(2) Eco Term Paper

8/6/2019 (2) Eco Term Paper

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I. Introduction

Economics is the social science that studies the production, distribution, and

consumption of goods and services. The term economics comes from the Ancient Greek for

oikos ("house") and nomos ("custom" or "law"), hence "rules of the house(hold)".

Current economic models developed out of the broader field of political economy in

the late 19th century, owing to a desire to use an empirical approach more akin to the

physical sciences A definition that captures much of modern economics is that of Lionel

Robbins in a 1932 essay: "the science which studies human behavior as a relationship

between ends and scarce means which have alternative uses.

Economics aims to explain how economies work and how economic agents interact.

Economic analysis is applied throughout society, in business and finance but also in crime,

education, the family, health, law, politics, religion, social institutions, and war. The

dominating effect of economics on the social sciences been described as economic

imperialism.

Economic imperialism, in contemporary economics, refers to economic analysis of

seemingly non-economic aspects of life, such as crime, law, irrational behavior, marriage,

prejudice, politics, religion, and war.

This paper aims to give a preview of what comprises the science of economics and

how each economic activity is seen in our daily lives.


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II. Scope of Economics

Macroeconomics

Macroeconomics is a branch of economics that deals with the performance, structure,

and behavior of a national or regional economy as a whole. Along with microeconomics,

macroeconomics is one of the two most general fields in economics. Macroeconomists study

aggregated indicators such as GDP, unemployment rates, and price indices to understand

how the whole economy functions. Macroeconomists develop models that explain the

relationship between such factors as national income, output, consumption, unemployment,

inflation, savings, investment, international trade and international finance. In contrast,

microeconomics is primarily focused on the actions of individual agents, such as firms and

consumers, and how their behavior determines prices and quantities in specific markets.

While macroeconomics is a broad field of study, there are two areas of research that

are emblematic of the discipline: the attempt to understand the causes and consequences of

short-run fluctuations in national income (the business cycle), and the attempt to understand

the determinants of long-run economic growth (increases in national income).

Macroeconomic models and their forecasts are used by both governments and large

corporations to assist in the development and evaluation of economic policy and business

strategy.

Growth

Growth economics studies factors that explain economic growth the increase in

output per capita of a country over a long period of time. The same factors are used to

explain differences in the level of output per capita between countries. Much-studied factors

include the rate of investment, population growth, and technological change. These are

represented in theoretical and empirical forms (as in the neoclassical growth model) and in

growth accounting.

Development of Macroeconomic Theory


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The first published use of the term "macroeconomics" was by the Norwegian

Economist Ragnar Frisch in 1933 and before this, there already was an effort to understand

many of the broad elements of the field.

Keynesianism

Until the 1930s, most economic analysis did not separate out individual behavior

from aggregate behavior. With the Great Depression of the 1930s and the development of the

concept of national income and product statistics, the field of macroeconomics began to

expand. Before that time, comprehensive national accounts, as we know them today, did not

exist. The ideas of the British economist John Maynard Keynes, who worked on explaining

the Great Depression, were particularly influential.

One of the challenges of economics has been a struggle to reconcile macroeconomic

and microeconomic models. Starting in the 1950s, macroeconomists developed micro-based

models of macroeconomic behavior, such as the consumption function. Dutch economist Jan

Tinbergen developed the first national macroeconomic model, which he first built for the

Netherlands and later applied to the United States and the United Kingdom after World War

II. The first global macroeconomic model, Wharton Econometric Forecasting Associates

LINK project, was initiated by Lawrence Klein and was mentioned in his citation for the

Nobel Memorial Prize in Economics in 1980.

Theorists such as Robert Lucas Jr suggested (in the 1970s) that at least some

traditional Keynesian (after John Maynard Keynes) macroeconomic models were

questionable as they were not derived from assumptions about individual behavior, but

instead based on observed past correlations between macroeconomic variables. However,

New Keynesian macroeconomics has generally presented microeconomic models to shore up

their macroeconomic theorizing, and some Keynesians have contested the idea that

microeconomic foundations are essential, if the model is analytically useful. An analogy is

the acceptance of continuous methods in physics despite our knowledge of subatomic

particles.

The various schools of thought are not always in direct competition with one another,

even though they sometimes reach differing conclusions. Macroeconomics is an ever

evolving area of research. The goal of economic research is not to be "right," but rather to be


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useful (Friedman, M. 1953). An economic model, according to Friedman, should accurately

reproduce observations beyond the data used to calibrate or fit the model.

Analytical approaches

The traditional distinction is between two different approaches to economics:

Keynesian economics, focusing on demand; and supply-side economics, focusing on supply.

Neither view is typically endorsed to the complete exclusion of the other, but most schools

do tend clearly to emphasize one or the other as a theoretical foundation.

* Keynesian economics: The first stage of macroeconomics was a period of academic

theory heavily influenced by the economist Keynes. This period focused on aggregate

demand to explain levels of unemployment and the business cycle. That is, business cycle

fluctuations should be reduced through fiscal policy (the government spends more or less

depending on the situation) and monetary policy. Early Keynesian macroeconomics was

"activist," calling for regular use of policy to stabilize the capitalist economy, while some

Keynesians called for the use of incomes policies.

