Managerial Econ

Economics: What Is Economics And The Three Economic Fallacies
Introduction to Economics
In order to understand Economics, you need to understand scarcity.
Scarcity is the idea or notion that we have unlimited wants and needs, but limited number of resources
to fill them.
Economics: Science of scarcity and choice.The way that any community makes choices as to how they’re
going to use the scarce resources.How given communities decide to use their resources.The choices they
make.
Opportunity Cost: Sum of all that is lost for by taking one course of action over the other that could be
accomplished in the same period of time.
I.e.Pick between working for 4 hours and make 40 dollars or go to the movies with a girl for 3 hours and
spend 30 dollars or stay at home with your mom and make her happy by playing monopoly.You have to
weigh every option.
If you went on the date, you would lose 40 dollars that you could’ve made from working + 30 bucks from
going on the date + the chance to make your mom happy.It becomes a $70 difference.
Economic Fallacies
1.Fallacy of Composition
The assumption that what is good for the individual is automatically good for society as a whole.
I.e.If the Canadian dollar became higher than the American dollar, it would be good for shoppers who
decided to go to America to buy things.In retrospect, retailers would be upset because they lose money
to places with lower currency.Tourist/service/entertainment places would be upset because we became
more expensive for tourists.Personal example of economic fallacy is becoming president: I’m happy and
some people are happy for me but not everyone wants me.
2.Post Hoc Fallacy
The assumption that what happens before is automatically the cause of what occurs after.0% correlation
Everything isn’t correlated.Event A occurred, and then B, and people say the two things are
related.I.e.someone comes late for a team try out, gets cut and believes that he got cut for the sole
reason of him being late, while in reality the coach didn’t even notice his lateness but cut him based on
skill.
3.Fallacy of Single Causation (Oversimplification)
The assumption that one person or one event was the sole cause of a particular event to occur.
People assume there was one reason for something when there really are more.I.e.people believe the
reason that the world went into a recession was because the twin towers got crashed into by two planes,
while in actuality the twin towers have some responsibility on the economic state, but there’s a lot more
to do with it then just that.
Fallacy of Single Causation has partial % of the cause of responsibility while post hoc fallacy doesn’t.
An Explanation of the Ten Principles of EconomicsEconomics
When talking about a list of economic principles, this most commonly refers to Gregory Mankiw’s “Ten
Principles of Economics.” The list is a set of principles about the way economy should work. The 10
principles are divided into three categories: decisions people make, the work of the economy as a whole
and people interactions.
Decisions Involve Tradeoffs
This refers to the concept of making compromises. A person may have to give something up to get
something else they want more. For example, say you are offered a chocolate bar or a lollipop. You have
to choose to give up one to get the other.
Opportunity Cost of Resource
The second economic principle emphasizes the cost of whatever it is you gave up. For example, you took
the lollipop, which has an economic profit, what you gain from the choice, of $.85. But you had to give
up the chocolate, which had an economic profit of $.45. So you actually only gained $.40 for your choice.
But if you didn’t have a choice and were only offered the lollipop, you wouldn’t have given anything up
and would have gained an economic profit of $.85.
Cost-Benefit Analysis
This principle can be a little difficult to grasp. Marginal thinking is to make small adjustments. For
example, a movie theater offers matinee prices. The theater knows fewer people see movies in the
afternoon. The standard ticket price of the movie is $10 and at that price the theater will sell two tickets
for a matinee show. But by offering a $6 matinee price, the theater ended up selling five tickets. By
selling the tickets at a 40 percent discount, the theater actually made $10 more.
Response to Incentives
People respond to different incentives in good or bad ways, but the point is that we respond. A bar might
offer buy one, get one free drink. The good side of the incentive is free drinks, the bad side might be a
college student who forgoes studying to drink. Either way, the response to the incentive was there.
Trading Services for Money
It is important to clarify that trades include using money to pay for something. Say someone is skilled at
giving massages. You get the massage, relying on this person, and then trade your money as a payment.
Markets Organize Economic Activity
Markets are defined simply as a place where people make an agreement, settle on a price and then
communicate that to the world at large. The food market, for example, has farmers making an
agreement to sell at a set price and then supermarkets communicate that by selling the food to the
public.
Government and Market Efficiency

The government may get involved if the market efficiency isn’t working or if the market is failing to
distribute. This failure is often caused by externality, which means that the product impacts more than
just the direct buyers and sellers. For example, cars benefit drivers, but emissions are also a health
concern for people.
Principal of Productivity
Simply put, this principle is productivity. The richer the country, the higher the level of productivity.
Too Much Money Causes Inflation
This principle refers to inflation. Prices go up to reflect the amount of money being printed. While the
more money makes people think they’re wealthier, inflation causes prices to go up and that money loses
some of its value.
Inflation and Unemployment Tradeoff
Also referred to as the Phillips Curve, this principle says that you can’t keep unemployment low and
inflation under control at the same time and, therefore, create a tradeoff.
Mankiw’s 10 Principles of Economics
Economics is about decision making in situations of scarcity
ECONOMICS is the study of how individuals, firms and government make decisions to manage scarce
resources. What does this mean exactly?
Professor Greg Mankiw teaches economics at Harvard University and is the author of a popular
economics text book called Principles of Economics which is used at many Ivy League schools. Mankiw’s
status within the economics profession makes him uniquely well placed to help us understand the basic
principles of economics.
Set out below are Mankiw’s 10 Principles of Economics:

How People Make Decisions
1. People face tradeoffs: To get one thing, you have to give up something else. You may have heard
economists say “there is no such thing as a free lunch”. What they mean by this is that, for example, you
might get a free bowl of soup at the student co-op, but the soup is not free because you have to give up
35-minutes waiting in line to be served.
2. The cost of something is what you give up to get it: Making a decision requires comparing the costs
and benefits of alternative courses of action. The cost of one option is not how much it will cost in dollar
terms, but rather the value of your second best alternative. For more explanation, see understanding the
cost benefit analysis.
3. Rational people think at the margin: People make decisions by comparing the marginal benefit with
the marginal cost. For example, you might buy one cup of coffee in the morning because it helps you
start the day, but you might not buy a second cup because this gives you no extra benefit (and costs
another $3).
4. People respond to incentives: Behaviour changes when costs or benefits change. For example, if your
hourly wage increases then you are likely to work more (unless of course your income is already too
high).
How People Interact
5. Trade can make everyone better off: Trade allows people to specialise in what they do best. By trading,
each person can then buy a variety of goods or services. For example, you may be a skilled management
consultant. Money you earn through your consulting work might be used to build a house even though
you may not have the skills to build the house yourself.
6. Markets are usually a good way to organise economic activity: Individuals and firms that operate in a
market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the
market to allocate resources efficiently. For example, if there is an oversupply of wheat on the world
market then individual farmers will lower the price they charge until they can sell all of their wheat.
Lower wheat prices will also likely reduce the total quantity of wheat that farmers decide to produce.
Market prices are able to adjust to equate supply and demand without the need for any central
planning.
7. Governments can sometimes improve market outcomes: Sometimes a market may fail to allocate
resources efficiently, and government regulation can be used to improve the outcome. Market failures
can occur due to the existence of public goods, monopolies and externalities. For example, an electricity
supplier might have a monopoly. Government regulation may be required to ensure that the supplier
does not abuse its market power.
How the Economy Works
8. A country’s standard of living depends on its ability to produce goods and services: A country whose
workers produce a large number of goods and services per unit of time will enjoy a high standard of
living.
9. Prices rise when the government prints too much money: Printing money causes inflation. When a
government prints money, the quantity of money increases and each unit of money therefore becomes
less valuable. As a result, more money is required to buy goods and services. For more explanation, see
quantitative easing.
10. Society faces a short-run tradeoff between inflation and unemployment: Reducing inflation often
causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects
of changes in taxes, government spending and monetary policy. For more explanation, see the Phillips
curve.
What is the 'Law Of Diminishing Marginal Utility'
The law of diminishing marginal utility is a law of economics stating that as a person increases
consumption of a product while keeping consumption of other products constant, there is a decline in
the marginal utility that person derives from consuming each additional unit of that product. Marginal
utility is derived as the change in utility as an additional unit is consumed.
BREAKING DOWN 'Law Of Diminishing Marginal Utility'

Marginal utility may decrease into negative utility, as it may become entirely unfavorable to consume
another unit of any product. Therefore, the first unit of consumption for any product is typically highest,
with every unit of consumption to follow holding less and less utility. Consumers handle the law of
diminishing marginal utility by consuming numerous quantities of numerous goods.
Diminishing Prices
The law of diminishing marginal utility directly relates to the concept of diminishing prices. As the utility
of a product decreases as its consumption increases, consumers are willing to pay smaller dollar
amounts for more of the product. For example, assume an individual pays $100 for a vacuum cleaner.
Because he has little value for a second vacuum cleaner, the same individual is willing to pay only $20 for
a second vacuum cleaner. The law of diminishing marginal utility directly impacts a company’s pricing
because the price charged for an item must correspond to the consumer’s marginal utility and
willingness to consume or utilize the good.
Example of Diminishing Marginal Utility
An individual can purchase a slice of pizza for $2; she is quite hungry and decides to buy five slices of
pizza. After doing so, the individual consumes the first slice of pizza and gains a certain positive utility
from eating the food. Because the individual was hungry and this is the first food she consumed, the first
slice of pizza has a high benefit. Upon consuming the second slice of pizza, the individual’s appetite is
becoming satisfied. She wasn't as hungry as before, so the second slice of pizza had a smaller benefit and
enjoyment as the first. The third slice, as before, holds even less utility as the individual is now not
hungry anymore.
In fact, the fourth slice of pizza has experienced a diminished marginal utility as well, as it is difficult to
be consumed because the individual experiences discomfort upon being full from food. Finally, the fifth
slice of pizza cannot even be consumed. The individual is so full from the first four slices that consuming
the last slice of pizza results in negative utility. The five slices of pizza demonstrate the decreasing utility
that is experienced upon the consumption of any good. In a business application, a company may benefit
from having three accountants on its staff. However, if there is no need for another accountant, hiring a
fourth accountant results in a diminished utility, as little benefit is gained from the new hire.
What is 'Law of Diminishing Marginal Returns'
The law of diminishing marginal returns states that, at some point, adding an additional factor of
production results in smaller increases in output. For example, a factory employs workers to
manufacture its products, and, at some point, the company operates at an optimal level. With other
production factors constant, adding additional workers beyond this optimal level will result in less
efficient operations.
BREAKING DOWN 'Law of Diminishing Marginal Returns'
The law of diminishing marginal returns is also known as the law of diminishing returns, the principle of
diminishing marginal productivity, and the law of variable proportions. This law affirms that the addition
of a larger amount of one factor of production, ceteris paribus, inevitably yields decreased per-unit
incremental returns. The law does not imply that the additional unit decreases total production, which is
known as negative returns; however, this is commonly the result.
The law of diminishing returns is not only a fundamental principle of economics, but it also plays a
starring role in production theory. Production theory is the study of the economic process of converting
inputs into outputs.
Origins
The idea of diminishing returns has ties to some of the world’s earliest economists including Jacques
Turgot, Johann Heinrich von Thünen, Thomas Robert Malthus, David Ricardo, and James Steuart.
The first recorded expression of diminishing returns came from Turgot in the mid-1700s. Classical
economists, such as Ricardo and Malthus, attribute successive diminishment of output to a decrease in
quality of input. Ricardo contributed to the development of the law, referring to it as the "intensive
margin of cultivation." He was the first to demonstrate how additional labor and capital to a fixed piece
of land would successively generate smaller output increases. Malthus introduced the idea during the
construction of his population theory. This theory argues that population grows geometrically while food
production increases arithmetically, resulting in a population outgrowing its food supply. Malthus’ ideas
about limited food production stem from diminishing returns.
Neoclassical economists postulate that each “unit” of labor is exactly the same, and diminishing returns
are caused by a disruption of the entire production process as extra units of labor are added to a set
amount of capital.
What is 'Comparative Advantage'

