single market often proceeds from the simplifying assumption that behavioral relations in other markets remain unchanged, that is, partial-equilibrium analysis. General-equilibrium theory allows for changes in different markets and aggregates across all markets, including their movements and interactions toward equilibrium.
Macroeconomics
Circulation in macroeconomics
Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and subaggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy. Since at least the 1960s, macroeconomics has been characterized by further integration as to micro-based modeling of sectors, including rationality of players, efficient use of market information, and imperfect competition. This has addressed a long-standing concern about inconsistent developments of the same subject. Macroeconomic analysis also considers factors affecting the long-term level and growth of national income. Such factors include capital accumulation, technological change and labor force growth.
Growth
Growth economics studies factors that explain economic growth – the increase in output per capita of a country over a long period of time. The same factors are used to explain differences in the level of output per capita between countries. Much-studied factors include the rate of investment, population growth, and technological change. These are represented in theoretical and empirical forms (as in the neoclassical growth model) and in growth accounting.
Inflation and monetary policy
A 640 BCE one-third stater electrum coin from Lydia, shown larger. One of the first standardized coins.
Some different currencies. Exchange rates are determined in currency markets used in international trade.
Money is a means of final payment for goods in most price system economies and the unit of account in which prices are typically stated. It includes currency held by the nonbank public and checkable deposits. It has been described as a social convention, like language, useful to one largely because it is useful to others. As a medium of exchange, money facilitates trade. Its economic function can be contrasted with barter (non-monetary exchange). Given a diverse array of produced goods and specialized producers, barter may entail a hard-to-locate double coincidence of wants as to what is exchanged, say apples and a book. Money can reduce the transaction cost of exchange because of its ready acceptability. Then it is less costly for the seller to accept money in exchange, rather than what the buyer produces.
At the level of an economy, theory and evidence are consistent with a positive relationship running from the total money supply to the nominal value of total output and to the general price level. For this reason, management of the money supply is a key aspect of monetary policy
Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and subaggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy. Since at least the 1960s, macroeconomics has been characterized by further integration as to micro-based modeling of sectors, including rationality of players, efficient use of market information, and imperfect competition. This has addressed a long-standing concern about inconsistent developments of the same subject. Macroeconomic analysis also considers factors affecting the long-term level and growth of national income. Such factors include capital accumulation, technological change and labor force growth.
Growth
Growth economics studies factors that explain economic growth – the increase in output per capita of a country over a long period of time. The same factors are used to explain differences in the level of output per capita between countries. Much-studied factors include the rate of investment, population growth, and technological change. These are represented in theoretical and empirical forms (as in the neoclassical growth model) and in growth accounting.
Inflation and monetary policy
A 640 BCE one-third stater electrum coin from Lydia, shown larger. One of the first standardized coins.
Some different currencies. Exchange rates are determined in currency markets used in international trade.
Money is a means of final payment for goods in most price system economies and the unit of account in which prices are typically stated. It includes currency held by the nonbank public and checkable deposits. It has been described as a social convention, like language, useful to one largely because it is useful to others. As a medium of exchange, money facilitates trade. Its economic function can be contrasted with barter (non-monetary exchange). Given a diverse array of produced goods and specialized producers, barter may entail a hard-to-locate double coincidence of wants as to what is exchanged, say apples and a book. Money can reduce the transaction cost of exchange because of its ready acceptability. Then it is less costly for the seller to accept money in exchange, rather than what the buyer produces.
At the level of an economy, theory and evidence are consistent with a positive relationship running from the total money supply to the nominal value of total output and to the general price level. For this reason, management of the money supply is a key aspect of monetary policy
International economics
International trade studies determinants of goods-and-services flows across international boundaries. It also concerns the size and distribution of gains from trade. Policy applications include estimating the effects of changing tariff rates and trade quotas. International finance is a macroeconomic field which examines the flow of capital across international borders, and the effects of these movements on exchange rates. Increased trade in goods, servics and capital between countries is a major effect of contemporary globalization
History of economic thought
The city states of Sumer developed a trade and market economy based originally on the commodity money of the Shekel which was a certain weight measure of barley, while the Babylonians and their city state neighbors later developed the earliest system of economics using a metric of various commodities, that was fixed in a legal code. The early law codes from Sumer could be considered the first (written) economic formula, and had many attributes still in use in the current price system today... such as codified amounts of money for business deals (interest rates), fines in money for 'wrong doing', inheritance rules, laws concerning how private property is to be taxed or divided, etc.[For a summary of the laws, see Babylonian law and Ancient economic thought.