* Neoclassical economics: For decades there existed a split between the Keynesians and

classical economists, the former studying macroeconomics and the latter studying

microeconomics. This schism has been resolved since the late 80s, however, and

macroeconomics has evolved well into its second phase. Keynesian models are now

considered to be outdated and new models have been designed, using the benchmark of

general equilibrium, and are more closely related to microeconomics. The main policy

difference in this second stage of macroeconomics is an increased focus on monetary policy,

such as interest rates and money supply. Mainstream macroeconomic theory today treats the

demand side as more important in the short run and the supply side as more important in the

long run.

Schools of Macroeconomics

* Monetarism, led by Milton Friedman, holds that inflation is always and everywhere a

monetary phenomenon. It rejects fiscal policy because it leads to "crowding out" of the

private sector. Further, it does not wish to combat inflation or deflation by means of active


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taxation. Changes in the level and composition of taxation and government spending can

impact on the following variables in the economy:

Aggregate demand and the level of economic activity

The pattern of resource allocation

The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The

three possible stances of fiscal policy are neutral, expansionary and contractionary:

A neutral stance of fiscal policy implies a balanced budget where G = T (Government

spending = Tax revenue). Government spending is fully funded by tax revenue and overall

the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government

spending (G > T) through a rise in government spending or a fall in taxation revenue or a

combination of the two. This will lead to a larger budget deficit or a smaller budget surplus

than the government previously had, or a deficit if the government previously had a balanced

budget. Expansionary fiscal policy is usually associated with a budget deficit.

Contractionary fiscal policy (G < T) occurs when net government spending is reduced

either through higher taxation revenue or reduced government spending or a combination of

the two. This would lead to a lower budget deficit or a larger surplus than the government

previously had, or a surplus if the government previously had a balanced budget.

Contractionary fiscal policy is usually associated with a surplus.

Methods of funding

Governments spend money on a wide variety of things, from the military and police

to services like education and healthcare, as well as transfer payments such as welfare

benefits.

This expenditure can be funded in a number of different ways:

Taxation

Seignorage, the benefit from printing money

Borrowing money from the population, resulting in a fiscal deficit.

Consumption of fiscal reserves.
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fund a deficit with the release of government bonds, an increase in interest rates across the

market can occur. This is because government borrowing creates higher demand for credit in

the financial markets, causing a higher aggregate demand (AD) due to the lack of disposable

income, contrary to the objective of a budget deficit. This concept is called crowding out.

Alternatively, governments may increase government spending by funding major

construction projects. This can also cause crowding out because of the lost opportunity for a

private investor to undertake the same project. Another problem is the time lag between the

implementation of the policy and detectable effects in the economy. An expansionary fiscal

policy (decreased taxes or increased government spending) is usually intended to produce an

increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead

to inflation. Hence, checks need to be kept in place.

ROLE OF FISCAL POLICY- ITS SIGNIFICANCE TO BUSINESS ECONOMY IN

DEVELOPING COUNTRIES

The main goal of the fiscal policy in developing countries is the promotion of the

highest possible rate of capital formation. Underdeveloped economies are in the

constant deficit of the capital in the economy and thus, in order to have balanced

growth accelerated rate of capital formation is required. For this purpose the fiscal

policy has to be designed in a way to raise the level of aggregate savings and to

reduce the actual and potential consumption of people.

To divert existing resources from unproductive to productive and socially more

desirable uses. Hence, fiscal policy must be blended with planning for development.

To create an equitable distribution of income and wealth in the society.

To protect the economy from the ills of inflation and unhealthy competition from

foreign countries.

To maintain relative price stability through fiscal measures.

The approach to fiscal policy must be aggregate as well as segmental. the sectoral

imbalances can be curbed by appropriate segmental fiscal measures.

The government expenditure on developmental planning projects must be increased.

For this deficit financing can be used. It refers to creation of additional money supply
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either by creation of new money by printing by government or by borrowing from the

central bank.

Public borrowing, loans from foreign nations etc can be used in the development of

the resources for public sector.

Fiscal policy in the developing economy has to operate within the framework of

social, cultural and political conditions which inhibit formation and implementation

of good economic policies.

In order to reduce inequalities of wealth and distribution, taxation must be

progressive and government spending must be welfare-oriented.

The hindrances in the effective implementation of fiscal policy in the developing

countries are loopholes in taxation laws, corrupt tax administration, a high population

growth, extravagant governmental spending on non-developmental items, an

orthodox society etc.

*Monetary policy is the process by which the government,central bank, or monetary

authority of a country controls (i) the supply ofmoney, (ii) availability of money, and (iii)

cost of money or rate of interest, in order to attain a set of objectives oriented towards the

growth and stability of the economy. Monetary theory provides insight into how to craft

optimal monetary policy.

Monetary policy is generally referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of money in

the economy, and a contractionary policy decreases the total money supply. Expansionary

policy is traditionally used to combat unemployment in a recession by lowering interest rates,

while contractionary policy involves raising interest rates in order to combat inflation.

Monetary policy should be contrasted with fiscal policy, which refers to government

borrowing, spending and taxation.

