Economics help blog – Page 77

Profit Maximisation

12 December 201916 July 2019 by Tejvan Pettinger

An assumption in classical economics is that firms seek to maximise profits. Profit = Total Revenue (TR) – Total Costs (TC). Therefore, profit maximisation occurs at the biggest gap between total revenue and total costs. A firm can maximise profits if it produces at an output where marginal revenue (MR) = marginal cost (MC) Diagram …

Bank Runs

15 July 2019 by Tejvan Pettinger

Bank run definition A bank run occurs when there is a sudden demand to withdraw money from a bank, that the commercial bank struggles to meet. The first signs of ‘bank panic’ will encourage other depositors to also try and withdraw their savings, causing a further ‘run on the bank.’ In a bank run, investors …

Macroeconomic objectives and conflicts

3 December 20199 July 2019 by Tejvan Pettinger

A look at the main macroeconomic objectives (economic growth, inflation and unemployment, government borrowing) and possible conflicts between these different macro-economic objectives.

The main macro-economic objectives

Economic growth – positive and sustainable growth (The UK, long-run trend rate is around 2.5%)
Low inflation (UK target 2% +/-1) –
Low unemployment / Full employment (e.g. around 3%)
Current account – balance of payments. Satisfactory position (i.e. avoid unsustainable current account deficit)
Low government borrowing/public sector debt.
Exchange rate stability

Some economists also consider:

Issues of equity (avoid inequality)
Environmental factors (long-run environmental sustainability)

Conflicts of macro-economic objectives

1. Economic growth vs inflation

One macro-economic conflict can come between economic growth and inflation (which leads to a similar conflict between unemployment and inflation). If there is rapid economic growth, it is more likely that inflationary pressures will increase. Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases faster than AS.

When the economy is growing very quickly, firms have difficulty employing sufficient skilled labour; this can lead to wage inflation and higher wages cause higher prices. Also, if demand grows faster than supply, firms will respond to shortages by putting up prices.

Inflationary growth

ad increase - inflation

In this diagram, there is an increase in AD, when the economy is close to full capacity. We get an increase in real GDP but also an increase in the inflation rate.

Example of conflict between economic growth and inflation

In the late 1980s during the Lawson boom, the UK experienced a high rate of economic growth (4-5% a year). This growth rate was above the long run trend rate of growth but caused inflationary pressures to increase. Also if growth is very quick, there may be supply constraints pushing up commodity price increases. This economic boom of the 1980s proved unsustainable and ultimately led to the recession in 1991 (as the government increased interest rates to try and control inflation.

The rapid economic growth of 1986-1989 led to inflation increasing to nearly 1%. It required interest rates of 12% and the recession of 1991/92 to bring inflation under control.

Low inflationary growth

However, it is possible to have economic growth without causing inflation. If growth is sustainable – if it is close to the long run trend rate, then LRAS will increase at the same rate as AD, and therefore, we will not see inflation.

Economic growth without inflation. AD and LRAS increasing at the same rate.

The UK between 1993-2007, had a long period of economic expansion. But, this prolonged economic growth did not cause inflation. This is sometimes known as the great moderation.

The UK great moderation from 1992 to 2008 – low inflation, positive economic growth.

Effect of the exchange rate on business

3 December 20194 July 2019 by Tejvan Pettinger

Readers Question: What are the effects of the exchange rate on UK businesses?

The exchange rate will play an important role for firms who export goods and import raw materials. Essentially:

A depreciation (devaluation) will make exports cheaper and exporting firms will benefit.
- However, firms importing raw materials will face higher costs of imports.
An appreciation makes exports more expensive and reduces the competitiveness of exporting firms.
- However, at least raw materials (e.g. oil) will be cheaper following an appreciation.

Effect of depreciation in the exchange rate

winners-losers-depreciation-table

If there is a depreciation in the value of the Pound, it will make UK exports cheaper, and it will make imports into the UK more expensive.

In this example:

At the start of 2007, the exchange rate was £1 = €1.50.
By Jan, 2009, the Pound had fallen in value so £1 was now only worth €1.10 (a depreciation of 26%)

Impact on British exporters

Suppose a British car costs £4,000 to build and sells for £5,000 in the UK.

In 2007, the European price of this car would be €7,500 (5,000 *1.5)
In 2008, the European price of this car would be €5,500 (5,000 *1.1)

The 26% depreciation means that European consumers now find British goods much cheaper. The cost of producing the car stays the same (assuming parts are not imported), but the effective market price in Europe has fallen. This should increase demand for British goods.

Increase profit margin or reduce the foreign price?

A British firm has a choice, it can reduce the European price from €7,500 to €5,500; this should lead to an increase in the quantity sold, and increase UK exports.

Alternatively, the firm could keep the price at €7,500 and just make a bigger profit margin. It is a good choice for exporters to have – reduce European price and sell more or keep price the same and make a bigger profit margin.

Impact on importers of raw materials

The downside of a depreciation is that British firms who import raw materials will see an increase in the cost of buying raw materials. If the British car company imports engines from Germany to make the car, it will have to pay more to buy the engines. This will reduce its profit margin.

Suppose an engine costs €1000 to import from Germany. In 2007, this costs £666 (1,000/1.5). In 2009, with the fall in the value of the Pound, they will have to spend £909 (1,000/1.1) to buy the same German engine.

Impact on incentives

In the long term, it is argued that a depreciation may reduce the incentives for exports to cut costs. The depreciation enables an ‘easy’ increase in their profit margin. As a result, there may be less incentive to cut costs and boost productivity. If a firm is facing an appreciation, then they may face a greater incentive to cut costs.

