Business Economics

Distance Learning Bradford MBA

-H. 'L*r'

Introduction to Economics
INTRODUCTION
No matter where in the world you as a student of economics may live, the basic principles of the subject and the basic economic problem remain the same. The economic problem relates to a scarcity of economic resources compared to the unlirnited wants that consulxers have within each country. Finite resources and infinite wants mean that there is the need for choice. Of course. the precise nature of this problern of scarcity may differ in its detail from country to country depending upon a whole range of factors such as the level of industrial development, the availability of indigenous natural resources and social and political factors to name but a few. Despite differing in emphasis and detail, the central problem remains essentially the same, that is, no matter how wealthy the country, consumers have wants that will outstrip the ability to satisfy these wants.

ln this first unit. we develop a theoretical framework which will enable you to understand the problem of scarcity over choice and identify how different economic systems in the world allocate these scarce resources in order to meet optimally the needs and desires of
the people.

Key reading: Begg and Ward, Chapter

OBJECTIVES
By the end of this unit, you should be able to:

define the economic problerr

define the concept ol'opportunity cost and understand its inrportancc in a variet-v ol' econouric situations but with panicular ref'erence to business

o o o

recognise produclion possibility frontiers and lrow they rnay be applied clistinguish between different econornic systelns and identify key f'eatures of each

develop an initial nppreciation e xplaining infonnation.

of how

econornists use diagrarns its

rneans of

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SCARCITY AND CHOICE

Figure

l.lz

The basic economic problem

Resources

Wants

(*'*-fu
Scarce

Unlimited

The basic economic problem occurs because the resources available to produce goods and services are scarce in relation to the unlimited wants that society has (Figure 1.1). The factors of production - land, labour, capital and enterprise - can't produce everything that people want so choices have to be made. The economic problem facing a government is demonstrated in Figure 1.2.

Figure l.2z A governruent's economic problent

Resources

Wants

Incomc tax. VAT

Scarcc

Unlimitcd

Elcctirtns

A government receives income from tarxation and this incotle is scarce in relation to the unlirnited demand for services that the government would like to provide. The
government needs to make a choice regarding its expenditure and the electorate has a vote
on this decision at election time.

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We can adapt this same approach to examine the economic problem faced by local governments or even your own household. For example, in the UK a local authority receives income from central government, from council tax and by charging for its services. If you consider the multi-demands placed upon local expenditure, it is clear that important choices need to be made regarding priorities and time scales. If we bring the scenario even closer to home, you will appreciate the nature of the economic problem by examining your own household incorne and wants. Your means and wants may be very different frotn ten years ago, but you are a very fortunate individual indeed if you do not experience the problem of scarce resources.

OPPORTUNITY COST
Read: Begg and Ward, pages 2-17
When resources are scarce, how these resources are allocated is of great impofiance. When resources are used to satisfy a parlicular want, the opporlunity cost includes all the wants that could have been satisfied with these resources instead. You may wish to consider the opporlunity cost of the government increasing expenditure on education. The foregone alternatives include the extra resources that could have been allocated to the health service or the extra investment in an integrated transporl policy, etc. The concept of opportunity cost is extremely imporlant and iurplies that all resources have alternative uses and it serves to emphasise that economists should examine a range of options in decision making.

PRODUCTION POSSIBILITY FRONTIER

The production possibility frontrer (PPF) allows the economist to demonstrate the consequences of sotne decisions on how resources should be allocated. It -9ives an inclication as to how rnuch productior.t can take place if all the econorny's resources are used efflciently. In additiorr. it allows for a cornparison of production over tirne atrd an
assessrnent

of how effrcierrtlv society is usinc the resources at its disnosal.

Considcr Filure 1.3. in which the output of the econolry is either capital or consunrcr goods. Thesc indices could include anylhine: quns arrcl butter have otien beerr usecl as exitnrples in the past. Wc havc usecl clpital arrcl consumer gooiis since they rspresent rlassive categories of procluction as well as representing the diff'erent general consurtrptiorr choices of households and businesses. The curve represents tlre PPF and thc PPF dernonstrates the various combinations of capital and consumer goods that could be produced. Any point along the PPF represents a full utilisartion of resources and a ve'., efficient econorny.