Comparative advantage is an economic law referring to the ability of any given economic actor to
produce goods and services at a lower opportunity cost than other economic actors. The law of
comparative advantage is popularly attributed to English political economist David Ricardo and his book
“Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James
Mill originated the analysis.
Comparative Advantage
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What is 'Comparative Advantage'
Comparative advantage is an economic law referring to the ability of any given economic actor to
produce goods and services at a lower opportunity cost than other economic actors. The law of
comparative advantage is popularly attributed to English political economist David Ricardo and his book
“Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James
Mill originated the analysis.
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BREAKING DOWN 'Comparative Advantage'
One of the most important concepts in economic theory, comparative advantage lays out the case that
all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a
foundational principle in the theory of international trade.
Comparative vs. Absolute Advantages
Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the ability
to produce more or better goods and services than somebody else. Comparative advantage refers to the
ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume.
To see the difference, consider an attorney and her secretary. The attorney is better at producing legal
services than her secretary and is also a faster typist and organizer. In this case, the attorney has an
absolute advantage in both the production of legal services and secretarial work.
Nevertheless, they benefit from trade thanks to their comparative advantages and disadvantages.
Suppose the attorney produces $175/hr in legal services and $25/hr in secretarial duties. The secretary
can produce $0 in legal services and $20 in secretarial duties in an hour. Here, the role of opportunity
cost is crucial.
To produce $25 in income from secretarial work, the attorney must lose $175 in income by not practicing
law. Her opportunity cost of secretarial work is very high. She is better off by producing an hour's worth
of legal services and hiring the secretary to type and organize. The secretary is much better off typing
and organizing for the attorney; his opportunity cost of doing so is extremely low. It’s where his
comparative advantage lies.
International Trade
David Ricardo famously demonstrated how England and Portugal both benefit by specializing and trading
according to their comparative advantages, Portugal with wine and England with cloth.
A contemporary example: China’s comparative advantage with the United States is in the form of cheap
labor. Chinese workers produce simple consumer goods at a much lower opportunity cost. The United
States’ comparative advantage is in specialized, capital-intensive labor. American workers produce
sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading
along these lines benefits each.
Diversity of Skills
People learn their comparative advantages through wages. This drives people into those jobs they are
comparatively best at. If a skilled mathematician earns more as an engineer than as a teacher, he and
everyone he trades with is better off when he practices engineering.
Wider gaps in opportunity costs allow for higher levels of value production simply by organizing labor
more efficiently. The greater the diversity in people and their skills, the greater the opportunity for
beneficial trade through comparative advantage.
The Four Types of Market Structures
There are quite a few different market structures that can characterize an economy. However, if you are
just getting started with this topic, you may want to look at the four basic types of market structures
first. Namely perfect competition, monopolistic competition, oligopoly, and monopoly. Each of them has
their own set of characteristics and assumptions, which in turn affect the decision making of firms and
the profits they can make.
It is important to note that not all of these market structures actually exist in reality, some of them are
just theoretical constructs. Nevertheless, they are of critical importance, because they can illustrate
relevant aspects of competition firms’ decision making. Hence, they will help you to understand the
underlying economic principles. With that being said, let’s look at them in more detail.
Perfect Competition
Perfect competition describes a market structure, where a large number of small firms compete against
each other. In this scenario, a single firm does not have any significant market power. As a result, the
industry as a whole produces the socially optimal level of output, because none of the firms have the
ability to influence market prices.
The idea of perfect competition builds on a number of assumptions: (1) all firms maximize profits (2)
there is free entry and exit to the market, (3) all firms sell completely identical (i.e. homogenous) goods,
(4) there are no consumer preferences. By looking at those assumptions it becomes quite obvious, that
we will hardly ever find perfect competition in reality. This is an important aspect, because it is the only
market structure that can (theoretically) result in a socially optimal level of output.
Probably the best example of a market with almost perfect competition we can find in reality is the stock
market. If you are looking for more information on perfect competition, you can also check our post on
perfect competition vs imperfect competition.
Monopolistic Competition
Monopolistic competition also refers to a market structure, where a large number of small firms
compete against each other. However, unlike in perfect competition, the firms in monopolistic
competition sell similar, but slightly differentiated products. This gives them a certain degree of market
power which allows them to charge higher prices within a certain range.
Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2) there is
free entry and exit to the market, (3) firms sell differentiated products (4) consumers may prefer one
product over the other. Now, those assumptions are a bit closer to reality than the ones we looked at in
perfect competition. However, this market structure will no longer result in a socially optimal level of
output, because the firms have more power and can influence market prices to a certain degree.
An example of monopolistic competition is the market for cereals. There is a huge number of different
brands (e.g. Cap’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of them probably taste slightly
different, but at the end of the day, they are all breakfast cereals.
Oligopoly
An oligopoly describes a market structure which is dominated by only a small number firms. This results
in a state of limited competition. The firms can either compete against each other or collaborate. By
doing so they can use their collective market power to drive up prices and earn more profit.
The oligopolistic market structure builds on the following assumptions: (1) all firms maximize profits, (2)
oligopolies can set prices, (3) there are barriers to entry and exit in the market, (4) products may be
homogenous or differentiated, and (5) there is only a few firms that dominate the market. Unfortunately,
it is not clearly defined what a «few» firms means exactly. As a rule of thumb, we say that an oligopoly
typically consists of about 3-5 dominant firms.
To give an example of an oligopoly, let’s look at the market for gaming consoles. This market is
dominated by three powerful companies: Microsoft, Sony, and Nintendo. This leaves all of them with a
significant amount of market power.
Monopoly
A monopoly refers to a market structure where a single firm controls the entire market. In this scenario,
the firm has the highest level of market power, as consumers do not have any alternatives. As a result,
monopilists often reduce output to increase prices and earn more profit.
The following assumptions are made when we talk about monopolies: (1) the monopolist maximizes
profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there is only one firm that
dominates the entire market.
From the perspective of society, most monopolies are usually not desirable, because they result in lower
outputs and higher prices compared to competitive markets. Therefore, they are often regulated by the
government. An example of a real life monopoly could be Monsanto. About 80% of all corn harvested in
the US is trademarked by this company. That gives Monsanto an extremely high level of market power.
You can find additional information about monopolies our post on monopoly power.
In a Nutshell
There are four basic types of market structures: perfect competition, imperfect competition, oligopoly,
and monopoly. Perfect competition describes a market structure, where a large number of small firms
compete against each other with homogenous products. Meanwhile, monopolistic competition refers to
a market structure, where a large number of small firms compete against each other with differentiated
products. An Oligopoly describes a market structure where a small number of firms compete against
each other. And last but not least a monopoly refers to a market structure where a single firm controls
the entire market.
5 Phases of a Business Cycle (With Diagram)
Business cycles are characterized by boom in one period and collapse in the subsequent period in the
economic activities of a country.
These fluctuations in the economic activities are termed as phases of business cycles.
The fluctuations are compared with ebb and flow. The upward and downward fluctuations in the
cumulative economic magnitudes of a country show variations in different economic activities in terms
of production, investment, employment, credits, prices, and wages. Such changes represent different
phases of business cycles.
The different phases of business cycles are shown in Figure-1:
Different Phases of Business Cycles
There are basically two important phases in a business cycle that are prosperity and depression. The
other phases that are expansion, peak, trough and recovery are intermediary phases.
Figure-2 shows the graphical representation of different phases of a business cycle:
Represtation of Business Cycle
As shown in Figure-2, the steady growth line represents the growth of economy when there are no
business cycles. On the other hand, the line of cycle shows the business cycles that move up and down
the steady growth line. The different phases of a business cycle (as shown in Figure-2) are explained
below.
1. Expansion:
The line of cycle that moves above the steady growth line represents the expansion phase of a business
cycle. In the expansion phase, there is an increase in various economic factors, such as production,
employment, output, wages, profits, demand and supply of products, and sales.
In addition, in the expansion phase, the prices of factor of production and output increases
simultaneously. In this phase, debtors are generally in good financial condition to repay their debts;
therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money.
In expansion phase, due to increase in investment opportunities, idle funds of organizations or
individuals are utilized for various investment purposes. Therefore, in such a case, the cash inflow and
outflow of businesses are equal. This expansion continues till the economic conditions are favorable.
2. Peak:
The growth in the expansion phase eventually slows down and reaches to its peak. This phase is known
as peak phase. In other words, peak phase refers to the phase in which the increase in growth rate of
business cycle achieves its maximum limit. In peak phase, the economic factors, such as production,
profit, sales, and employment, are higher, but do not increase further. In peak phase, there is a gradual
decrease in the demand of various products due to increase in the prices of input.
The increase in the prices of input leads to an increase in the prices of final products, while the income
of individuals remains constant. This also leads consumers to restructure their monthly budget. As a
result, the demand for products, such as jewellery, homes, automobiles, refrigerators and other
durables, starts falling.
3. Recession:
As discussed earlier, in peak phase, there is a gradual decrease in the demand of various products due to
increase in the prices of input. When the decline in the demand of products becomes rapid and steady,
the recession phase takes place.
In recession phase, all the economic factors, such as production, prices, saving and investment, starts
decreasing. Generally, producers are unaware of decrease in the demand of products and they continue
to produce goods and services. In such a case, the supply of products exceeds the demand.
Over the time, producers realize the surplus of supply when the cost of manufacturing of a product is
more than profit generated. This condition firstly experienced by few industries and slowly spread to all
industries.
This situation is firstly considered as a small fluctuation in the market, but as the problem exists for a
longer duration, producers start noticing it. Consequently, producers avoid any type of further
investment in factor of production, such as labor, machinery, and furniture. This leads to the reduction in
the prices of factor, which results in the decline of demand of inputs as well as output.
4. Trough:
During the trough phase, the economic activities of a country decline below the normal level. In this
phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid
decline in national income and expenditure.
In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of interest
decreases; therefore, banks do not prefer to lend money. Consequently, banks face the situation of
increase in their cash balances.
Apart from this, the level of economic output of a country becomes low and unemployment becomes
high. In addition, in trough phase, investors do not invest in stock markets. In trough phase, many weak
organizations leave industries or rather dissolve. At this point, an economy reaches to the lowest level of
shrinking.
5. Recovery:
As discussed above, in trough phase, an economy reaches to the lowest level of shrinking. This lowest
level is the limit to which an economy shrinks. Once the economy touches the lowest level, it happens to
be the end of negativism and beginning of positivism.
This leads to reversal of the process of business cycle. As a result, individuals and organizations start
developing a positive attitude toward the various economic factors, such as investment, employment,
and production. This process of reversal starts from the labor market.
Consequently, organizations discontinue laying off individuals and start hiring but in limited number. At
this stage, wages provided by organizations to individuals is less as compared to their skills and abilities.
This marks the beginning of the recovery phase.
In recovery phase, consumers increase their rate of consumption, as they assume that there would be no
further reduction in the prices of products. As a result, the demand for consumer products increases.
In addition in recovery phase, bankers start utilizing their accumulated cash balances by declining the
lending rate and increasing investment in various securities and bonds. Similarly, adopting a positive
approach other private investors also start investing in the stock market As a result, security prices
increase and rate of interest decreases.
Price mechanism plays a very important role in the recovery phase of economy. As discussed earlier,
during recession the rate at which the price of factor of production falls is greater than the rate of
reduction in the prices of final products.
Therefore producers are always able to earn a certain amount of profit, which increases at trough stage.
The increase in profit also continues in the recovery phase. Apart from this, in recovery phase, some of
the depreciated capital goods are replaced by producers and some are maintained by them. As a result,
investment and employment by organizations increases. As this process gains momentum an economy
again enters into the phase of expansion. Thus, a business cycle gets completed.
Managerial Economics: Meaning, Scope, Techniques & other DetailsDetails
Meaning:
The science of Managerial Economics has emerged only recently. With the growing variability and
unpredictability of the business environment, business managers have become increasingly concerned
with finding rational and ways of adjusting to an exploiting environmental change.
The problems of the business world attracted the attentions of the academicians from 1950 onwards.
Managerial economics as a subject gained popularity in the USA after the publication of the book
“Managerial Economics” by Joel Dean in 1951.
Managerial economics generally refers to the integration of economic theory with business practice.
Economics provides tools managerial economics applies these tools to the management of business. In
simple terms, managerial economics means the application of economic theory to the problem of
management. Managerial economics may be viewed as economics applied to problem solving at the
level of the firm.
It enables the business executive to assume and analyse things. Every firm tries to get satisfactory profit