Monetary policy rests on the relationship between the rates of interest in an economy,

that is the price at which money can be borrowed, and the total supply of money. Monetary

policy uses a variety of tools to control one or both of these, to influence outcomes like

economic growth, inflation, exchange rates with other currencies and unemployment. Where

currency is under a monopoly of issuance, or where there is a regulated system of issuing
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currency through banks which are tied to a central bank, the monetary authority has the

ability to alter the money supply and thus influence the interest rate (in order to achieve

policy goals). The beginning of monetary policy as such comes from the late 19th century,

where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or

raises the interest rate. An expansionary policy increases the size of the money supply, or

decreases the interest rate. Furthermore, monetary policies are described as accommodative

in the following cases: if the interest rate set by the central monetary authority is intended to

create economic growth; neutral if it is intended to neither create growth nor combat

inflation; or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing

interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All

have the effect of contracting the money supply; and, if reversed, expand the money supply.

Since the 1970s, monetary policy has generally been formed separately from fiscal policy.

Even prior to the 1970s, the Bretton Woods system still ensured that most nations would

form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank of England,

the European Central Bank, the Federal Reserve System in the United States, the Bank of

Japan orNippon Gink, the Bank of Canada or the Reserve Bank of Australia) exist which

have the task of executing the monetary policy and often independently of the executive. In

general, these institutions are called central banks and often have other responsibilities such

as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails

managing the quantity of money in circulation through the buying and selling of various

credit instruments, foreign currencies or commodities. All of these purchases or sales result

in more or less base currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short

term interest rate target. In other instances, monetary policy might instead entail the targeting

of a specific exchange rate relative to some foreign currency or else relative to gold. For

example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at

which member banks lend to one another overnight; however, the monetary policy of China
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is to target the exchange rate between the Chinese renminbi and a basket of foreign

currencies.

The other primary means of conducting monetary policy include: (i) Discount

window lending (i.e. lender of last resort); (ii) Fractional deposit lending (i.e. changes in the

reserve requirement); (iii) Moral suasion (i.e. cajoling certain market players to achieve

specified outcomes); (iv) "Open mouth operations" (i.e. talking monetary policy with the

market).

Types of monetary policy

In practice, all types of monetary policy involve modifying the amount of base

currency (M0) in circulation. This process of changing the liquidity of base currency through

the open sales and purchases of (government-issued) debt and credit instruments is called

open market operations.

Constant market transactions by the monetary authority modify the supply of

currency and this impacts other market variables such as short term interest rates and the

exchange rate.

The distinction between the various types of monetary policy lies primarily with the

set of instruments and target variables that are used by the monetary authority to achieve

their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnight

debtA given rate of change in the CPI

Price Level TargetingInterest rate on overnight

debtA specific CPI number

Monetary AggregatesThe growth in money

supply

A given rate of change in the CPI

Fixed Exchange RateThe spot price of the

currencyThe spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the gold

price

Mixed Policy Usually interest rates Usually unemployment + CPI change
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The different types of policy are also called monetary regimes, in parallel to exchange

rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard

results in a relatively fixed regime towards the currency of other countries on the gold

standard and a floating regime towards those that are not. Targeting inflation, the price level

or other monetary aggregates implies floating exchange rate unless the management of the

relevant foreign currencies is tracking the exact same variables (such as a harmonized

consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition

such as Consumer Price Index, within a desired range.The inflation target is achieved through periodic adjustments to the Central Bank

interest rate target. The interest rate used is generally the interbank rate at which banks lend

to each other overnight for cash flow purposes. Depending on the country this particular

interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market

operations. Typically the duration that the interest rate target is kept constant will vary

between months and years. This interest rate target is usually reviewed on a monthly or

quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators

in an attempt to forecast economic trends and in so doing keep the market on track towards

achieving the defined inflation target. For example, one simple method of inflation targeting

called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and

the output gap. The rule was proposed by John B. TaylorofStanford University.

The inflation targeting approach to monetary policy approach was pioneered in New

Zealand. It is currently used in Australia, Canada, Chile, the Euro zone, New Zealand,

Norway, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting
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Price level targeting is similar to inflation targeting except that CPI growth in one

year is offset in subsequent years such that over time the price level on aggregate does not

move.

Something similar to price level targeting was tried by Sweden in the 1930s, and

seems to have contributed to the relatively good performance of the Swedish economy during

the Great Depression. As of 2004, no country operates monetary policy based on a price level

target.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the

money supply. This approach was refined to include different classes of money and credit

(M0, M1 etc). In the USA this approach to monetary policy was discontinued with the

selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called

monetarism.

While most monetary policy focuses on a price signal of one form or another, this

approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation to how

rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority

declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate.

Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,

import/export licenses, etc.). In this case there is a black market exchange rate where the

currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central

bank or monetary authority on a daily basis to achieve the target exchange rate. This target

rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until

the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate
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Mixed policy

In practice, a mixed policy approach is most like "inflation targeting". However some

consideration is also given to other goals such as economic growth, unemployment and asset

bubbles. This type of policy was used by the Federal Reserve in 1998.