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Figure 1.3: Production p ossibility Jrontier

Consumer
goods

Capital
goods

Points a, b, c, d and e all represent a full utilisation of scarce resources within an economy. With existing productive capacity the economy is unable to reach point x. The only way

x can be reached in future is through developing productive capacity, that is, through econotnic growth. Now consider point l'. Production is below the PPF and as such represents an underutilisation of resources. A society in such a situation faces a major challenge if it is to allocate its resources more effectively.
point

ACTIVITY 1.1
1.
In theory all points along the PPF signify a well{unctioning economy. Can you identify, however, future problems that may occur with the extreme combinations of goods produced at points a and b? the best combination c or e?

2. Which represents

Answer to Activity

1.1

At point

rz, where all resources are used to produce capital goods there will be an extremely unhappy electorate with little choice of home-produced consumer

goods to purchase. Consumer goods would have to be imported; in short, a very unbalanced econorny would occur. At point b, there are consurler goods galore. A materialist's paradise! But if all the resources are used to produce consumer goods, then what will be used to produce capital goods when current

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machinery becomes worn out? Can we import all the capital goods we need? Would that provide a balanced economy?
The answer to question 2, is inconclusive. It is not really possible to say which is the better combination, they are both theoretically as good as each other. No

information is given regarding the quality of the capital and consumer goods vis-d-vis the foreign competition. More resources may be allocated to a sector either because it is extremely efficient or to make up for its relative weakness.
The PPF can be used to examine the concept of opportunity cost. Take an individual firrn that has diversified its production and produces good A and good B.

Figure 1.4: Production of good A and good B

Curlently the firrn is producing at point.r which represents rr, production of cood A urrtl b, production o1'good B. The firm, afier extensive urarkel research, decides that procluct ll represents tlre nrore profitable long-tenl future and clecides to reallocate resources 1l'orl the prodr.rction of good A to good B. This decision would invol ve a reductiorr in thc output of good A fiorn (ttIo u. (the opponunity cost) in order to increase the procluctiorr ol' B l'rorn /r, lo i,-. point r.

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ACTIVITY 1.2
Consider Figure 1.5.

Figure 1.5 : P r o d ucti o n p o s sibility

Consumer goods

./r o nti

er

gr

ap hs

Capital goods
1

Which PPF could be used to represent the year 1750 and which the year 20O9?
a developed economy and which a developing economy?

2. Which PPF represents

Answer to Activity 1.2

PPF, represents both tlre year l7-50 and the current developing econolny. Clearly, output is rrrore limited in 1750 since the ability to use resources efficiently would lrave been lirnited compared with today's econor.ny and successive years ol'econornic growth will shift 2(X)9's output to PPF..

ECONOMIC SYSTEMS
No econornic system can solve the economic problenr. Different allocation systems offer alternative approaches to the problem. There are three main allocation systems, ret'erred to as a free market economy, a planned economy and a mixed economy. Each economic systeln elttempts to answer three questions.

l.

What to produce?

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2.

How to produce?

3. For whom to produce?

In a planned or command economy, the important decisions regarding 'what', 'how' and 'for whom'would be made by state officials or bureaucrats. These officials would have the job of planning the production of the whole economy and would issue five-year plans to the whole of industry. Planning was such an enormous task that reality would rarely resemble the out-of-touch ideas of the bureaucrats.

The former pre-Gorbachev Soviet Union provides a good example

of a planned

economy. The system was characterised by the extensive queuing that formed an essential part of everyday life. Subsidies meant officially low prices and queuing was, in essence, a

form of rationing. Consider the opportunity cost involved in queuing and where the Soviet Union was in relation to its PPF. Gorbachev started the significant move towards a more market-oriented economy with peresfroika (economic reconstruction). The queues began to disappear. The rrarket mechanism was now the means of satisfying the exchange between demand and supply. The market allowed prices to increase, consumers could only queue if they could afford the products. Our focus in Unit 2 is how the market mechanism determines the price of products.

In a free market economy, the important decisions are left to free merrket forces. The interaction of consurners and producers determines what should be produced. The role of the government is to create the conditions for the free market to flourish. This type of market structure will be the focus for much of the theory that follows in later units.
A mixed economy is one that has both public and private sector ownership of resources. The state has some role in economic decision rnaking and plays an important role in economic mana-qement, but the bulk of resources are privately owned. The UK is u good exarnple of a mixed economy with both private and public ownership of resources. Various privatisations since the early 1980s have moved the economy towards the ll'ee market point on the continuutn. However, the econorlic systern is still essentially a ntixed econotny with the government playing a substantial role in the allocation of resources.