even though economics emphasises maximizing of profit. Hence, it becomes necessary to redesign
economic ideas to the practical world. This function is being done by managerial economics.
Definition:
Managerial economists have defined managerial economics in a variety of ways:
According to E.F. Brigham and J. L. Pappar, Managerial Economics is “the application of economic theory
and methodology to business administration practice.”
To Christopher Savage and John R. Small: “Managerial Economics is concerned with business efficiency”.
Milton H. Spencer and Lonis Siegelman define Managerial Economics as “the integration of economic
theory with business practice for the purpose of facilitating decision making and forward planning by
management.”
In the words of Me Nair and Meriam, “Managerial Economics consists of the use of economic modes of
thought to analyse business situations.”
D.C. Hague describes Managerial Economics as “a fundamental academic subject which seeks to
understand and analyse the problems of business decision making.”
In the opinion of W.W. Haynes “Managerial Economics is the study of the allocation of resources
available to a firm of other unit of management among the activities of that unit.”
According to Floyd E. Gillis, “Managerial Economics deals almost exclusively with those business
situations that can be quantified and dealt with in a model or at least approximated quantitatively.”
The above definitions emphasise the interrelationship of economic theory with business decision making
and forward planning.
Economic Theory and Managerial Theory:
Economic Theory is a system of inter-relationships. Among the social sciences, economics is the most
advanced in terms of theoretical orientations. There are well defined theoretical structures in eco-
nomics. One of the most widely discussed structures is the postulational or axiomatic method of theory
formulation.
It insists that there is a logical core of theory consisting of postulates and their predictions which forms
the basis of economic reasoning and analysis. This logical core of theory cannot easily be detached from
the empirical part of the theory. Economics has a logically consistent system of reasoning. The theory of
competitive equilibrium is entirely based on axiomatic method. Both in deductive inferences and
inductive generalisations, the underlying principle is the interrelationships.
Managerial theory refers to those aspects of economic theory and application which are directly relevant
to the practice of management and the decision making process. Managerial theory is pragmatic. It is
concerned with those analytical tools which are useful in improving decision making.
Managerial theory provides necessary conceptional tools which can be of considerable help to the
manager in taking scientific decisions. The managerial theory provides the maximum help to a business
manager in his decision making and business planning. The managerial theoretical concepts and
techniques are basic to the entire gamut of managerial theory.
Economic theory deals with the body of principles. But managerial theory deals with the application of
certain principles to solve the problem of a firm.
Economic theory has the characteristics of both micro and macro economics. But managerial theory has
only micro characteristics.
Economic theory deals with a study of individual firm as well as individual consumer. But managerial
theory studies only about individual firm.
Economic theory deals with a study of distribution theories of rent, wages, interest and profits. But
managerial theory deals with a study of only profit theories.
Economic theory is based on certain assumptions. But in managerial theory these assumptions
disappear due to practical situations.
Economic theory is both positive and normative in character but managerial theory is essentially
normative in nature.
Economic theory studies only economic aspect of the problem whereas managerial theory studies both
economic and non-economic aspects.
Nature of Managerial Economics:
Managerial economics is a science applied to decision making. It bridges the gap between abstract
theory and managerial practice. It concentrates more on the method of reasoning. In short, managerial
economics is “Economics applied in decision making”.
Decision Making:
Managerial economics is supposed to enrich the conceptual and technical skill of a manager. It is
concerned with economic behaviour of the firm. It concentrates on the decision process, decision model
and decision variables at the firm level. It is the application of economic analysis to evaluate business
decisions.
The primary function of a manager in business organisation is decision making and forward planning
under uncertain business conditions. Some of the important management decisions are production
decision, inventory decision, cost decision, marketing decision, financial decision, personnel decision and
miscellaneous decisions. One of the hallmarks of a good executive is the ability to take quick decision. He
must have the clarity of goals, use all the information he can get, weigh pros and cons and make fast
decisions.
The decisions are taken to achieve certain objectives. Objectives are the motivating factors in taking
decision. Several acts are performed to attain the objectives quantitative techniques are also used in
decision making. But it may be noted that acts and quantitative techniques alone will not produce
desirable results. It is important to remember that other variables such as human and behavioural con-
siderations, technological forces and environmental factors influence the choices and decisions made by
managers.
Scope of Marginal Economics:
Managerial Economics is a developing subject. The scope of managerial economics refers to its area of
study. Managerial economics has its roots in economic theory. The empirical nature of managerial
economics makes its scope wider. Managerial economics provides management with strategic planning
tools that can be used to get a clear perspective of the way the business world works and what can be
done to maintain profitability in an ever changing environment.
Managerial economics refers to those aspects of economic theory and application which are directly
relevant to the practice of management and the decision making process within the enterprise. Its scope
does not extend to macro-economic theory and the economics of public policy which will also be of
interest to the manager. While considering the scope of managerial economics we have to understand
whether it is positive economics or normative economics.
Positive versus Normative Economics:
Most of the managerial economists are of the opinion that managerial economics is fundamentally
normative and prescriptive in nature. It is concerned with what decisions ought to be made.
The application of managerial economics is inseparable from consideration of values or norms, for it is
always concerned with the achievement of objectives or the optimization of goals. In managerial
economics, we are interested in what should happen rather than what does happen. Instead of
explaining what a firm is doing, we explain what it should do to make its decision effective.
Positive Economics:
A positive science is concerned with ‘what is’. Robbins regards economics as a pure science of what is,
which is not concerned with moral or ethical questions. Economics is neutral between ends. The
economist has no right to pass judgment on the wisdom or folly of the ends itself.
He is simply concerned with the problem of resources in relation to the ends desired. The manufacture
and sale of cigarettes and wine may be injurious to health and therefore morally unjustifiable, but the
economist has no right to pass judgment on these since both satisfy human wants and involve economic
activity.
Normative Economics:
Normative economics is concerned with describing what should be the things. It is, therefore, also called
prescriptive economics. What price for a product should be fixed, what wage should be paid, how
income should be distributed and so on, fall within the purview of normative economics?
It should be noted that normative economics involves value judgments. Almost all the leading
managerial economists are of the opinion that managerial economics is fundamentally normative and
prescriptive in nature.
It refers mostly to what ought to be and cannot be neutral about the ends. The application of managerial
economics is inseparable from consideration of values, or norms for it is always concerned with the
achievement of objectives or the optimisation of goals.
In managerial economics, we are interested in what should happen rather than what does happen.
Instead of explaining what a firm is doing, we explain what it should do to make its decision effective.
Managerial economists are generally preoccupied with the optimum allocation of scarce resources
among competing ends with a view to obtaining the maximum benefit according to predetermined
criteria.
To achieve these objectives they do not assume ceteris paribus, but try to introduce policies. The very
important aspect of managerial economics is that it tries to find out the cause and effect relationship by
factual study and logical reasoning. The scope of managerial economics is so wide that it embraces
almost all the problems and areas of the manager and the firm.
Subject Matter of Marginal Economics:
(i) Demand Analysis and Forecasting:
A firm is an economic organisation which transforms inputs into output that is to be sold in a market.
Accurate estimation of demand, by analysing the forces acting on demand of the product produced by
the firm, forms the vital issue in taking effective decision at the firm level.
A major part of managerial decision making depends on accurate estimates of demand. When demand is
estimated, the manager does not stop at the stage of assessing the current demand but estimates future
demand as well. This is what is meant by demand forecasting.
This forecast can also serve as a guide to management for maintaining or strengthening market position
and enlarging profit. Demand analysis helps in identifying the various factors influencing the demand for
a firm’s product and thus provides guidelines to manipulate demand. The main topics covered are:
Demand Determinants, Demand Distinctions and Demand Forecasting.
(ii) Cost and Production Analysis:
Cost analysis is yet another function of managerial economics. In decision making, cost estimates are
very essential. The factors causing variation in costs must be recognised and allowed for if management
is to arrive at cost estimates which are significant for planning purposes.
The determinants of estimating costs, the relationship between cost and output, the forecast of cost and
profit are very vital to a firm. An element of cost uncertainty exists because all the factors determining
costs are not always known or controllable. Managerial economics touches these aspects of cost analysis
as an effective knowledge and the application of which is corner stone for the success of a firm.
Production analysis frequently proceeds in physical terms. Inputs play a vital role in the economics of
production. The factors of production otherwise called inputs, may be combined in a particular way to
yield the maximum output.
Alternatively, when the price of inputs shoots up, a firm is forced to work out a combination of inputs so
as to ensure that this combination becomes the least cost combination. The main topics covered under
cost and production analysis are production function, least cost combination of factor inputs, factor
productiveness, returns to scale, cost concepts and classification, cost-output relationship and linear
programming.
(iii) Inventory Management:
An inventory refers to a stock of raw materials which a firm keeps. Now the problem is how much of the
inventory is the ideal stock. If it is high, capital is unproductively tied up. If the level of inventory is low,
production will be affected.
Therefore, managerial economics will use such methods as Economic Order Quantity (EOQ) approach,
ABC analysis with a view to minimising the inventory cost. It also goes deeper into such aspects as
motives of holding inventory, cost of holding inventory, inventory control, and main methods of
inventory control and management.
(iv) Advertising:
To produce a commodity is one thing and to market it is another. Yet the message about the product
should reach the consumer before he thinks of buying it. Therefore, advertising forms an integral part of
decision making and forward planning. Expenditure on advertising and related types of promotional
activities is called selling costs by economists.
There are different methods for setting advertising budget: Percentage of Sales Approach, All You can
Afford Approach, Competitive Parity Approach, Objective and Task Approach and Return on Investment
Approach.
(v) Pricing Decision, Policies and Practices:
Pricing is very important area of managerial economics. The control functions of an enterprise are not
only productions but pricing as well. When pricing a commodity, the cost of production has to be taken
into account. Business decisions are greatly influenced by pervading market structure and the structure
of markets that has been evolved by the nature of competition existing in the market.
Pricing is actually guided by consideration of cost plan pricing and the policies of public enterprises. The
knowledge of the pricing of a product under conditions of oligopoly is also essential. The price system
guides the manager to take valid and profitable decision.
(vi) Profit Management:
A business firm is an organisation designed to make profits. Profits are acid test of the individual firm’s
performance. In appraising a company, we must first understand how profit arises. The concept of profit
maximisation is very useful in selecting the alternatives in making a decision at the firm level.
Profit forecasting is an essential function of any management. It relates to projection of future earnings
and involves the analysis of actual and expected behaviour of firms, the sales volume, prices and com-
petitor’s strategies, etc. The main aspects covered under this area are the nature and measurement of
profit, and profit policies of special significance to managerial decision making.
Managerial economics tries to find out the cause and effect relationship by factual study and logical
reasoning. For example, the statement that profits are at a maximum when marginal revenue is equal to
marginal cost, a substantial part of economic analysis of this deductive proposition attempts to reach
specific conclusions about what should be done.
The logic of linear programming is deduction of mathematical form. In fine, managerial economics is a
branch of normative economics that draws from descriptive economics and from well established
deductive patterns of logic.
(vii) Capital Management:
Planning and control of capital expenditures is the basic executive function. The managerial problem of
planning and control of capital is examined from an economic stand point. The capital budgeting process
takes different forms in different industries.
It involves the equi-marginal principle. The objective is to assure the most profitable use of funds, which
means that funds must not be applied when the managerial returns are less than in other uses. The main
topics dealt with are: Cost of Capital, Rate of Return and Selection of Projects.
Thus we see that a firm has uncertainties to rock on with. Therefore, we can conclude that the subject
matter of managerial economics consists of applying economic principles and concepts towards
adjusting with these uncertainties of the firm.
In recent years, there is a trend towards integration of managerial economics and Operation Research.
Hence, techniques such as linear Programming, Inventory Models, Waiting Line Models, Bidding Models,
Theory of Games, etc. have also come to be regarded as part of managerial economics.
Relation to Other Branches of Knowledge:
A useful method of throwing light on the nature and scope of managerial economics is to examine its
relationship with other disciplines. To classify the scope of a field of study is to discuss its relation to
other subjects. If we take the subject in isolation, our study would not be useful. Managerial economics
has a close linkage with other disciplines and fields of study.
The subject has gained by the interaction with economics, mathematics and statistics and has drawn
upon management theory and accounting concepts. The managerial economics integrates concepts and
methods from these disciplines and bringing them to bear on managerial problems.
Managerial Economics and Economics:
Managerial Economics has been described as economics applied to decision making. It may be studied as
a special branch of economics, bridging the gap between pure economic theory and managerial practice.
Economics has two main branches—micro-economics and macro-economics.
Micro-economics:
‘Micro’ means small. It studies the behaviour of the individual units and small groups of such units. It is a
study of particular firms, particular households, individual prices, wages, incomes, individual industries
and particular commodities. Thus micro-economics gives a microscopic view of the economy.
The micro-economic analysis may be undertaken at three levels:
(i) The equalisation of individual consumers and produces;