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This

directly changes the total amount of money circulating in the economy. A central bank can

use open market operations to change the monetary base. The central bank would buy/sell

bonds in exchange for hard currency. When the central bank disburses/collects this hard

currency payment, it alters the amount of currency in the economy, thus altering the

monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be

implemented by changing the proportion of total assets that banks must hold in reserve with

the central bank. Banks only maintain a small portion of their assets as cash available for

immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By

changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes

the availability of loanable funds. This acts as a change in the money supply.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial

institutions within their country. By calling in existing loans or extending new loans, the

monetary authority can directly change the size of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the

nominal interest rates. Monetary authorities in different nations have differing levels of

control of economy-wide interest rates. In the United States, the Federal Reserve can set the

discount rate, as well as achieve the desired Federal funds rate by open market operations.
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This rate has significant effect on other market interest rates, but there is no perfect

relationship. In the United States open market operations are a relatively small part of the

total volume in the bond market.

In other nations, the monetary authority may be able to mandate specific interest rates

on loans, savings accounts or other financial assets. By raising the interest rate(s) under its

control, a monetary authority can contract the money supply, because higher interest rates

encourage savings and discourage borrowing. Both of these effects reduce the size of the

money supply.

Currency board

A currency board is a monetary arrangement which pegs the monetary base of a

country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange

rate, whereby local currency in circulation is backed by foreign currency from the anchor

nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign

currency must be held in reserves with the currency board. This limits the possibility for the

local monetary authority to inflate or pursue other objectives. The principal rationales behind

a currency board are three-fold: (i) To import monetary credibility of the anchor nation; (ii)

To maintain a fixed exchange rate with the anchor nation; (iii) To establish credibility with

the exchange rate (the currency board arrangement is the hardest form of fixed exchange

rates outside of dollarisation).

In theory, it is possible that a country may peg the local currency to more than one

foreign currency; although, in practice this has never happened (and it would be a more

complicated to run than a simple single-currency currency board).

The currency board in question will no longer issue fiat money but instead will only issue a

set number of units of local currency for each unit of foreign currency it has in its vault. The

surplus on thebalance of payments of that country is reflected by higherdeposits local banks

hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at

their local banks. The growth of the domestic money supply can now be coupled to the

additional deposits of the banks at the central bank that equals additional hard foreign

exchange reserves in the hands of the central bank. The virtue of this system is that questions

of currency stability no longer apply. The drawbacks are that the country no longer has the
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ability to set monetary policy according to other domestic considerations, and that the fixed

exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of

economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a

currency board pegged to the Deutschmark in 1992 after gaining independence, and this

policy is seen as a mainstay of that country's subsequent economic success (see Economy of

Estonia for a detailed description of the Estonian currency board). Argentina abandoned its

currency board in January 2002 after a severe recession. This emphasised the fact that

currency boards are not irrevocable, and hence may be abandoned in the face ofspeculation

by foreign exchange traders.

Currency boards have advantages for small, open economies which would find independent

monetary policy difficult to sustain. They can also form a credible commitment to low

inflation.

A gold standard is a special case of a currency board where the value of the national

currency is linked to the value of gold instead of a foreign currency.

Monetary policy theory

It is important for policymakers to make credible announcements and degrade interest

rates as they are non- important and irrelevant in regarding to monetary policies. If private

agents (consumers and firms) believe that policymakers are committed to lowering inflation,

they will anticipate future prices to be lower than otherwise (how those expectations are

formed is an entirely different matter; compare for instance rational expectations with

adaptive expectations). If an employee expects prices to be high in the future, he or she will

draw up a wage contract with a high wage to match these prices. Hence, the expectation of

lower wages is reflected in wage-setting Behavior between employees and employers (lower

wages since prices are expected to be lower) and since wages are in fact lower there is no

demand pull inflation because employees are receiving a smaller wage and there is no cost

push inflation because employers are paying out less in wages.

In order to achieve this low level of inflation, policymakers must have credible

announcements; that is, private agents must believe that these announcements will reflect

actual future policy. If an announcement about low-level inflation targets is made but not
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believed by private agents, wage-setting will anticipate high-level inflation and so wages will

be higher and inflation will rise. A high wage will increase a consumer's demand ( demand

pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a

policymaker's announcements regarding monetary policy are not credible, policy will not

have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an

incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing

economic output outweighs the marginal cost of inflation); however, assuming private agents

have rational expectations, they know that policymakers have this incentive. Hence, private

agents know that if they anticipate low inflation, an expansionist policy will be adopted that

causes a rise in inflation. Consequently, (unless policymakers can make their announcement

of low inflation credible), private agents expect high inflation. This anticipation is fulfilled

through adaptive expectation (wage-setting Behavior);so, there is higher inflation (without

the benefit of increased output). Hence, unless credible announcements can be made,

expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an

independent central bank with low inflation targets (but no output targets). Hence, private

agents know that inflation will be low because it is set by an independent body. Central

banks can be given incentives to meet their targets (for example, larger budgets, a wage

bonus for the head of the bank) in order to increase their reputation and signal a strong

commitment to a policy goal. Reputation is an important element in monetary policy

implementation. But the idea of reputation should not be confused with commitment. While a

central bank might have a favorable reputation due to good performance in conducting

monetary policy, the same central bank might not have chosen any particular form of

commitment (such as targeting a certain range for inflation). Reputation plays a crucial role

in determining how much would markets believe the announcement of a particular

commitment to a policy goal but both concepts should not be assimilated. Also, note that

under rational expectations, it is not necessary for the policymaker to have established its

reputation through past policy actions; as an example, the reputation of the head of the

central bank might be derived entirely from her or his ideology, professional background,

public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. "The
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Optimal Commitment to an Intermediate Monetary Target" in 'Quarterly Journal of

Economics' #100, pp. 1169-1189) that in order to prevent some pathologies related to the

time-inconsistency of monetary policy implementation (in particular excessive inflation), the

head of a central bank should have a larger distaste for inflation than the rest of the economy

on average. Hence the reputation of a particular central bank is not necessary tied to past

performance, but rather to particular institutional arrangements that the markets can use to

form inflation expectations.