Economic thought dates from earlier Mesopotamian, Greek, Roman, Indian, Chinese, Persian and Arab civilizations. Notable writers include Aristotle, Chanakya, Qin Shi Huang, Thomas Aquinas and Ibn Khaldun through to the 14th century. Joseph Schumpeter initially considered the late scholastics of the 14th to 17th centuries as "coming nearer than any other group to being the 'founders' of scientific economics" as to monetary, interest, and value theory within a natural-law perspective. After discovering Ibn Khaldun'sMuqaddimah, however, Schumpeter later viewed Ibn Khaldun as being the closest forerunner of modern economics, as many of his economic theories were not known in Europe until relatively modern times.
Two other groups, later called 'mercantilists' and 'physiocrats', more directly influenced the subsequent development of the subject. Both groups were associated with the rise of economic nationalism and modern capitalism in Europe. Mercantilism was an economic doctrine that flourished from the 16th to 18th century in a prolific pamphlet literature, whether of merchants or statesmen. It held that a nation's wealth depended on its accumulation of gold and silver. Nations without access to mines could obtain gold and silver from trade only by selling goods abroad and restricting imports other than of gold and silver. The doctrine called for importing cheap raw materials to be used in manufacturing goods, which could be exported, and for state regulation to impose protective tariffs on foreign manufactured goods and prohibit manufacturing in the colonies
History of economic thought
The city states of Sumer developed a trade and market economy based originally on the commodity money of the Shekel which was a certain weight measure of barley, while the Babylonians and their city state neighbors later developed the earliest system of economics using a metric of various commodities, that was fixed in a legal code. The early law codes from Sumer could be considered the first (written) economic formula, and had many attributes still in use in the current price system today... such as codified amounts of money for business deals (interest rates), fines in money for 'wrong doing', inheritance rules, laws concerning how private property is to be taxed or divided, etc.[For a summary of the laws, see Babylonian law and Ancient economic thought.
Economic thought dates from earlier Mesopotamian, Greek, Roman, Indian, Chinese, Persian and Arab civilizations. Notable writers include Aristotle, Chanakya, Qin Shi Huang, Thomas Aquinas and Ibn Khaldun through to the 14th century. Joseph Schumpeter initially considered the late scholastics of the 14th to 17th centuries as "coming nearer than any other group to being the 'founders' of scientific economics" as to monetary, interest, and value theory within a natural-law perspective. After discovering Ibn Khaldun'sMuqaddimah, however, Schumpeter later viewed Ibn Khaldun as being the closest forerunner of modern economics, as many of his economic theories were not known in Europe until relatively modern times.
Two other groups, later called 'mercantilists' and 'physiocrats', more directly influenced the subsequent development of the subject. Both groups were associated with the rise of economic nationalism and modern capitalism in Europe. Mercantilism was an economic doctrine that flourished from the 16th to 18th century in a prolific pamphlet literature, whether of merchants or statesmen. It held that a nation's wealth depended on its accumulation of gold and silver. Nations without access to mines could obtain gold and silver from trade only by selling goods abroad and restricting imports other than of gold and silver. The doctrine called for importing cheap raw materials to be used in manufacturing goods, which could be exported, and for state regulation to impose protective tariffs on foreign manufactured goods and prohibit manufacturing in the colonies
International finance
History of economic thought
The city states of Sumer developed a trade and market economy based originally on the commodity money of the Shekel which was a certain weight measure of barley, while the Babylonians and their city state neighbors later developed the earliest system of economics using a metric of various commodities, that was fixed in a legal code. The early law codes from Sumer could be considered the first (written) economic formula, and had many attributes still in use in the current price system today... such as codified amounts of money for business deals (interest rates), fines in money for 'wrong doing', inheritance rules, laws concerning how private property is to be taxed or divided, etc.[For a summary of the laws, see Babylonian law and Ancient economic thought.
Economic thought dates from earlier Mesopotamian, Greek, Roman, Indian, Chinese, Persian and Arab civilizations. Notable writers include Aristotle, Chanakya, Qin Shi Huang, Thomas Aquinas and Ibn Khaldun through to the 14th century. Joseph Schumpeter initially considered the late scholastics of the 14th to 17th centuries as "coming nearer than any other group to being the 'founders' of scientific economics" as to monetary, interest, and value theory within a natural-law perspective. After discovering Ibn Khaldun'sMuqaddimah, however, Schumpeter later viewed Ibn Khaldun as being the closest forerunner of modern economics, as many of his economic theories were not known in Europe until relatively modern times.
Two other groups, later called 'mercantilists' and 'physiocrats', more directly influenced the subsequent development of the subject. Both groups were associated with the rise of economic nationalism and modern capitalism in Europe. Mercantilism was an economic doctrine that flourished from the 16th to 18th century in a prolific pamphlet literature, whether of merchants or statesmen. It held that a nation's wealth depended on its accumulation of gold and silver. Nations without access to mines could obtain gold and silver from trade only by selling goods abroad and restricting imports other than of gold and silver. The doctrine called for importing cheap raw materials to be used in manufacturing goods, which could be exported, and for state regulation to impose protective tariffs on foreign manufactured goods and prohibit manufacturing in the colonies.
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