(ii) The equalization of the single market;
(iii) The simultaneous equilibrium of all markets. The problems of scarcity and optimal or ideal allocation
of resources are the central problem in micro-economics.
The roots of managerial economics spring from micro-economic theory. In price theory, demand
concepts, elasticity of demand, marginal cost marginal revenue, the short and long runs and theories of
market structure are sources of the elements of micro-economics which managerial economics draws
upon. It also makes use of well known models in price theory such as the model for monopoly price, the
kinked demand theory and the model of price discrimination.
Macro-economics:
‘Macro’ means large. It deals with the behaviour of the large aggregates in the economy. The large
aggregates are total saving, total consumption, total income, total employment, general price level, wage
level, cost structure, etc. Thus macro-economics is aggregative economics.
It examines the interrelations among the various aggregates, and causes of fluctuations in them.
Problems of determination of total income, total employment and general price level are the central
problems in macro-economics.
Macro-economies is also related to managerial economics. The environment, in which a business

operates, fluctuations in national income, changes in fiscal and monetary measures and variations in the
level of business activity have relevance to business decisions. The understanding of the overall opera-
tion of the economic system is very useful to the managerial economist in the formulation of his policies.
The chief contribution of macro-economics is in the area of forecasting. The post-Keynesian aggregative
theory has direct implications for forecasting general business conditions. Since the prospects of an
individual firm often depend greatly on business in general, for-casts of an individual firm depend on
general business forecasts, which make use of models derived from theory. The most widely used model
in modern forecasting is the gross national product model.
Production Possibility Frontier - PPFPPF
Production Possibility Frontier - PPF
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What is the 'Production Possibility Frontier - PPF'
The production possibility frontier (PPF) is a curve depicting all maximum output possibilities for two
goods, given a set of inputs consisting of resources and other factors. The PPF assumes that all inputs are
used efficiently.
Factors such as labor, capital and technology, among others, will affect the resources available, which will
dictate where the production possibility frontier lies. The PPF is also known as the production possibility
curve or the transformation curve.
BREAKING DOWN 'Production Possibility Frontier - PPF'
The PPF indicates the production possibilities of two commodities when resources are fixed. This means
that the production of one commodity can only increase when the production of the other commodity is
reduced, due to the availability of resources. Therefore, the PPF measures the efficiency in which two
commodities can be produced together, helping managers and leaders decide what mix of commodities
are most beneficial. The PPF assumes that technology is constant, resources are used efficiently, and that
there is normally only a choice between two commodities.
Understanding and Interpreting the PPF