Microeconomics

Microeconomics is a branch of economics that studies how individuals, households

and firms make decisions to allocate limited resources, typically in markets where goods or

services are being bought and sold. Microeconomics examines how these decisions and

behaviors affect the supply and demand for goods and services, which determines prices; and

how prices, in turn, determine the supply and demand of goods and services.

Macroeconomics, on the other hand, involves the "sum total of economic activity,

dealing with the issues of growth, inflation and unemployment, and with national economic

policies relating to these issues and the effects of government actions (such as changing

taxation levels) on them. Particularly in the wake of the Lucas critique, much of modernmacroeconomic theory has been built upon 'microfoundations' i.e. based upon basic

assumptions about micro-level behavior.

One of the goals of microeconomics is to analyze market mechanisms that establish

relative prices amongst goods and services and allocation of limited resources amongst many

alternative uses. Microeconomics analyzes market failure, where markets fail to produce

efficient results, as well as describing the theoretical conditions needed for perfect

competition. Significant fields of study in microeconomics include general equilibrium,

markets under asymmetric information, choice under uncertainty and economic applications

of game theory. Also considered is the elasticity of products


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Markets

In microeconomics, production is the conversion of inputs into outputs. It is an

economic process that uses resources to create a commodity that is suitable for exchange.

This can include manufacturing, storing, shipping, and packaging. Some economists define

production broadly as all economic activity other than consumption. They see every

commercial activity other than the final purchase as some form of production.

Production is a process, and as such it occurs through time and space. Because it is a

flow concept, production is measured as a "rate of output per period of time". There are three

aspects to production processes, including the quantity of the commodity produced, the form

of the good created and the temporal and spatial distribution of the commodity produced.

Opportunity cost expresses the idea that for every choice, the true economic cost is

the next best opportunity. Choices must be made between desirable yet mutually exclusive

actions. It has been described as expressing "the basic relationship between scarcity and

choice. The notion of opportunity cost plays a crucial part in ensuring that scarce resources

are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs:

the real cost of output forgone, lost time, pleasure or any other benefit that provides utility

should also be considered.

In economic theory, factors of production (or productive inputs) are the resources

employed to produce goods and services. Here the rate of output is modeled as a function of

the rate of use of each input employed.

The first factor of production is the time of the entrepreneur, which, when combined

with other factors, determines the rate of output for a particular good or service and the cost

to the entrepreneur of various rates of supply.

The choice by the entrepreneur of the rate and volume of the good or service to

supply is determined by the extent of the market. [Adam Smith] When producing in autarky,

the extent of the market is the demand by the entrepreneur himself. As additional individuals

enter the economy, the market may widen. But, in addition, competitive suppliers might also

enter. It is this dynamic system that determines the production of the good or service, and the

returns to the relevant factors of production.


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Classification of factors can include such broad aggregates as labor, land, capital, the

overall state of technology, and entrepreneurship. The number and definition of factors can

vary, depending on theoretical purpose, empirical emphasis, or school of economics.

The inputs or resources used in the production process are called factors of

production. Possible inputs are typically grouped into six categories. These factors are:

* Raw materials

* Machinery

* Labor services

* Capital goods

* Land

* Entrepreneur

In the short-run, as opposed to the long-run, at least one of these factors of production

is fixed. Examples include major pieces of equipment, suitable factory space, and key

managerial personnel. A variable factor of production is one whose usage rate can be

changed easily. Examples include electrical power consumption, transportation services, and

most raw material inputs. In the "long-run", all of these factors of production can be adjusted

by management. In the short run, a firm's "scale of operations" determines the maximum

number of outputs that can be produced, but in the long run, there are no scale limitations.

Long-run and short-run changes play an important part in economic models.

Economic efficiency

Economic efficiency describes how well a system generates the maximum desired

output a with a given set of inputs and available technology. Efficiency is improved if more

output is generated without changing inputs, or in other words, the amount of "friction" or

"waste" is reduced. Economists look for Pareto efficiency, which is reached when a change

can make someone better off without making anyone worse off.

Economic efficiency is used to refer to a number of related concepts. A system can be

called economically efficient if:

* No one can be made better off without making someone else worse off.


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In more general terms, it is theorized that market incentives, including prices of

outputs and productive inputs, select the allocation of factors of production by comparative

advantage, that is, so that (relatively) low-cost inputs are employed to keep down the

opportunity cost of a given type of output. In the process, aggregate output increases as a by

product or by design. Such specialization of production creates opportunities for gains from

trade whereby resource owners benefit from trade in the sale of one type of output for other,

more highly-valued goods. A measure of gains from trade is the increased output (formally,

the sum of increased consumer surplus and producer profits) from specialization in

production and resulting trade.

