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Main article: Markets Economists study trade, production and consumption decisions, such as those that occur in a traditional marketplace. In Virtual Markets, buyer and seller are not present and trade via intermediates and electronic information. Pictured: São Paulo Stock Exchange.Microeconomics examines how entities, forming a market structure, interact within a market to create a market system. These entities include private and public players with various classifications, typically operating under scarcity of tradeable units and government regulation. The item traded may be a tangible product such as apples or a service such as repair services, legal counsel, or entertainment. In theory, in a free market the aggregates (sum of) of quantity demanded by buyers and quantity supplied by sellers will be equal and reach economic equilibrium over time in reaction to price changes; in practice, various issues may prevent equilibrium, and any equilibrium reached may not necessarily morally equitable. For example, if the supply of healthcare services is limited by external factors, the equilibrium price may be unaffordable for many who desire it but cannot pay for it. Various market structures exist. In perfectly competitive markets, no participants are large enough to have the market power to set the price of a homogeneous product. In other words, every participant is a "price taker" as no participant influences the price of a product. In the real world, markets often experience imperfect competition. Forms include monopoly (in which there is only one seller of a good), duopoly (in which there are only two sellers of a good), oligopoly (in which there are few sellers of a good), monopolistic competition (in which there are many sellers producing highly differentiated goods), monopsony (in which there is only one buyer of a good), and oligopsony (in which there are few buyers of a good). Unlike perfect competition, imperfect competition invariably means market power is unequally distributed. Firms under imperfect competition have the potential to be "price makers", which means that, by holding a disproportionately high share of market power, they can influence the prices of their products. Microeconomics studies individual markets by simplifying the economic system by assuming that activity in the market being analysed does not affect other markets. This method of analysis is known as partial-equilibrium analysis (supply and demand). This method aggregates (the sum of all activity) in only one market. General-equilibrium theory studies various markets and their behaviour. It aggregates (the sum of all activity) across all markets. This method studies both changes in markets and their interactions leading towards equilibrium.[32] Production, cost, and efficiencyMain articles: Production theory basics, Opportunity cost, Economic efficiency, and Production–possibility frontier In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses inputs to create a commodity or a service for exchange or direct use. Production is a flow and thus a rate of output per period of time. Distinctions include such production alternatives as for consumption (food, haircuts, etc.) vs. investment goods (new tractors, buildings, roads, etc.), public goods (national defense, small-pox vaccinations, etc.) or private goods (new computers, bananas, etc.), and "guns" vs. "butter". Opportunity cost refers to the economic cost of production: the value of the next best opportunity foregone. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice.".[33] The opportunity cost of an activity is an element in ensuring that scarce resources are used efficiently, such that the cost is weighed against the value of that activity in deciding on more or less of it. Opportunity costs are not restricted to monetary or financial costs but could be measured by the real cost of output forgone, leisure, or anything else that provides the alternative benefit (utility).[34] Inputs used in the production process include such primary factors of production as labour services, capital (durable produced goods used in production, such as an existing factory), and land (including natural resources). Other inputs may include intermediate goods used in production of final goods, such as the steel in a new car. Economic efficiency describes how well a system generates desired output 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 "waste" is reduced. A widely accepted general standard is Pareto efficiency, which is reached when no further change can make someone better off without making someone else worse off. An example production–possibility frontier with illustrative points marked.The production–possibility frontier (PPF) is an expository figure for representing scarcity, cost, and efficiency. In the simplest case an economy can produce just two goods (say "guns" and "butter"). The PPF is a table or graph (as at the right) showing the different quantity combinations of the two goods producible with a given technology and total factor inputs, which limit feasible total output. Each point on the curve shows potential total output for the economy, which is the maximum feasible output of one good, given a feasible output quantity of the other good. Scarcity is represented in the figure by people being willing but unable in the aggregate to consume beyond the PPF (such as at X) and by the negative slope of the curve.