The PPF drives home the idea that opportunity costs normally come up when an economic organization
with limited resources must decide between two alternatives. The PPF is depicted graphically as an arc,
with one commodity on the X axis and the other commodity on the Y axis. At each point on the arc,
there is an efficient number of the two commodities that can be produced with available resources.
Therefore, it's up to the organization to look at the PPF and decide what number of each commodity
should be produced to maximize the overall benefit to the economy.
Production Possibility Frontier - PPF
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What is the 'Production Possibility Frontier - PPF'
The production possibility frontier (PPF) is a curve depicting all maximum output possibilities for two
goods, given a set of inputs consisting of resources and other factors. The PPF assumes that all inputs are
used efficiently.
Factors such as labor, capital and technology, among others, will affect the resources available, which will
dictate where the production possibility frontier lies. The PPF is also known as the production possibility
curve or the transformation curve.
Next Up
MARGINAL RATE OF TRANSFORMATION
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VIDEO
BREAKING DOWN 'Production Possibility Frontier - PPF'
The PPF indicates the production possibilities of two commodities when resources are fixed. This means
that the production of one commodity can only increase when the production of the other commodity is
reduced, due to the availability of resources. Therefore, the PPF measures the efficiency in which two
commodities can be produced together, helping managers and leaders decide what mix of commodities
are most beneficial. The PPF assumes that technology is constant, resources are used efficiently, and that
there is normally only a choice between two commodities.
Understanding and Interpreting the PPF
The PPF drives home the idea that opportunity costs normally come up when an economic organization
with limited resources must decide between two alternatives. The PPF is depicted graphically as an arc,
with one commodity on the X axis and the other commodity on the Y axis. At each point on the arc,
there is an efficient number of the two commodities that can be produced with available resources.
Therefore, it's up to the organization to look at the PPF and decide what number of each commodity
should be produced to maximize the overall benefit to the economy.
If, for example, a government organization is deciding between the production mix of textbooks and
computers, and it can produce either 40 textbooks and 7 computers or 70 text books and 3 computers,
it's up to that organization to determine what it needs more. In this example, the opportunity cost of
producing an additional 30 textbooks is 4 computers.
Understanding the Pareto Efficiency
The Pareto Efficiency is a concept named after Italian economist Vilfredo Pareto that measures the
efficiency of the commodity allocation on the PPF. The Pareto Efficiency states that any point within the
PPF curve is considered inefficient because the total output of commodities is below the output capacity.
Conversely, any point outside the PPF curve is considered to be impossible because it represents a mix of
commodities that will take more resources to produce than can be obtained.
Therefore, any mix of two commodities, given limited resources, is only efficient when it lies on the PPF
curve, with one commodity on the X axis and one commodity on the Y axis. Achieving the Pareto
Efficiency means that an economy is operating at maximum potential and lies directly on the PPF.
What is the difference between positive and normative economics?
What is the difference between positive and normative economics?
By Amy Fontinelle | Updated January 3, 2018 — 9:21 AM EST
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A:
The distinction between positive economics and normative economics may seem simple, but it is not
always easy to differentiate between the two. Positive economics is objective and fact based, while
normative economics is subjective and value based. Positive economic statements must be able to be
tested and proved or disproved. Normative economic statements are opinion based, so they cannot be
proved or disproved. In fact, many widely accepted statements that people hold as fact are actually
value based.
Example of Positive Economics vs Normative Economics
For example, the statement, "government should provide basic healthcare to all citizens" is a normative
economic statement. There is no way to prove whether government "should" provide healthcare; this
statement is based on opinions about the role of government in individuals' lives, the importance of
healthcare, and who should pay for it.
The statement, "government-provided healthcare increases public expenditures" is a positive economic
statement, as it can be proved or disproved by examining healthcare spending data in countries like
Canada and Britain, where the government provides healthcare.
Disagreements over public policies typically revolve around normative economic statements, and the
disagreements persist because neither side can prove that it is correct or that its opponent is incorrect. A
clear understanding of the difference between positive and normative economics should lead to better
policy making if policies are made based on facts (positive economics), not opinions (normative
economics). Nonetheless, numerous policies on issues ranging from international trade to welfare are at
least partially based on normative economics.
What's the difference between microeconomics and macroeconomics?
Macroeconomics and microeconomics, and their wide array of underlying concepts, have been the
subject of a great deal of writings. The field of study is vast; so here is a brief summary of what each
covers. Microeconomics is generally the study of individuals and business decisions, while
macroeconomics looks at higher up country and government decisions.
Microeconomics
Microeconomics is the study of decisions that people and businesses make regarding the allocation of
resources and prices of goods and services. This means also taking into account taxes and regulations
created by governments. Microeconomics focuses on supply and demand and other forces that
determine the price levels seen in the economy. For example, microeconomics would look at how a
specific company could maximize its production and capacity, so that it could lower prices and better
compete in its industry. (Find out more about microeconomics in How does government policy impact
microeconomics?
Microeconomics' rules flow from a set of compatible laws and theorems, rather than beginning with
empirical study.
Macroeconomics
Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy
as a whole, not just of specific companies, but entire industries and economies. It looks at economy-wide
phenomena, such as Gross Domestic Product (GDP) and how it is affected by changes in unemployment,
national income, rate of growth, and price levels. For example, macroeconomics would look at how an
increase/decrease in net exports would affect a nation's capital account or how GDP would be affected
by the unemployment rate. (To keep reading on this subject, see Macroeconomic Analysis.)
John Maynard Keynes is often credited with founding macroeconomics, when he initiated the use of
monetary aggregates to study broad phenomena. Some economists reject his theory and many of those
who use it disagree on how to interpret it.
Micro and Macro
While these two studies of economics appear to be different, they are actually interdependent and
complement one another since there are many overlapping issues between the two fields. For example,
increased inflation (macro effect) would cause the price of raw materials to increase for companies and
in turn affect the end product's price charged to the public.
Microeconomics takes what is referred to as a bottoms-up approach to analyzing the economy while
macroeconomics takes a top-down approach. In other words, microeconomics tries to understand
human choices and resource allocation, while macroeconomics tries to answer such questions as "What
should the rate of inflation be?" or "What stimulates economic growth?"
Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional
and should be studied together in order to fully understand how companies operate and earn revenues
and thus, how an entire economy is managed and sustained.
What Should Individual Investors Look At?
Individual investors are probably better off focusing on microeconomics than macroeconomics. There
may be some disagreement between fundamental (particularly value) investors and technical investors
about the proper role of economic analysis, but it is more likely that microeconomics will affect an
individual investment proposal.
Warren Buffett has famously stated that macroeconomic forecasts don't influence his investing decisions.
When asked about how he and Charlie Munger, his business partner, choose investments, Buffett
responded, "Charlie and I don't pay attention to macro forecasts. We've worked together for 50+ years,
and I can't think of a time when they influenced a decision about stock or a company." Buffett has also
referred to macroeconomic literature as "the funny papers."
John Templeton, another famously successful value investor, shared a similar sentiment. "I never ask if
the market is going to go up or down, because I don't know. It doesn't matter. I search nation after
nation for stocks, asking: 'where is the one that is lowest priced in relation to what I believe it's worth?'"
said Templeton.
The Divide Between Microeconomics and Macroeconomics
Microeconomics concerns itself with the small details that make a difference when evaluating individual
companies. This includes production costs and market prices for goods and services. A lot of
microeconomic information can be gleaned from the financial statements.
Macroeconomics focuses on aggregates and econometric correlations. Investors of mutual funds or

interest rate-sensitive securities should keep an eye toward monetary and fiscal policy. Outside of a few
meaningful and measurable impacts, macroeconomics doesn't offer much for specific investments.
Moreover, economists generally agree on the principles of microeconomics. As the International

Monetary Fund (IMF) website states, "There are no competing schools of thought in microeconomics."
This is not true with macroeconomics. Macroeconomic forecasting has a very poor track record, and the
accepted version of macroeconomics has changed several times since its inception.
DEFINE MANAGEMENT & ITS FUNCTIONSFUNCTIONS
Management is the process of reaching organizational goals by working with and through people and
other organizational resources.
Management has the following 3 characteristics:
It is a process or series of continuing and related activities.
It involves and concentrates on reaching organizational goals.

It reaches these goals by working with and through people and other organizational resources.
MANAGEMENT FUNCTIONS:
The 4 basic management functions that make up the management process are described in the following
sections:
PLANNING
ORGANIZING
INFLUENCING
CONTROLLING.
PLANNING: Planning involves choosing tasks that must be performed to attain organizational goals,
outlining how the tasks must be performed, and indicating when they should be performed.
Planning activity focuses on attaining goals. Managers outline exactly what organizations should do to be
successful. Planning is concerned with the success of the organization in the short term as well as in the
long term.
ORGANIZING:
Organizing can be thought of as assigning the tasks developed in the planning stages, to various
individuals or groups within the organization. Organizing is to create a mechanism to put plans into
action.
People within the organization are given work assignments that contribute to the company’s goals. Tasks
are organized so that the output of each individual contributes to the success of departments, which, in
turn, contributes to the success of divisions, which ultimately contributes to the success of the
organization.
INFLUENCING:
Influencing is also referred to as motivating,leading or directing.Influencing can be defined as guiding the