Supply and demand, prices and quantities

The supply and demand model describes how prices vary as a result of a balance

between product availability and demand. The graph depicts an increase (that is, right-shift)

in demand from D1 to D2 along with the consequent increase in price and quantity required

to reach a new equilibrium point on the supply curve (S).

The supply and demand model describes how prices vary as a result of a balance

between product availability and demand. The graph depicts an increase (that is, right-shift)

in demand from D1 to D2 along with the consequent increase in price and quantity required

to reach a new equilibrium point on the supply curve (S).

The theory of demand and supply is an organizing principle to explain prices and

quantities of goods sold and changes thereof in a market economy. In microeconomic theory,

it refers to price and output determination in a perfectly competitive market. This has served

as a building block for modeling other market structures and for other theoretical approaches.

For a given market of a commodity, demand shows the quantity that all prospective

buyers would be prepared to purchase at each unit price of the good. Demand is often

represented using a table or a graph relating price and quantity demanded (see boxed figure).

Demand theory describes individual consumers as rationally choosing the most preferred

quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility

maximization' (with income as the constraint on demand). Here, utility refers to the

(hypothesized) preference relation for individual consumers. Utility and income are then used

to model hypothesized properties about the effect of a price change on the quantity


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demanded. The law of demand states that, in general, price and quantity demanded in a given

market are inversely related. In other words, the higher the price of a product, the less of it

people would be able and willing to buy of it (other things unchanged). As the price of a

commodity rises, overall purchasing power decreases (the income effect) and consumers

move toward relatively less expensive goods (the substitution effect). Other factors can also

affect demand; for example an increase in income will shift the demand curve outward

relative to the origin, as in the figure.

Supply is the relation between the price of a good and the quantity available for sale

from suppliers (such as producers) at that price. Supply is often represented using a table or

graph relating price and quantity supplied. Producers are hypothesized to be profit-

maximizers, meaning that they attempt to produce the amount of goods that will bring them

the highest profit. Supply is typically represented as a directly proportional relation between

price and quantity supplied (other things unchanged). In other words, the higher the price at

which the good can be sold, the more of it producers will supply. The higher price makes it

profitable to increase production. At a price below equilibrium, there is a shortage of quantity

supplied compared to quantity demanded. This pulls the price up. At a price above

equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This

pushes the price down. The model of supply and demand predicts that for given supply and

demand curves, price and quantity will stabilize at the price that makes quantity supplied

equal to quantity demanded. This is at the intersection of the two curves in the graph above,

market equilibrium.

For a given quantity of a good, the price point on the demand curve indicates the

value, or marginal utility to consumers for that unit of output. It measures what the consumer

would be prepared to pay for the corresponding unit of the good. The price point on the

supply curve measures marginal cost, the increase in total cost to the supplier for the

corresponding unit of the good. The price in equilibrium is determined by supply and

demand. In a perfectly competitive market, supply and demand equate cost and value at

equilibrium.

Demand and supply can also be used to model the distribution of income to the

factors of production, including labor and capital, through factor markets. In a labor market

for example, the quantity of labor employed and the price of labor (the wage rate) are


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modeled as set by the demand for labor (from business firms etc. for production) and supply

of labor (from workers).

Demand and supply are used to explain the behavior of perfectly competitive

markets, but their usefulness as a standard of performance extends to any type of market.

Demand and supply can also be generalized to explain variables applying to the whole

economy, for example, quantity of total output and the general price level, studied in

macroeconomics.

Diminishing marginal utility, given quantification

Diminishing marginal utility, given quantification

In supply-and-demand analysis, the price of a good coordinates production and

consumption quantities. Price and quantity have been described as the most directly

observable characteristics of a good produced for the market. Supply, demand, and market

equilibrium are theoretical constructs linking price and quantity. But tracing the effects of

factors predicted to change supply and demandand through them, price and quantityis a

standard exercise in applied microeconomics and macroeconomics. Economic theory can

specify under what circumstances price serves as an efficient communication device to

regulate quantity. A real-world application might attempt to measure how much variables

that increase supply or demand change price and quantity.

Marginalism is the use of marginal concepts within economics. Marginal concepts are

associated with a specific change in the quantity used of a good or of a service, as opposed to

some notion of the over-all significance of that class of good or service, or of some total

quantity thereof. The central concept of marginalism proper is that of marginal utility, but

marginalists following the lead of Alfred Marshall were further heavily dependent upon the

concept of marginal physical productivity in their explanation of cost; and the neoclassical

tradition that emerged from British marginalism generally abandoned the concept of utility

and gave marginal rates of substitution a more fundamental role in analysis.

Market failure

Pollution can be a simple example of market failure. If costs of production are not

borne by producers but are by the environment, accident victims or others, then prices are

distorted.


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for changes of equilibrium due to a shift in demand or supply. In many areas, some form of

price stickiness is postulated to account for quantities, rather than prices, adjusting in the

short run to changes on the demand side or the supply side. This includes standard analysis of

the business cycle in macroeconomics. Analysis often revolves around causes of such price

stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples

of such price stickiness in particular markets include wage rates in labor markets and posted

prices in markets deviating from perfect competition.