[35] If production of one good increases along the curve, production of the other good decreases, an inverse relationship. This is because increasing output of one good requires transferring inputs to it from production of the other good, decreasing the latter. The slope of the curve at a point on it gives the trade-off between the two goods. It measures what an additional unit of one good costs in units forgone of the other good, an example of a real opportunity cost. Thus, if one more Gun costs 100 units of butter, the opportunity cost of one Gun is 100 Butter. Along the PPF, scarcity implies that choosing more of one good in the aggregate entails doing with less of the other good. Still, in a market economy, movement along the curve may indicate that the choice of the increased output is anticipated to be worth the cost to the agents. By construction, each point on the curve shows productive efficiency in maximizing output for given total inputs. A point inside the curve (as at A), is feasible but represents production inefficiency (wasteful use of inputs), in that output of one or both goods could increase by moving in a northeast direction to a point on the curve. Examples cited of such inefficiency include high unemployment during a business-cycle recession or economic organization of a country that discourages full use of resources. Being on the curve might still not fully satisfy allocative efficiency (also called Pareto efficiency) if it does not produce a mix of goods that consumers prefer over other points. Much applied economics in public policy is concerned with determining how the efficiency of an economy can be improved. Recognizing the reality of scarcity and then figuring out how to organize society for the most efficient use of resources has been described as the "essence of economics", where the subject "makes its unique contribution."[36] SpecializationMain articles: Division of labour, Comparative advantage, and Gains from trade A map showing the main trade routes for goods within late medieval Europe.Specialization is considered key to economic efficiency based on theoretical and empirical considerations. Different individuals or nations may have different real opportunity costs of production, say from differences in stocks of human capital per worker or capital/labour ratios. According to theory, this may give a comparative advantage in production of goods that make more intensive use of the relatively more abundant, thus relatively cheaper, input. Even if one region has an absolute advantage as to the ratio of its outputs to inputs in every type of output, it may still specialize in the output in which it has a comparative advantage and thereby gain from trading with a region that lacks any absolute advantage but has a comparative advantage in producing something else. It has been observed that a high volume of trade occurs among regions even with access to a similar technology and mix of factor inputs, including high-income countries. This has led to investigation of economies of scale and agglomeration to explain specialization in similar but differentiated product lines, to the overall benefit of respective trading parties or regions.[37] The general theory of specialization applies to trade among individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be a corresponding division of labour with different work groups specializing, or correspondingly different types of capital equipment and differentiated land uses.[38] An example that combines features above is a country that specializes in the production of high-tech knowledge products, as developed countries do, and trades with developing nations for goods produced in factories where labour is relatively cheap and plentiful, resulting in different in opportunity costs of production. More total output and utility thereby results from specializing in production and trading than if each country produced its own high-tech and low-tech products. Theory and observation set out the conditions such that market prices of outputs and productive inputs select an allocation of factor inputs by comparative advantage, so that (relatively) low-cost inputs go to producing low-cost outputs. In the process, aggregate output may increase as a by-product or by design.[39] 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 income levels that trade may facilitate.[40] Supply and demandMain article: Supply and demand 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).Prices and quantities have been described as the most directly observable attributes of goods produced and exchanged in a market economy.[41] The theory of supply and demand is an organizing principle for explaining how prices coordinate the amounts produced and consumed. In microeconomics, it applies to price and output determination for a market with perfect competition, which includes the condition of no buyers or sellers large enough to have price-setting power. For a given market of a commodity, demand is the relation of the quantity that all buyers would be prepared to purchase at each unit price of the good. Demand is often represented by a table or a graph showing price and quantity demanded (as in the 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 and wealth as the constraints on demand). Here, utility refers to the hypothesized relation of each individual consumer for ranking different commodity bundles as more or less preferred. The law of demand states that, in general, price and quantity demanded in a given market are inversely related. That is, the higher the price of a product, the less of it people would be prepared to buy of it (other things unchanged). As the price of a commodity falls, consumers move toward it from relatively more expensive goods (the substitution effect). In addition, purchasing power from the price decline increases ability to buy (the