activities of organization members in he direction that helps the organization move towards the
fulfillment of the goals.
The purpose of influencing is to increase productivity. Human-oriented work situations usually generate
higher levels of production over the long term than do task oriented work situations because people find
the latter type distasteful.
CONTROLLING:
Controlling is the following roles played by the manager:
Gather information that measures performance
Compare present performance to pre established performance norms.
Determine the next action plan and modifications for meeting the desired performance parameters.
Controlling is an ongoing process.
Economics Basics: Supply and DemandDemand
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired
by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain
price; the relationship between price and quantity demanded is known as the demand relationship.
Supply represents how much the market can offer. The quantity supplied refers to the amount of a
certain good producers are willing to supply when receiving a certain price. The correlation between
price and how much of a good or service is supplied to the market is known as the supply relationship.
Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of resources. In
market economy theories, demand and supply theory will allocate resources in the most efficient way
possible. How? Let us take a closer look at the law of demand and the law of supply.
A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less
people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more. The chart
below shows that the curve is a downward slope.
economics3.gif
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between
quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will
be P1, and so on. The demand relationship curve illustrates the negative relationship between price and
quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower
the price, the more the good will be in demand (C).
B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price.
But unlike the law of demand, the supply relationship shows an upward slope. This means that the
higher the price, the higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at a higher price increases revenue.
economics4.gif
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between
quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2,
and so on. (To learn how economic factors are used in currency trading,
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to
supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is
important to try and determine whether a price change that is caused by demand will be temporary or
permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season;
suppliers may simply accommodate demand by using their production equipment more intensively. If,
however, there is a climate change, and the population will need umbrellas year-round, the change in
demand and price will be expected to be long term; suppliers will have to change their equipment and
production facilities in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and
demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record company's
previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs
were released because the opportunity cost is too high for suppliers to produce more. If, however, the
ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand
relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more
CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity
supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because
the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with
their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining
ten CDs. The lower price will then make the CD more available to people who had previously decided
that the opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the
economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because
the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given
price, suppliers are selling all the goods that they have produced and consumers are getting all the goods
that they are demanding.
Economics Basics: Supply and Demand
By Adam Hayes, CFA
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Economics Basics: Introduction
Economics Basics: What Is Economics?
Economics Basics: Utility
Economics Basics: Elasticity
Economic Basics: Competition, Monopoly and Oligopoly
Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and Trade
Economic Basics: Measuring Economic Activity
Economics Basics: Alternatives to Neoclassical Economics
Economics Basics: Conclusion
economics3.gif
economics4.gif
and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough:
Economics.)
Time and Supply
permanent.
supplied.
D. Equilibrium
economics5.gif
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity
will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative
inefficiency.
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At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however,
the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is
greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to
produce more goods, which they hope to sell to increase profits, but those consuming the goods will find
the product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too
many consumers want the good while producers are not making enough of it.
economics7.gif
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there
are too few goods being produced to satisfy the wants (demand) of the consumers. However, as
consumers have to compete with one other to buy the good at this price, the demand will push the price
up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent
very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in
both price and quantity demanded from one point to another on the curve. The movement implies that
the demand relationship remains consistent. Therefore, a movement along the demand curve will occur
when the price of the good changes and the quantity demanded changes in accordance to the original
demand relationship. In other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.
economics8.gif
Like a movement along the demand curve, a movement along the supply curve means that the supply
relationship remains consistent. Therefore, a movement along the supply curve will occur when the price
of the good changes and the quantity supplied changes in accordance to the original supply relationship.
In other words, a movement occurs when a change in quantity supplied is caused only by a change in
price, and vice versa.
economics9.gif
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even
though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of
beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in
the demand curve imply that the original demand relationship has changed, meaning that quantity
demand is affected by a factor other than price. A shift in the demand relationship would occur if, for
instance, beer suddenly became the only type of alcohol available for consumptiogif
By Adam Hayes, CFA
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economics3.gif
economics4.gif
and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough:
Economics.)
Time and Supply
permanent.
supplied.
D. Equilibrium
economics5.gif
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity
will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative
inefficiency.
economics6.gif
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however,
the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is
greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to
produce more goods, which they hope to sell to increase profits, but those consuming the goods will find
the product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too
many consumers want the good while producers are not making enough of it.
economics7.gif
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there
are too few goods being produced to satisfy the wants (demand) of the consumers. However, as
consumers have to compete with one other to buy the good at this price, the demand will push the price
up, making suppliers want to supply more and bringing the price closer to its equilibrium.
F. Shifts vs. Movement
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent
very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in
both price and quantity demanded from one point to another on the curve. The movement implies that
the demand relationship remains consistent. Therefore, a movement along the demand curve will occur
when the price of the good changes and the quantity demanded changes in accordance to the original
demand relationship. In other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.
economics8.gif
Like a movement along the demand curve, a movement along the supply curve means that the supply
relationship remains consistent. Therefore, a movement along the supply curve will occur when the price
of the good changes and the quantity supplied changes in accordance to the original supply relationship.
In other words, a movement occurs when a change in quantity supplied is caused only by a change in
price, and vice versa.
economics9.gif
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even
though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of
beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in
the demand curve imply that the original demand relationship has changed, meaning that quantity
demand is affected by a factor other than price. A shift in the demand relationship would occur if, for
instance, beer suddenly became the only type of alcohol available for consumption.
economics10.gif
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2,
then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply
curve implies that the original supply curve has changed, meaning that the quantity supplied is effected
by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster
caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same
price.
economics11.gif
We’ve seen that the demand and supply of goods react to changes in price, and that prices in turn move
along with changes in quantity. We’ve also seen that the utility, or satisfaction received from consuming
or acquiring goods diminishes with each additional unit consumed. The degree to which demand or
supply reacts to a change in price is called elasticity.
Elasticity varies from product to product because some products may be more essential to the consumer
than others. Demand for products that are considered necessities is less sensitive to price changes
because consumers will still continue buying these products despite price increases. On the other hand,
an increase in price of a good or service that is far less of a necessity will deter consumers because the
opportunity cost of buying the product will become too high.
A good or service is considered highly elastic if even a slight change in price leads to a sharp change in
the quantity demanded or supplied. Usually these kinds of products are readily available in the market
and a person may not necessarily need them in his or her daily life, or if there are good substitutes. For
example, if the price of Coke rises, people may readily switch over to Pepsi. On the other hand, an
inelastic good or service is one in which large changes in price produce only modest changes in the
quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity
to the consumer in his or her daily life, such as gasoline.
To determine the elasticity of the supply or demand of something, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)
If the elasticity is greater than or equal to 1, the curve is considered to be elastic. If it is less than one, the
curve is said to be inelastic.
As we saw previously, the demand curve has a negative slope. If a large drop in the quantity demanded is
accompanied by only a small increase in price, the demand curve will appear looks flatter, or more
horizontal. People would rather stop consuming this product or switch to some alternative rather than
pay a higher price. A flatter curve means that the good or service in question is quite elastic.
economics12.gif
Meanwhile, inelastic demand can be represented with a much steeper curve: large changes in price
barely affect the quantity demanded.
economics13.gif
Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the
supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or
equal to one.The elasticity of supply works similarly to that of demand. Remember that the supply curve
is upward sloping. If a small change in price results in a big change in the amount supplied, the supply
curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to
one.
economics14.gif
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the
supply curve is steeper and its elasticity would be less than one. The good in question is inelastic with
regard to supply.
economics15.gif
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand:
1. Availability of Substitutes In general, the more good substitutes there are, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace
their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good because a
small increase in price will cause a large decrease in demand as consumers start buying more tea instead
of coffee.
However, if the price of caffeine itself were to go up, we would probably see little change in the
consumption of coffee or tea because there may be few good substitutes for caffeine. Most people in
this case might not willing to give up their morning cup of caffeine no matter what the price. We would
say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be
elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique
goods such as diamonds are inelastic because they have few if any substitutes.
By Adam Hayes, CFA
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economics12.gif
economics13.gif
one.
economics14.gif
regard to supply.
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of coffee.
2. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay
higher prices for it. For example, people need to get to work or drive for any number of reasons.
Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.
3. Time The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with
very few available substitutes will most likely continue buying his or her daily cigarettes. This means that
tobacco is inelastic because the change in price will not have a significant influence on the quantity
demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and
begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer
becomes elastic in the long run.
Income Elasticity of Demand