* Macroeconomic instability, addressed below, is a prime source of market failure,

whereby a general loss of business confidence or external shock can grind production and

distribution to a halt, undermining ordinary markets that are otherwise sound.

Some specialized fields of economics deal in market failure more than others. The

economics of the public sector is one example, since where markets fail, some kind of

regulatory or government program is the remedy. Much environmental economics concerns

externalities or "public bads". Policy options include regulations that reflect cost-benefit

analysis or market solutions that change incentives, such as emission fees or redefinition of

property rights. Environmental economics is related to ecological economics but there are

differences.

Most environmental economists have been trained as economists. They apply the

tools of economics to address environmental problems, many of which are related to so-

called market failurescircumstances wherein the "invisible hand" of economics is

unreliable. Most ecological economists have been trained as ecologists, but have expanded

the scope of their work to consider the impacts of humans and their economic activity on

ecological systems and services, and vice-versa. This field takes as its premise that

economics is a strict subfield of ecology. Ecological economics is sometimes described as

taking a more pluralistic approach to environmental problems and focuses more explicitly on

long-term environmental sustainability and issues of scale. Agricultural economics is one the

oldest and most established fields of economics. It is the study of the economic forces that

affect the agricultural sector and the agricultural sector's impact on the rest of the economy. It

is an area of economics that, thanks to the necessity of applying microeconomic theories to

complex real world situations, has given rise to many important advances of more general

applicability; the role of risk and uncertainty, the Behavior of households and links between


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property rights and incentives. More recently policy areas such as international commodity

trade and the environment have been stressed.

Firms

One of the assumptions of perfectly competitive markets is that there are many

producers, none of whom can influence prices or act independently of market forces. In

reality, however, people do not simply trade on markets, they work and produce through

firms. The most obvious kinds of firms are corporations, partnerships and trusts. According

to Ronald Coase people begin to organize their production in firms when the costs of doing

business becomes lower than doing it on the market. Firms combine labor and capital, and

can achieve far greater economies of scale (when producing two or more things is cheaper

than one thing) than individual market trading.

Labor economics seeks to understand the functioning of the market and dynamics for

labor. Labor markets function through the interaction of workers and employers. Labor

economics looks at the suppliers of labor services (workers), the demanders of labor services

(employers), and attempts to understand the resulting patterns of wages and other labor

income and of employment and unemployment, Practical uses include assisting the

formulation of full employment of policies.

Industrial organization studies the strategic behavior of firms, the structure of markets

and their interactions. The common market structures studied include perfect competition,

monopolistic competition, various forms of oligopoly, and monopoly.

Financial economics, often simply referred to as finance, is concerned with the

allocation of financial resources in an uncertain (or risky) environment. Thus, its focus is on

the operation of financial markets, the pricing of financial instruments, and the financial

structure of companies.

Managerial economics applies microeconomic analysis to specific decisions in

business firms or other management units. It draws heavily from quantitative methods such

as operations research and programming and from statistical methods such as regression

analysis in the absence of certainty and perfect knowledge. A unifying theme is the attempt

to optimize business decisions, including unit-cost minimization and profit maximization,

given the firm's objectives and constraints imposed by technology and market conditions.


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Public sector

Public finance is the field of economics that deals with budgeting the revenues and

expenditures of a public sector entity, usually government. The subject addresses such

matters as tax incidence (who really pays a particular tax), cost-benefit analysis of

government programs, effects on economic efficiency and income distribution of different

kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory,

models public-sector behavior analogously to microeconomics, involving interactions of self-

interested voters, politicians, and bureaucrats.

Much of economics is positive, seeking to describe and predict economic phenomena.

Normative economics seeks to identify what is economically good and bad.

Welfare economics is a normative branch of economics that uses microeconomic

techniques to simultaneously determine the allocative efficiency within an economy and the

income distribution associated with it. It attempts to measure social welfare by examining the

economic activities of the individuals that comprise society.

III. Review Of Related Literature

Foreign Literature

Alfred Marshall's Principles of Economics was the most influential textbook in

economics. Marshall defined economics as

"a study of mankind in the ordinary business of life; it examines that part of

individual and social action which is most closely connected with the attainment and with the

use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and onthe other, and more important side, a part of the study of man."

Many other books of the period included in their definitions something about the "study of

exchange and production." Definitions of this sort emphasize that the topics with which

economics is most closely identified concern those processes involved in meeting man's

material needs. Economists today do not use these definitions because the boundaries of


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economics have expanded since Marshall. Economists do more than study exchange and

production, though exchange remains at the heart of economics.

Most contemporary definitions of economics involve the notions of choice and

scarcity. Perhaps the earliest of these is by Lionell Robbins in 1935: "Economics is a science

which studies human behavior as a relationship between ends and scarce means which have

alternative uses." Virtually all textbooks have definitions that are derived from this

definition.

The state, according to Keynesian economics, can help maintain economic growth

and stability in a mixed economy, in which both the public and private sectorsplay important

roles. Keynesian economics seeks to provide solutions to what some consider failures of

laissez-faireeconomic liberalism, which advocates that markets and the private sector

operate best without state intervention. The theories forming the basis of Keynesian

economics were first presented in The General Theory of Employment, Interest and Money,

published in 1936.