income effect). Other factors can change demand; for example an increase in income will shift the demand curve for a normal good outward relative to the origin, as in the figure. All determinants are predominantly taken as constant factors of demand and supply. Supply is the relation between the price of a good and the quantity available for sale at that price. It may be represented as a table or graph relating price and quantity supplied. Producers, for example business firms, are hypothesized to be profit-maximizers, meaning that they attempt to produce and supply 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). That is, the higher the price at which the good can be sold, the more of it producers will supply, as in the figure. The higher price makes it profitable to increase production. Just as on the demand side, the position of the supply can shift, say from a change in the price of a productive input or a technical improvement. The "Law of Supply" states that, in general, a rise in price leads to an expansion in supply and a fall in price leads to a contraction in supply. Here as well, the determinants of supply, such as price of substitutes, cost of production, technology applied and various factors inputs of production are all taken to be constant for a specific time period of evaluation of supply. Market equilibrium occurs where quantity supplied equals quantity demanded, the intersection of the supply and demand curves in the figure above. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This is posited to bid 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. Similarly, demand-and-supply theory predicts a new price-quantity combination from a shift in demand (as to the figure), or in supply. For a given quantity of a consumer good, the point on the demand curve indicates the value, or marginal utility, to consumers for that unit. It measures what the consumer would be prepared to pay for that unit.[42] The corresponding 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 marginal cost and marginal utility at equilibrium.[43] On the supply side of the market, some factors of production are described as (relatively) variable in the short run, which affects the cost of changing output levels. Their usage rates can be changed easily, such as electrical power, raw-material inputs, and over-time and temp work. Other inputs are relatively fixed, such as plant and equipment and key personnel. In the long run, all inputs may be adjusted by management. These distinctions translate to differences in the elasticity (responsiveness) of the supply curve in the short and long runs and corresponding differences in the price-quantity change from a shift on the supply or demand side of the market. Marginalist theory, such as above, describes the consumers as attempting to reach most-preferred positions, subject to income and wealth constraints while producers attempt to maximize profits subject to their own constraints, including demand for goods produced, technology, and the price of inputs. For the consumer, that point comes where marginal utility of a good, net of price, reaches zero, leaving no net gain from further consumption increases. Analogously, the producer compares marginal revenue (identical to price for the perfect competitor) against the marginal cost of a good, with marginal profit the difference. At the point where marginal profit reaches zero, further increases in production of the good stop. For movement to market equilibrium and for changes in equilibrium, price and quantity also change "at the margin": more-or-less of something, rather than necessarily all-or-nothing. Other applications of demand and supply include the distribution of income among the factors of production, including labour and capital, through factor markets. In a competitive labour market for example the quantity of labour employed and the price of labour (the wage rate) depends on the demand for labour (from employers for production) and supply of labour (from potential workers). Labour economics examines the interaction of workers and employers through such markets to explain patterns and changes of wages and other labour income, labour mobility, and (un)employment, productivity through human capital, and related public-policy issues.[44] Demand-and-supply analysis is used to explain the behavior of perfectly competitive markets, but as a standard of comparison it can be extended to any type of market. It can also be generalized to explain variables across the economy, for example, total output (estimated as real GDP) and the general price level, as studied in macroeconomics.[45] Tracing the qualitative and quantitative effects of variables that change supply and demand, whether in the short or long run, is a standard exercise in applied economics. Economic theory may also specify conditions such that supply and demand through the market is an efficient mechanism for allocating resources.[46] FirmsMain articles: Theory of the firm, Industrial organization, Business economics, and Managerial economics People frequently do not trade directly on markets. Instead, on the supply side, they may work in and produce through firms. The most obvious kinds of firms are corporations, partnerships and trusts. According to Ronald Coase people begin to organise their production in firms when the costs of doing business becomes lower than doing it on the market.