Income elasticity of demand is the amount of income available to spend on goods and services. This also
affects demand since it regulates how much people can spend in general. Thus, if the price of a car goes
up from $25,000 to $30,000 and income stays the same, the consumer is forced to reduce his or her
demand for that car. If there is an increase in price and no change in the amount of income available to
spend on the good, there will be an elastic reaction in demand: demand will be sensitive to a change in
price if there is no change in income. It follows, then, that if there is an increase in income, demand in
general tends to increase as well. The degree to which an increase in income will cause an increase in
demand is called the “income elasticity of demand,” which can be expressed in the following equation:
economics_formula1.gif
If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less
than 1, demand is considered to be income inelastic. Luxury items usually have higher income elasticity
because when people have a higher income, they don't have to forfeit as much to buy these luxury
items. As an example, consider what some consider a luxury good: vacation travel. Bob has just received
a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new higher purchasing
power, he decides that he can now afford to go on vacation twice a year instead of his previous once a
year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is 7, which is highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These
cases often involve goods and services considered of inferior quality that will be dropped by a consumer
who receives a salary increase. An example may be the decrease in going out to fast food restaurants as
income increases, which are generally considered to be of lower quality that other dining alternatives.
Products for which the demand decreases as income increases have an income elasticity of less than
zero. Products that witness no change in demand despite a change in income usually have an income
elasticity of zero. These goods and services are considered necessities and are sometimes referred to as
Giffin Goods.
By Adam Hayes, CFA
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economics12.gif
economics13.gif
one.
economics14.gif
regard to supply.
economics15.gif
of coffee.
2. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay
higher prices for it. For example, people need to get to work or drive for any number of reasons.
Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.
3. Time The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with
very few available substitutes will most likely continue buying his or her daily cigarettes. This means that
tobacco is inelastic because the change in price will not have a significant influence on the quantity
demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and
begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer
becomes elastic in the long run.
Income Elasticity of Demand
Income elasticity of demand is the amount of income available to spend on goods and services. This also
affects demand since it regulates how much people can spend in general. Thus, if the price of a car goes
up from $25,000 to $30,000 and income stays the same, the consumer is forced to reduce his or her
demand for that car. If there is an increase in price and no change in the amount of income available to
spend on the good, there will be an elastic reaction in demand: demand will be sensitive to a change in
price if there is no change in income. It follows, then, that if there is an increase in income, demand in
general tends to increase as well. The degree to which an increase in income will cause an increase in
demand is called the “income elasticity of demand,” which can be expressed in the following equation:
If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less
than 1, demand is considered to be income inelastic. Luxury items usually have higher income elasticity
because when people have a higher income, they don't have to forfeit as much to buy these luxury
items. As an example, consider what some consider a luxury good: vacation travel. Bob has just received
a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new higher purchasing
power, he decides that he can now afford to go on vacation twice a year instead of his previous once a
year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is 7, which is highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These
cases often involve goods and services considered of inferior quality that will be dropped by a consumer
who receives a salary increase. An example may be the decrease in going out to fast food restaurants as
income increases, which are generally considered to be of lower quality that other dining alternatives.
Products for which the demand decreases as income increases have an income elasticity of less than
zero. Products that witness no change in demand despite a change in income usually have an income
elasticity of zero. These goods and services are considered necessities and are sometimes referred to as
Giffin Goods.
Another anomaly in elasticity occurs when the demand for something increases as its price rises. We’ve
learned that if the price of something goes up, people will demand less – but certain luxury or status
items may be demanded because they are expensive. For example, designer label clothing or accessories
or luxury car brands signal status and prestige. A work of art, a personal chef, or a diamond ring all may
be in high demand precisely because they are expensive. These types of goods are referred to as Veblen
Goods.
By Adam Hayes, CFA
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Economists make the assumption that there are a large number of different buyers and sellers in the
marketplace for each good or service available. This means that we have competition in the market,
which allows price to change in response to changes in supply and demand. For example, if the price of a
good is very high and some firms are making extra profits in that sector, other firms will be induced to
start producing that same good – in competition with the others – which will increase supply and reduce
the selling price. Furthermore, for almost every product there are substitutes, so if one product becomes
too expensive, a buyer can choose a cheaper substitute instead (recall the section on elasticity). In a
market with many buyers and sellers, both the consumer and the supplier have equal ability to compete
on price.
Adam Smith in the 18th century recognized that competition between producers is crucial for the
invisible hand to keep an economy efficient. Smith imagined a primitive society with only two products:
beaver and deer. A hunter can produce only one type of game and therefore must choose whether to
hunt for beaver or deer each day. If given the same effort, a deer sells for twice as much as a beaver,
people will switch from beaver production to hunt deer instead. The result is more deer and less beaver,
so the profit rates for deer begin to decline as beaver increases. Smith predicted that in a world of
competition, the profit rates for all industries will converge to the same rate of profit, since if it becomes
more profitable to be in a certain line of business, new companies will pop up to exploit that difference –
pushing it back in line in the process.
Economists call this assumption about competitive producers perfect competition. Perfect competition is
characterized by many buyers and sellers, many products that are similar in nature and, as a result, many
substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and
prices are determined by supply and demand. Thus, producers in a perfectly competitive market are
subject to the prices determined by the market and do not have any leverage. For example, in a perfectly
competitive market, should a single firm decide to increase its selling price of a good, the consumers can
just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose
market share and profits. Take for example corn farmers. Many hundreds of farmers all produce an
identical product: corn. Buyers do not care which farmer sells them their corn, and so buyers’ only
concern is the price of corn. Therefore, the lowest priced corn seller will sell the majority of corn. If a
corn seller cannot compete because his cost of production is too high, he will be forced to find ways to
lower his costs or risk going out of business.
Monopoly and Oligopoly
In some industries, however, we find that there are no good substitutes and there little competition. In a
market that has only one or few suppliers of a good or service, the producer(s) can control price.
Consequently, consumers do not have much choice.
A monopoly is a market structure in which there is only one producer and seller for a product. In other
words, the single business is the entire producer in the industry. Entry into such a market can be
restricted due to high costs or other impediments, which may be economic, social or political that keep
potential competitors out. For instance, a government can create a monopoly over an industry that it
wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic
industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in
Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a
company has a copyright or patent that prevents others from entering the market. Pfizer, for instance,
had a patent on Viagra. Most economists agree that monopolies are inefficient since without
competition, they can keep prices artificially high.
In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control
over the price and, like a monopoly, an oligopoly has high barriers to entry to keep out potential
competitors. The products that the oligopolistic firms produce are often nearly identical and, therefore,
the companies, which are competing for market share, are interdependent as a result of market forces.
Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its
competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and,
therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market
share, thereby forcing Company Y to lower its prices as well. In certain cases, types of oligopolies (for
example cartels) are illegal.
Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and TradeTrade
Production Possibility Frontier (PPF)
In the field of macroeconomics, the production possibility frontier (PPF) represents the point at which a
country’s economy is most efficiently producing its goods and services and, therefore, allocating its
resources in the best way possible. There are just enough apple orchards producing apples, just enough
car factories making cars, and just enough accountants offering tax services. If the economy is not
producing the quantities indicated by the PPF, resources are being managed inefficiently and the stability
of the economy will dwindle. The production possibility frontier shows us that there are limits to
production, so an economy, to achieve efficiency, must decide what combination of goods and services
can and should be produced.
Let's turn to an example and consider the chart below. Imagine an economy that can produce only two
things: wine and cotton. According to the PPF, points A, B and C – all appearing on the PPF curve –
represent the most efficient use of resources by the economy. For instance, producing 5 units of wine
and 5 units of cotton (point B) is just as desirable as producing 3 units of wine and 7 units of cotton. Point
X represents an inefficient use of resources, while point Y represents the goals that the economy simply
cannot attain with its present levels of resources.
economics1.gif
As we can see, in order for this economy to produce more wine, it must give up some of the resources it
is currently using to produce cotton (point A). If the economy starts producing more cotton (represented
by points B and C), it would need to divert resources from making wine and, consequently, it will
produce less wine than it is producing at point A. As the figure shows, by moving production from point
A to B, the economy must decrease wine production by a small amount in comparison to the increase in
cotton output. However, if the economy moves from point B to C, wine output will be significantly
reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the
most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF
and which combination to use. If more wine is in demand, the cost of increasing its output is
proportional to the cost of decreasing cotton production. Markets play an important role in telling the
economy what the PPF ought to look like.
Consider point X on the figure above. Being at point X means that the country's resources are not being
used efficiently or, more specifically, that the country is not producing enough cotton or wine given the
potential of its resources. On the other hand, point Y, as we mentioned above, represents an output level
that is currently unattainable by this economy. But, if there were a change in technology while the level
of land, labor and capital remained the same, the time required to pick cotton and grapes would be
reduced. Output would increase, and the PPF would be pushed outwards. A new curve, represented in
the figure below on which Y would fall, would then represent the new efficient allocation of resources.
economics2.gif
When the PPF shifts outwards, we can imply that there has been growth in an economy. Alternatively,
when the PPF shifts inwards it indicates that the economy is shrinking due to a failure in its allocation of
resources and optimal production capability. A shrinking economy could be a result of a decrease in
supplies or a deficiency in technology.
An economy can only be producing on the PPF curve in theory; in reality, economies constantly struggle
to reach an optimal production capacity. And because scarcity forces an economy to forgo some choice
in favor of others, the slope of the PPF will always be negative; if production of product A increases then
production of product B will have to decrease accordingly.
Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy may be able to produce for itself all of the goods and services it needs to function using the
PPF as a guide, but this may actually lead to an overall inefficient allocation of resources and hinder
future growth – when considering the benefits of trade. Through specialization, a country can
concentrate on the production of just a few things that it can do best, rather than dividing up its
resources among everything.
Let us consider a hypothetical world that has just two countries (Country A and Country B) and only two
products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country A has very
little fertile land and an abundance of steel available for car production. Country B, on the other hand,
has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and
cotton, it would need to divide up its resources, and since it requires a great deal of effort to produce
cotton by irrigating its land, Country A would have to sacrifice producing cars – which it is much more
capable of doing. The opportunity cost of producing both cars and cotton is high for Country A, as it will
have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of
producing both products is high because the effort required to produce cars is far greater than that of
producing cotton.
Each country in our example can produce one of these products more efficiently (at a lower cost) than
the other. We can say that Country A has a comparative advantage over Country B in the production of
cars, and Country B has a comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) decide to specialize in producing the goods with which they
have a comparative advantage. If they then trade the goods that they produce for other goods in which
they don't have a comparative advantage, both countries will be able to enjoy both products at a lower
cost. Furthermore, each country will be exchanging the best product it can make for another good or
service that is the best that the other country can produce so quality improves. Specialization and trade
also works when several different countries are involved. For example, if Country C specializes in the
production of corn, it can trade its corn for cars from Country A and cotton from Country B.
By Adam Hayes, CFA
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So far, we have gone over key topics of economics that have focused generally on microeconomic
phenomena. Here, we turn to more macroeconomic matters that occur on the level of national
economies.
Production Possibility Frontier (PPF)
In the field of macroeconomics, the production possibility frontier (PPF) represents the point at which a
country’s economy is most efficiently producing its goods and services and, therefore, allocating its
resources in the best way possible. There are just enough apple orchards producing apples, just enough
car factories making cars, and just enough accountants offering tax services. If the economy is not
producing the quantities indicated by the PPF, resources are being managed inefficiently and the stability
of the economy will dwindle. The production possibility frontier shows us that there are limits to
production, so an economy, to achieve efficiency, must decide what combination of goods and services
can and should be produced.
Let's turn to an example and consider the chart below. Imagine an economy that can produce only two
things: wine and cotton. According to the PPF, points A, B and C – all appearing on the PPF curve –
represent the most efficient use of resources by the economy. For instance, producing 5 units of wine
and 5 units of cotton (point B) is just as desirable as producing 3 units of wine and 7 units of cotton. Point
X represents an inefficient use of resources, while point Y represents the goals that the economy simply
cannot attain with its present levels of resources.
economics1.gif
As we can see, in order for this economy to produce more wine, it must give up some of the resources it
is currently using to produce cotton (point A). If the economy starts producing more cotton (represented
by points B and C), it would need to divert resources from making wine and, consequently, it will
produce less wine than it is producing at point A. As the figure shows, by moving production from point
A to B, the economy must decrease wine production by a small amount in comparison to the increase in
cotton output. However, if the economy moves from point B to C, wine output will be significantly
reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the
most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF
and which combination to use. If more wine is in demand, the cost of increasing its output is
proportional to the cost of decreasing cotton production. Markets play an important role in telling the
economy what the PPF ought to look like.
Consider point X on the figure above. Being at point X means that the country's resources are not being
used efficiently or, more specifically, that the country is not producing enough cotton or wine given the
potential of its resources. On the other hand, point Y, as we mentioned above, represents an output level
that is currently unattainable by this economy. But, if there were a change in technology while the level
of land, labor and capital remained the same, the time required to pick cotton and grapes would be
reduced. Output would increase, and the PPF would be pushed outwards. A new curve, represented in
the figure below on which Y would fall, would then represent the new efficient allocation of resources.
economics2.gif
When the PPF shifts outwards, we can imply that there has been growth in an economy. Alternatively,
when the PPF shifts inwards it indicates that the economy is shrinking due to a failure in its allocation of
resources and optimal production capability. A shrinking economy could be a result of a decrease in
supplies or a deficiency in technology.
An economy can only be producing on the PPF curve in theory; in reality, economies constantly struggle
to reach an optimal production capacity. And because scarcity forces an economy to forgo some choice
in favor of others, the slope of the PPF will always be negative; if production of product A increases then
production of product B will have to decrease accordingly.
Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy may be able to produce for itself all of the goods and services it needs to function using the
PPF as a guide, but this may actually lead to an overall inefficient allocation of resources and hinder
future growth – when considering the benefits of trade. Through specialization, a country can
concentrate on the production of just a few things that it can do best, rather than dividing up its
resources among everything.
Let us consider a hypothetical world that has just two countries (Country A and Country B) and only two
products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country A has very
little fertile land and an abundance of steel available for car production. Country B, on the other hand,
has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and
cotton, it would need to divide up its resources, and since it requires a great deal of effort to produce
cotton by irrigating its land, Country A would have to sacrifice producing cars – which it is much more
capable of doing. The opportunity cost of producing both cars and cotton is high for Country A, as it will
have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of
producing both products is high because the effort required to produce cars is far greater than that of
producing cotton.
Each country in our example can produce one of these products more efficiently (at a lower cost) than
the other. We can say that Country A has a comparative advantage over Country B in the production of
cars, and Country B has a comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) decide to specialize in producing the goods with which they
have a comparative advantage. If they then trade the goods that they produce for other goods in which
they don't have a comparative advantage, both countries will be able to enjoy both products at a lower
cost. Furthermore, each country will be exchanging the best product it can make for another good or
service that is the best that the other country can produce so quality improves. Specialization and trade
also works when several different countries are involved. For example, if Country C specializes in the
production of corn, it can trade its corn for cars from Country A and cotton from Country B.
Determining how countries exchange goods produced by a comparative advantage ("the best for the
best") is the backbone of international trade theory. This method of exchange via trade is considered an
optimal allocation of resources, whereby national economies, in theory, will no longer be lacking
anything that they need. Like opportunity cost, specialization and comparative advantage also apply to
the way in which individuals interact within an economy.
Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though countries
both have the same amount of inputs. For example, Country A may have a technological advantage that,
with the same amount of inputs (good land, steel, labor), enables the country to easily manufacture
more of both cars and cotton than Country B. A country that can produce more of both goods is said to
have an absolute advantage. Better access to quality resources can give a country an absolute advantage
as can a higher level of education, skilled labor, and overall technological advancement. It is not possible,
however, for a country to have an absolute advantage in everything that it produces, so it will always be
able to benefit from trade.
Explaining Price Elasticity of SupplySupply
Price elasticity of supply (PES) measures the relationship between change in quantity supplied following
a change in priceprice
If supply is elastic (i.e. PES > 1), then producers can increase output without a rise in cost or a time delay
If supply is inelastic (i.e. PES <1), then firms find it hard to change production in a given time period.
What is the formula for calculating price elasticity of supply?