In Keynes's theory, some micro-level actions of individuals and firms can lead to

aggregate macroeconomic outcomes in which the economy operates below itspotential

output and growth. Many classical economists had believed in Say's Law, that supply creates

its own demand, so that a "general glut" would therefore be impossible. Keynes contended

that aggregate demand forgoods might be insufficient during economic downturns, leading

to unnecessarily high unemployment and losses of potential output. Keynes argued that

government policies could be used to increase aggregate demand, thus increasing economic

activity and reducing high unemployment and deflation. Keynes's macroeconomic theories

were a response to mass unemployment in 1920s Britain and in 1930s America.

Keynes argued that the solution to depression was to stimulate the economy

("inducement to invest") through some combination of two approaches :

a reduction in interest rates.
http://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Mixed_economyhttp://en.wikipedia.org/wiki/Private_sectorhttp://en.wikipedia.org/wiki/Laissez-fairehttp://en.wikipedia.org/wiki/Economic_liberalismhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/Microeconomicshttp://en.wikipedia.org/wiki/Macroeconomicshttp://en.wikipedia.org/wiki/Potential_outputhttp://en.wikipedia.org/wiki/Potential_outputhttp://en.wikipedia.org/wiki/Classical_economicshttp://en.wikipedia.org/wiki/Say's_Lawhttp://en.wikipedia.org/wiki/Aggregate_demandhttp://en.wikipedia.org/wiki/Good_(economics)http://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Deflation_(economics)http://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Mixed_economyhttp://en.wikipedia.org/wiki/Private_sectorhttp://en.wikipedia.org/wiki/Laissez-fairehttp://en.wikipedia.org/wiki/Economic_liberalismhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/Microeconomicshttp://en.wikipedia.org/wiki/Macroeconomicshttp://en.wikipedia.org/wiki/Potential_outputhttp://en.wikipedia.org/wiki/Potential_outputhttp://en.wikipedia.org/wiki/Classical_economicshttp://en.wikipedia.org/wiki/Say's_Lawhttp://en.wikipedia.org/wiki/Aggregate_demandhttp://en.wikipedia.org/wiki/Good_(economics)http://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Deflation_(economics)


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Government investment in infrastructure - the injection of income results in more

spending in the general economy, which in turn stimulates more production and

investment involving still more income and spending and so forth. The initial

stimulation starts a cascade of events, whose total increase in economic activity is a

multiple of the original investment.[1]

A central conclusion of Keynesian economics is that in some situations, no strong

automatic mechanism moves output and employment towards full employment levels. This

conclusion conflicts with economic approaches that assume a general tendency towards an

equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with

a micro foundation, the conditions ofGeneral equilibrium allow for price adjustment to

achieve this goal.

The New Classical Macroeconomics movement, which began in the late 1960s and early

1970s, criticized Keynesian theories, while "New Keynesian" economics have sought to base

Keynes's idea on more rigorous theoretical foundations.

More broadly, Keynes saw his as ageneraltheory, in which utilization of resources could be

high or low, whereas previous economics focused on theparticularcase of full utilization.

Local Literature

No available resources.
http://en.wikipedia.org/wiki/Keynesian_economics#cite_note-0http://en.wikipedia.org/wiki/Full_employmenthttp://en.wikipedia.org/wiki/Economic_equilibriumhttp://en.wikipedia.org/wiki/Neoclassical_synthesishttp://en.wikipedia.org/wiki/General_equilibriumhttp://en.wikipedia.org/wiki/Keynesian_economics#cite_note-0http://en.wikipedia.org/wiki/Full_employmenthttp://en.wikipedia.org/wiki/Economic_equilibriumhttp://en.wikipedia.org/wiki/Neoclassical_synthesishttp://en.wikipedia.org/wiki/General_equilibrium


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IV. Conclusion:

We therefore conclude, that the understanding of how our government our economy

works is a good way of exercising our citizenship membership to a political society of

whatever race that we belong to. Knowledge in economic systems allows us to be more

aware and be more cautious in taking care of our business transactions in a way that it also

allows us to be more sensitive of what our actions may bring to our neighbors. Being

members of a Christian society, we should exercise a healthy and friendly competence when

it comes to the developing of our nations economy. A nation should work as one to reach

economic success.

V. Recommendation

We highly recommend this paper to all students of any levels who want to have an

overview of what Economics is. We really hope that this paper will help them broaden their

knowledge of some governmental functions as such, in a way that it will develop their critical

minds to think of some measures that can possibly resolve our nations economic crisis.

VI. Problems Encountered

The problems in making this research paper are as follows:

Conflict of schedules

Unavailable resources(information)

Other projects

Procrastination

Late release of the Term Paper title, thus it became a conflict for us. Cramming.


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INTRODUCTION TO ECONOMICS

ECONOMICS 11B16

MWF 4:30 5:30

Members

Mariel Galanao

Mc Christian Mano

Ronald Barnillo

Rian Paul NoblezaClark Vincent Lacsamana

Christi Anne Pamela Ledesma

(2) Eco Term Paper

Documents

Transcript of (2) Eco Term Paper