SUMMARY
Read: Summary in Begg and Ward, page 17-18

In this unit, you have been introduced to the idea of scarcity and choice and how important this is to understanding the need for a good systern of resource allocation. All
econotnic decisions involve an opportunity cost and economists need to weigh up a range

alternatives before irnporlant decisions can be made. The production possibility frontiers demonstrate the opportunity cost principle at work and show the need for effective decisions regarding the 'how', 'what' and 'for whom' to produce if the economic system is to be efficient and to utilise scarce resources in an optimal way.

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REVIEW ACTIVITY
lmagine that a business is facing a sustained increase in demand for its products.

1. Examine the opportunity cost of the tirm responding

a new faclory in another part of the country.

to this scenario by deciding to open

2. Consider the opportunity

increased demand.

cost of taking on additional full-time workers to meet this

3. Would your answers to questions 1 and 2 be ditferent

to be temporary?

if the increased demand was likelv

4.

lf applicable, how should your business respond to the situations described above?

ANSWERS TO REVIEW ACTIVITY

l
The key word in this question is 'sustained'. The sustained increase in demand lneans the firm is able to plan more for the long term and make important strategic decisions about its future. Ifthe firm opens a new factory in another pafi ofthe country, think of all the costs that will be incurred. You may have heard entrepreneurs commenting upon the three most important aspects of where to site a new factory: location, location, location! Time and money will need to be spent researching this location. Once a location has been decided, the firm will need to pay:

. o o o o

rent for the premises

costs of hiring a workforce costs of training that workforce

capital costs of purchase of machinery relocation expenses. where appropriute.

The opportunity cost of openirrg il new plunt rlieht be to use the rnoney on expandinn the original lactory. Tlrc llrnr coulcl take on adclitiorral workqrs. intplernent a night shifi. irrvest hcavilf in nc* nlrchinery lncl an autornatecl reduce
production line, etc.

2.

The

finr could increase the amount of rrachinery used in the production process. A fully automated production line would the need for workers. Part of the production

process, for example, component supplies, could be contracted out.

3. If the increase

in demand is likely to be temporary, the firm needs to retain flexibility. Opening a new factory may be a gamble. Why not pay workers oveftime or take on temporary staff?

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lssues relating to Demand

INTRODUCTION
In most economies, markets are the principal ways in which scarce resources are allocated to the production of goods and services. A market is anywhere there is a buyer and seller. In essence, markets operate through the price mechanism which co-ordinates the buyers and sellers. For example, as prices rise relative to costs of production, firms offer more for sale. In this way, the price acts as a signal to firms that scarce resources should be reallocated from markets where profits are low to markets where profits are high. The price mechanism is often referred to as the 'invisible hand' since it is the result of free
market forces.

Have you ever considered why baked beans only cost 25p when they enjoy so much popularity? Why do firms not cash in on this demand by charging 99p? Why does a pint of beer cost f2.25 in your local pub compared to f3.50 in a nightclub? Why does the government tax cigarettes and beer but not apples? Why does the accountant working at your firnr earn more than the cleaner? The answers to all these questions can be found by analysing how demand and supply interact in the market place.

In this unit you will begin to develop your understanding of how markets behave. First, you will concentrate on the demand side of the market. What affects the level of demand, how do consufilers react to price chan-ges, how can firms set prices which will maxinrise their revenues; and why do finns set different prices for different market segments? Once you feel cornfortable with this knowled-ee, unrt 3 will then introduce concepts related to the supply side of the market. Unit 4 will then combine the ideas frorn units 2 and 3 into an intecrated understanding of rnarkets. Hopefully. you can see that economics is a subject which builds upon itself and it is, therefore, irrrportant to gain confidence in the ideas and issues of each unit before rnovinq onto the next.

Key reading: Begg and Ward, Chapter

OBJECTIVES
By the end of this unit, you should be able to:

. o

explain the theory of demand understand the determinants of demand

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explain the concept of consumer and producer surplus

explain the concept of elasticity and to appreciate its importance when managers are
developing pricin g strategies

explain the relationship between elasticity and revenue

THE DEMAND CURVE

Read: Begg and Ward, Chapter 2, pages 22-32

The demand curve demonstrates the relationship between the quantity demanded and price. Demand is considered as effective demand. which means dernand backed up by the ability to pay. Much of the demand curve is hypothetical in that it states what consurners would denrand at relative prices. The dernund curve is sornetirres drawn as a straight line or ils ir curve. It doesn't really martter since botlr are examples of how the econornist attempts to develop theory through making assumptions to sirnplify the process.