Stock market explained

1 February 20202 July 2019 by Tejvan Pettinger

The stock market is a place where traders buy and sell shares, government bonds and other assets. The stock market shows the price of shares and facilitates companies to raise revenue from issuing shares. Investors buy shares for both dividends and the prospect of capital gains. the US stock exchange based in NY (NYSE) has …

How does US / China trade war affect EU, Asia and Africa?

1 July 20191 July 2019 by Tejvan Pettinger

Readers Question: To what extent does the trade war between USA and China actually impact on the economies of other nations? A trade war between the US and China is concerning for other countries because a trade war can precipitate a fall in global trade, and lead to lower investment, lower confidence and a drop …

Costs and benefits of globalisation

24 November 201927 June 2019 by Tejvan Pettinger

Globalisation is a complex and controversial issue. This is a look at some of the main benefits and costs associated with the greater globalisation of the world economy.

Definition of Globalisation The process of increased integration and co-operation of different national economies. It involves national economies becoming increasingly inter-related and integrated.

Globalisation has involved:

Greater free trade.
Greater movement of labour.
Increased capital flows.
The growth of multi-national companies.
Increased integration of global trade cycle.
Increased communication and improved transport, effectively reducing barriers between countries.

Summary of costs/benefits

Benefits	Costs
Lower prices/ greater choice	Structural unemployment
Economies of scale – lower prices	Environmental costs
Increased global investment	Tax competition and avoidance
Free movement of labour	Brain drain from some countries
May reduce global inequality	Less cultural diversity

Benefits of globalisation

1. Free trade is a way for countries to exchange goods and resources. This means countries can specialise in producing goods where they have a comparative advantage (this means they can produce goods at a lower opportunity cost). When countries specialise there will be several gains from trade:

Lower prices for consumers
Greater choice of goods, e.g food imports enable a more extensive diet.
Bigger export markets for domestic manufacturers
Economies of scale through being able to specialise in certain goods
Greater competition

See: Benefits of Free Trade

Scarcity in economics

2 December 201925 June 2019 by Tejvan Pettinger

Definition: Scarcity refers to resources being finite and limited. Scarcity means we have to decide how and what to produce from these limited resources. It means there is a constant opportunity cost involved in making economic decisions. Scarcity is one of the fundamental issues in economics.

Examples of scarcity

Land – a shortage of fertile land for populations to grow food. For example, the desertification of the Sahara is causing a decline in land useful for farming in Sub-Saharan African countries.
Water scarcity – Global warming and changing weather, has caused some parts of the world to become drier and rivers to dry up. This has led to a shortage of drinking water for both humans and animals.
Labour shortages. In the post-war period, the UK experienced labour shortages – insufficient workers to fill jobs, such as bus drivers. In more recent years, shortages have been focused on particular skilled areas, such as nursing, doctors and engineers
Health care shortages. In any health care system, there are limits on the available supply of doctors and hospital beds. This causes waiting lists for certain operations.
Seasonal shortages. If there is a surge in demand for a popular Christmas present, it can cause temporary shortages as demand as greater than supply and it takes time to provide.
Fixed supply of roads. Many city centres experience congestion – there is a shortage of road space compared to number of road users. There is a scarcity of available land to build new roads or railways.

How does the free market solve the problem of scarcity?

If we take a good like oil. The reserves of oil are limited; there is a scarcity of the raw material. As we use up oil reserves, the supply of oil will start to fall.

Diagram of fall in supply of oil

fall-supply-oil-price-ar

If there is a scarcity of a good the supply will be falling, and this causes the price to rise. In a free market, this rising price acts as a signal and therefore demand for the good falls (movement along the demand curve). Also, the higher price of the good provides incentives for firms to:

Look for alternative sources of the good e.g. new supplies of oil from the Antarctic.
Look for alternatives to oil, e.g. solar panel cars.
If we were unable to find alternatives to oil, then we would have to respond by using less transport. People would cut back on transatlantic flights and make fewer trips.

Demand over time

In the short-term, demand is price inelastic. People with petrol cars, need to keep buying petrol. However, over time, people may buy electric cars or bicycles, therefore, the demand for petrol falls. Demand is more price elastic over time.

Therefore, in a free market, there are incentives for the market mechanisms to deal with the issue of scarcity.

Causes of scarcity

fall-s-rise-d-scarcity

Scarcity can be due to both

Demand-induced scarcity
Supply-induced scarcity

and a combination of the two. See more at: Causes of scarcity.

Scarcity and potential market failure

With scarcity, there is a potential for market failure. For example, firms may not think about the future until it is too late. Therefore, when the good becomes scarce, there might not be any practical alternative that has been developed.

Another problem with the free market is that since goods are rationed by price, there may be a danger that some people cannot afford to buy certain goods; they have limited income. Therefore, economics is also concerned with the redistribution of income to help everyone be able to afford necessities.

Another potential market failure is a scarcity of environmental resources. Decisions we take in this present generation may affect the future availability of resources for future generations. For example, the production of CO2 emissions lead to global warming, rising sea levels, and therefore, future generations will face less available land and a shortage of drinking water.

The problem is that the free market is not factoring in this impact on future resource availability. Production of CO2 has negative externalities, which worsen future scarcity.

Tragedy of the commons

The tragedy of the commons occurs when there is over-grazing of a particular land/field. It can occur in areas such as deep-sea fishing which cause loss of fish stocks. Again the free-market may fail to adequately deal with this scarce resource.

Further reading on Tragedy of the Commons