The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price
When Pes > 1, then supply is price elastic
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic following a change in demand
An elastic supply curve
Elasticity of supply
What factors affect the elasticity of supply?
Spare production capacity: If there is plenty of spare capacity then a business can increase output
without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods
and services is most elastic during a recession, when there is plenty of spare labour and capital
resources.
Stocks of finished products and components: If stocks of raw materials and finished products are at a
high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when
stocks are low, dwindling supplies force prices higher because of scarcity
The ease and cost of factor substitution/mobility: If both capital and labour are occupationally mobile
then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched.
E.g. a printing press which can switch easily between printing magazines and greetings cards. Or falling
prices of cocoa encourage farmers to switch into rubber production
Time period and production speed: Supply is more price elastic the longer the time period that a firm is
allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is
determined mainly by planting decisions made months before, and also climatic conditions, which affect
the production yield. In contrast the supply of milk is price elastic because of a short time span from
cows producing milk and products reaching the market place.
Supply elasticity
Summary of key factors affecting price elasticity of supply
Elastic market supply
Here are some topical applications of the concept of price elasticity of supply
Explaining Price Elasticity of DemandDemand
Price elasticity of demand measures the responsiveness of demand after a change in a product's own
price.
What is the formula for calculating the coefficient of price elasticity of demand?
The formula for calculating the co-efficient of elasticity of demand is:
Percentage change in quantity demanded divided by the percentage change in price
Since changes in price and quantity usually move in opposite directions, usually we do not bother to put
in the minus sign. We are more concerned with the co-efficient of elasticity of demand rather than the
sign!
How much does quantity demanded change when price changes? By a lot or by a little? Elasticity can
help us understand this important question.
What are the important values for price elasticity of demand?
We use the word "coefficient" to describe the values for price elasticity of demand
If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the
demand curve will be vertical.
If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage
change in price), then demand is inelastic.
If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit
elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at
each price level.
If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic.
For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity
of demand for this price change is –3
Inelastic demand (Ped <1)
Elastic demand (Ped >1)
Perfectly inelastic demand (Ped = zero)
Perfectly elastic demanddemand
Unitary price elasticity of demanddemand
INTRODUCTION
The Great Depression was the worst economic downturn in the history of the industrialized world,
lasting from 1929 to 1939. It began after the stock market crash of October 1929, which sent Wall Street
into a panic and wiped out millions of investors. Over the next several years, consumer spending and
investment dropped, causing steep declines in industrial output and employment as failing companies
laid off workers. By 1933, when the Great Depression reached its lowest point, some 15 million
Americans were unemployed and nearly half the country’s banks had failed.
WHAT CAUSED THE GREAT DEPRESSION?
Throughout the 1920s, the U.S. economy expanded rapidly, and the nation’s total wealth more than
doubled between 1920 and 1929, a period dubbed “the Roaring Twenties.”
The stock market, centered at the New York Stock Exchange on Wall Street in New York City, was the
scene of reckless speculation, where everyone from millionaire tycoons to cooks and janitors poured
their savings into stocks. As a result, the stock market underwent rapid expansion, reaching its peak in
August 1929.
By then, production had already declined and unemployment had risen, leaving stock prices much higher
than their actual value. Additionally, wages at that time were low, consumer debt was proliferating, the
agricultural sector of the economy was struggling due to drought and falling food prices, and banks had
an excess of large loans that could not be liquidated.
The American economy entered a mild recession during the summer of 1929, as consumer spending
slowed and unsold goods began to pile up, which in turn slowed factory production. Nonetheless, stock
prices continued to rise, and by the fall of that year had reached stratospheric levels that could not be
justified by expected future earnings.
STOCK MARKET CRASH OF 1929
On October 24, 1929, as nervous investors began selling overpriced shares en masse, the stock market
crash that some had feared happened at last. A record 12.9 million shares were traded that day, known
as “Black Thursday.”
Five days later, on October 29 or “Black Tuesday,” some 16 million shares were traded after another wave
of panic swept Wall Street. Millions of shares ended up worthless, and those investors who had bought
stocks “on margin” (with borrowed money) were wiped out completely.
As consumer confidence vanished in the wake of the stock market crash, the downturn in spending and
investment led factories and other businesses to slow down production and begin firing their workers.
For those who were lucky enough to remain employed, wages fell and buying power decreased.
Many Americans forced to buy on credit fell into debt, and the number of foreclosures and repossessions
climbed steadily. The global adherence to the gold standard, which joined countries around the world in
a fixed currency exchange, helped spread economic woes from the United States throughout the world,
especially Europe.
BANK RUNS AND THE HOOVER ADMINISTRATION
Despite assurances from President Herbert Hoover and other leaders that the crisis would run its course,
matters continued to get worse over the next three years. By 1930, 4 million Americans looking for work
could not find it; that number had risen to 6 million in 1931.
Meanwhile, the country’s industrial production had dropped by half. Bread lines, soup kitchens and
rising numbers of homeless people became more and more common in America’s towns and cities.
Farmers couldn’t afford to harvest their crops, and were forced to leave them rotting in the fields while
people elsewhere starved.
In the fall of 1930, the first of four waves of banking panics began, as large numbers of investors lost
confidence in the solvency of their banks and demanded deposits in cash, forcing banks to liquidate
loans in order to supplement their insufficient cash reserves on hand.
Bank runs swept the United States again in the spring and fall of 1931 and the fall of 1932, and by early
1933 thousands of banks had closed their doors.
In the face of this dire situation, Hoover’s administration tried supporting failing banks and other
institutions with government loans; the idea was that the banks in turn would loan to businesses, which
would be able to hire back their employees.
ROOSEVELT ELECTED
Hoover, a Republican who had formerly served as U.S. secretary of commerce, believed that government
should not directly intervene in the economy, and that it did not have the responsibility to create jobs or
provide economic relief for its citizens.
In 1932, however, with the country mired in the depths of the Great Depression and some 15 million
people (more than 20 percent of the U.S. population at the time) unemployed, Democrat Franklin D.
Roosevelt won an overwhelming victory in the presidential election.
By Inauguration Day (March 4, 1933), every U.S. state had ordered all remaining banks to close at the
end of the fourth wave of banking panics, and the U.S. Treasury didn’t have enough cash to pay all
government workers. Nonetheless, FDR (as he was known) projected a calm energy and optimism,
famously declaring that “the only thing we have to fear is fear itself.”
Roosevelt took immediate action to address the country’s economic woes, first announcing a four-day
“bank holiday” during which all banks would close so that Congress could pass reform legislation and
reopen those banks determined to be sound. He also began addressing the public directly over the radio
in a series of talks, and these so-called “fireside chats” went a long way towards restoring public
confidence.
During Roosevelt’s first 100 days in office, his administration passed legislation that aimed to stabilize
industrial and agricultural production, create jobs and stimulate recovery.
In addition, Roosevelt sought to reform the financial system, creating the Federal Deposit Insurance
Corporation (FDIC) to protect depositors’ accounts and the Securities and Exchange Commission (SEC) to
regulate the stock market and prevent abuses of the kind that led to the 1929 crash.
THE NEW DEAL: A ROAD TO RECOVERY
Among the programs and institutions of the New Deal that aided in recovery from the Great Depression
were the Tennessee Valley Authority (TVA), which built dams and hydroelectric projects to control
flooding and provide electric power to the impoverished Tennessee Valley region, and the Works
Progress Administration (WPA), a permanent jobs program that employed 8.5 million people from 1935
to 1943.
When the Great Depression began, the United States was the only industrialized country in the world
without some form of unemployment insurance or social security. In 1935, Congress passed the Social
Security Act, which for the first time provided Americans with unemployment, disability and pensions for
old age.
After showing early signs of recovery beginning in the spring of 1933, the economy continued to improve
throughout the next three years, during which real GDP (adjusted for inflation) grew at an average rate
of 9 percent per year.
A sharp recession hit in 1937, caused in part by the Federal Reserve’s decision to increase its
requirements for money in reserve. Though the economy began improving again in 1938, this second
severe contraction reversed many of the gains in production and employment and prolonged the effects
of the Great Depression through the end of the decade.
Depression-era hardships had fueled the rise of extremist political movements in various European
countries, most notably that of Adolf Hitler’s Nazi regime in Germany. German aggression led war to
break out in Europe in 1939, and the WPA turned its attention to strengthening the military
infrastructure of the United States, even as the country maintained its neutrality.
GREAT DEPRESSION ENDS AND WORLD WAR II BEGINS
With Roosevelt’s decision to support Britain and France in the struggle against Germany and the other
Axis Powers, defense manufacturing geared up, producing more and more private sector jobs.
The Japanese attack on Pearl Harbor in December 1941 led to America’s entry into World War II, and the
nation’s factories went back in full production mode.
This expanding industrial production, as well as widespread conscription beginning in 1942, reduced the
unemployment rate to below its pre-Depression level. The Great Depression had ended at last, and the
United States turned its attention to the global conflict of World War II.

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