Figure 2.1: The demand curve

Quantit-y

we exarnine the demand curve in Figure 2.1, consider how dernand is higher at low prices and how this demand changes as prices increase. Look art how the demand changes as price drops from ptto pz. There is an extension of demand from q, to q.. What would cause a contraction of demand? The only factor that causes either an extension or contraction of demand is a change in the price of the product itself. Anything other than a change in price causes a shift in the demand curve itself. These other factors are referred to

If

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as the

determinants of demand and include:

price of substitute and cornplementary goods

changes in consumer incomes

consumers'tastes and preferences and how these may be affected

fashion. etc.

by

advertising,

o o

expectations of future price changes time period.

A change in any of

these determinants of demand causes a shift in the demand curve. In Figure 2.2, aslttft from D, to D2 means more of the product is demanded at every price. A shift from D1 to Dj is a reduction in demand at every prrce

Figure 2.2: Demand curt,es

Quunlity

If the original price is p,,, at successful advertisirrg campaign may increase the dernancl from D,to D.. We have shifted from point a to point b on Figure 2.3 below. The quantity demanded at this price has increased from Qtto 4y

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Figure 2.3: Change in the demand curve

Plice

ACTIVITY 2.1
For each of the following scenarios, construct a diagram to show the efiect on your firm's demand.

1.

An increase in the price of a complementary good.

A decrease in the price of a substitute good.

2. 3.

An increase in consumer incomes. A brilliant advertising campaign by your main competitor.

A decrease in the price of your product.

Answers to Activity

2.1

If there is an increase in the price of a cornplementary good, then the

demand curve will shift to the left. This is because the complementary good will be demanded less al the higher price and. since the products are jointly demanded, our product will face a reduction in dernand as a result.

2. If there is a decrease in the price of a substitute good, then the demand curve for our product will shift to the left since consumers will purchase the
cheaper substitute product instead.

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3.

If

there is an increase in consumer income, then we would expect the demand curve to shift to the right since consumers can afford to purchase more of our product at every price.
there is a brilliant advertising campaign by our main competitor. then our demand will shift to the left.

4. If

5. If our product is decreased in price, then we will experience an extension of demand. This means there will be a movement along the orisinal demand
curve itself.

Of course, at this stage we are only focusing upon demand. You should go back to our definition of a market. We now need to examine the role of the sellers who supply the products if we are to establish how the market
determines price and output.

PRICE ELASTICITY OF DEMAND

Read: Begg and Ward, Chapter 2, pages 32-43
Price elastic of demand is a crucial concept for businesses to grasp if they are to be successful in the market place. It is worthwhile reflecting on the material at each stage that follows and taking stock of the ideas covered before tackling the activities to be covered later in the unit.
The price elasticity of demand measures the responsiveness of the change in demand for a change in price. If a firm has control over its own pricing policies. the concept allows the

firm to establish the effects of a change in price on its revenue and, hence. its profits. It allows firrns to answer the questions such as what will happen to revenue if we increase
our prices by 2 per cent or reduce price by Elasticity of dernand can be calculatecl
7-5p.

usir.rp.

lhe 1'orrnula:

E,=

Different demand elasticities

o If the E,, is > 0 but less than I the denrand is price inelastic. o If the E,, is >l the demand is price elastic
Exceptional
7

cases are:

o If the E is = I the demand has unit elasticity. o If the E,, is infinity the demand is perfectly elastic. o If the E7 is = 0 the dernand is perfectly inelastic.
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Elastic and inelastic demand

Elastic demand means that a relatively small change in price leads to a relatively large change in the quantity demanded. This is shown in Figure 2.4.

Figure 2.42 Ehsrtc demand

Price

pl

')

Quantity

Inelastic demand means that a relatively large change in price leads to a relatively small change in the quantity demanded. This is shown in Figure 2.5.

Figure 2.52 Inelastic demand

Quantity

If we examine Figures 2.4 and 2.5, we can show the relationships between
the axes.

the relative changes in price and quantity demanded. Strictly speaking this approach should be used to simplify the idea only, since the validity of the diagrams is dependent upon the scale of

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