[47] Firms combine labour and capital, and can achieve far greater economies of scale (when the average cost per unit declines as more units are produced) than individual market trading. In perfectly competitive markets studied in the theory of supply and demand, there are many producers, none of which significantly influence price. Industrial organization generalizes from that special case to study the strategic behavior of firms that do have significant control of price. It considers the structure of such markets and their interactions. Common market structures studied besides perfect competition include monopolistic competition, various forms of oligopoly, and monopoly.[48] 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.[49] Uncertainty and game theoryMain articles: Information economics, Game theory, and Financial economics Uncertainty in economics is an unknown prospect of gain or loss, whether quantifiable as risk or not. Without it, household behavior would be unaffected by uncertain employment and income prospects, financial and capital markets would reduce to exchange of a single instrument in each market period, and there would be no communications industry.[50] Given its different forms, there are various ways of representing uncertainty and modelling economic agents' responses to it.[51] Game theory is a branch of applied mathematics that considers strategic interactions between agents, one kind of uncertainty. It provides a mathematical foundation of industrial organization, discussed above, to model different types of firm behavior, for example in an oligopolistic industry (few sellers), but equally applicable to wage negotiations, bargaining, contract design, and any situation where individual agents are few enough to have perceptible effects on each other. As a method heavily used in behavioral economics, it postulates that agents choose strategies to maximize their payoffs, given the strategies of other agents with at least partially conflicting interests.[52][53] In this, it generalizes maximization approaches developed to analyze market actors such as in the supply and demand model and allows for incomplete information of actors. The field dates from the 1944 classic Theory of Games and Economic Behavior by John von Neumann and Oskar Morgenstern. It has significant applications seemingly outside of economics in such diverse subjects as formulation of nuclear strategies, ethics, political science, and evolutionary biology.[54] Risk aversion may stimulate activity that in well-functioning markets smooths out risk and communicates information about risk, as in markets for insurance, commodity futures contracts, and financial instruments. Financial economics or simply finance describes the allocation of financial resources. It also analyzes the pricing of financial instruments, the financial structure of companies, the efficiency and fragility of financial markets,[55] financial crises, and related government policy or regulation.[56] Some market organizations may give rise to inefficiencies associated with uncertainty. Based on George Akerlof's "Market for Lemons" article, the paradigm example is of a dodgy second-hand car market. Customers without knowledge of whether a car is a "lemon" depress its price below what a quality second-hand car would be.[57] Information asymmetry arises here, if the seller has more relevant information than the buyer but no incentive to disclose it. Related problems in insurance are adverse selection, such that those at most risk are most likely to insure (say reckless drivers), and moral hazard, such that insurance results in riskier behavior (say more reckless driving).[58] Both problems may raise insurance costs and reduce efficiency in driving otherwise willing transactors from the market ("incomplete markets"). Moreover, attempting to reduce one problem, say adverse selection by mandating insurance, may add to another, say moral hazard. Information economics, which studies such problems, has relevance in subjects such as insurance, contract law, mechanism design, monetary economics, and health care.[58] Applied subjects include market and legal remedies to spread or reduce risk, such as warranties, government-mandated partial insurance, restructuring or bankruptcy law, inspection, and regulation for quality and information disclosure.[59][52] Market failureMain articles: Market failure, Government failure, Information economics, Environmental economics, and Agricultural economics 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.The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently, the following categories emerge in the main texts.[60] Information asymmetries and incomplete markets may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies, as discussed above. Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, is an extreme case of failure of competition as a restraint on producers. Extreme economies of scale are one possible cause. Public goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time. Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities.[61] Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply.[62] 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 labour markets and posted prices in markets deviating from perfect competition. Environmental scientist sampling waterSome specialised fields of economics deal in market failure more than others. The economics of the public sector is one example. 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.[63] Public sectorMain articles: Economics of the public sector and Public finance See also: Welfare economics 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.[64] Much of economics is positive, seeking to describe and predict economic phenomena. Normative economics seeks to identify what economies ought to be like. 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.[65] |
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