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Economy
- The wealth and resources of a country
especially in terms of production, distribution
and consumption of goods and services
Economics
- Social science concerned with the description
and analysis of how goods services are
produced, distributed and consumed.
- Economics is the study of how humans
make decisions in the face of scarcity.
These can be individual decisions, family
decisions, business decisions,
or societal decisions.
- If you look around carefully,
you will see that scarcity is
a fact of life.
NEEDS
are things that people require to survive. If a human body does not have those things, the body cannot function, will die.
WANTS
are things that a person would like to have but are not needed for survival.
SCARCITY
means that human wants for goods, services, and resources exceed what is available. Scarcity is the inability to satisfy all our wants.
Wants & Needs Drive The Economy
A consumer needs clothes so they buy from a
business and put money into the economy,
but when a consumer wants designer clothes
they spend more money and therefore put
more money into the economy.
Resources, such as labor, land,
entrepreneurship, tools and raw materials are
necessary to produce the goods and services
we want, but they exist in limited supply.
Of course, the ultimate scarce resource is…
time — everyone, rich or poor, has just 24
hours in the day to try to acquire the goods
they want. At any point in time, there is a finite
amount of resources available.
“We always want more than we can get,
so we face scarcity.”
Faced with scarcity, we must make choices
We must choose among the available
alternatives. The choices we make depend on
the incentives we face. We have thus arrived
at the definition of economics as provided in
the learning unit.
To summarize, Economics is the social
science that studies the choices that
individuals, businesses, governments, and
entire societies make when they cope with
scarcity ; the incentives that influence those
choices; and the arrangements that
coordinate them.
Microeconomics
[Micro: Small scale; Localized]
The study of the choices that individuals and
businesses make and the way these choices
interact and are influenced by governments.
Microeconomics shows how and why different
goods have different values, how individuals
and businesses conduct and benefit from
efficient production and exchange, and how
individuals best coordinate and cooperate with
one another.
Choices in the Social Media Age
Economics is greatly impacted by how well
information travels through society. Today,
social media giants are major forces on the
information superhighway.
Choices depend on information we have
available at any given moment.
Economists call this “imperfect” because we
rarely have all the data we need to make
perfect decisions.
Despite the lack of perfect information, we still
make hundreds of decisions a day.
Choices and Decisions in the SM Age
Choice
act of selecting or making a decision when faced with two or more possibilities.
Decisions are responses to many different choices.
Positive And Normative Economics
Microeconomics can be applied in a positive or normative sense.
POSITIVE NORMATIVE
describes and explains various economic phenomena. focuses on the value of economic fairness, or what the economy "should be" or "ought to be." is based on fact and can be proved. is based on value judgments seeks to understand behavior without making judgments about outcomes. analyzes outcomes of economic behavior, evaluates them as good or bad and sometimes prescribes a course of action. e.g. workers’ wages is $5 per hour. e.g. if workers’ wages should be more than $10 per hour. could help an investor see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. could explain why a higher minimum wage might force The Wendy's Company to hire fewer workers.
Positive microeconomics describes economic
behavior and explains what to expect if certain
conditions change or it is based on economic
phenomena.
If a manufacturer raises the prices of cars,
positive microeconomics says consumers will
tend to buy fewer than before.
If a major copper mine collapses in South
America, the price of copper will tend to
increase, because supply is restricted.
What is Microeconomics?
- Studies the behavior of individual
consumers, producers etc. It explains
consumption, production, allocation and the
pricing of goods. -- Price theory.
- Study of how individuals and businesses
make choices regarding the best use of
limited resources.
Microeconomics in real life:
- How a local business decides to allocate their funds.
- How a city decides to spend a government surplus.
- How does a housewife accomplish her normal routine.
Birth Of Economic Theory: Classical E.
Economic theory saw its birth during the
mid-1700s and 1800s. From this era, two
important economists emerged.
ADAM SMITH “Father of Economics”
Wealth of the Nations (1776) “The bible in economics ”
First is Adam Smith of
Scotland, who is considered
the most important
personality in the history of
economics. Responsible for
the recognition of
economics as a separate
body of knowledge.
JOHN STUART MILL
Developed the basic analysis
of the political economy or
the importance of a state's
role in its national economy.
KARL MARX
Greatly influenced by the
conditions brought about by
the Industrial Revolution
upon the working classes.
Das Kapital, centerpiece
from which major socialist
thoughts were developed.
CAPITALISM - Private ownership in which the free market alone controls the production of goods&services. MARXISM - Examines the effect of capitalism on the Labor, productivity, and economic development and argues for a worker revolution to overturn capitalism in favor of communism. COMMUNISM - Karl Marx and Friedrich Engels and advocated the usage of resources of society, by society and for society. Advocating for a classless system in which the means of production are owned communally and private property is nonexistent or severely curtailed. Opposition to liberal democracy and capitalism. [Russia, China, North Korea]
Neoclassical Economics
- A broad theory that focuses on supply and
demand as the driving forces behind the
production, pricing, and consumption of goods
and services.
- A dominant economic theory that argues, as
the consumers goal is utility maximization and
the organizations goal is profit maximization,
the customer is ultimately in control of market
forces such as price and demand.
- The theory relates the supply and demand to
an individuals rationality and ability to
maximize utility.
- Rationality, for economists, simply means
that when you make a choice, you will choose
the thing you like best.
Buyers attempt to maximize their gains from getting goods, and they do this by increasing their purchases of a good until what they gain from an extra unit is just balanced by what they have to give up to obtain it.
UTILITY - the satisfaction associated with the
consumption of goods and services.
Supply Demand
is the quantity of a product that producers are willing and able to provide at different market prices over a period of time. is the quantity of a product that producers are willing and able to provide at different market prices over a period of time.
Aggregate Supply Aggregate Demand
An economy's gross domestic product (GDP), total amount a nation produces and sells. The total amount spent on domestic goods and services in an economy.
Post-Keynesian Economics (1940s-1950s)
- After World War II, the Post Keynesian
Period saw the development of rules and
regulations of different private and public
views are known as the post-Keynesian
“mainstream economics”. This peri
institutions. This period introduced major
post-Keynesian neoclassical economists;
whose od welcomed various economists like
Paul A. Samuelson, Kenneth J. Arrow, James
Tobin and Lawrence Klein. Intellectual
products of the era include Joan Robinson
and Michael Kolechi.
- Combination of neoclassical economics and
Keynesian economics, the mainstream
economic approach is doggedly
nonjudgmental about people's preferences:
what the individual wants is presumed to be
good for that individual.
Economists
Financial experts who study market activity.
Their primary responsibilities include
collecting and analyzing financial and
socioeconomic data, advising businesses and
governments on economic decisions, and
developing models for economic forecasting.
How does an economist think?
Economists evaluate the “cost” of individual
and social choices to determine the best
choices for themselves or others in the face of
this scarcity.
The Division of and Specialization of Labor
Smith introduced the concept
of division of labor. -which
means that the way one
produces a good or service is
divided into a number of tasks
that different workers perform,
instead of all the tasks being
done by the same person.
When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity/output.
Smith offered three reasons.
First, specialization
- In a particular small job allows workers to
focus on the parts of the production process
where they have an advantage. People have
different skills, talents, and interests, so they
will be better at some jobs than at others.
The particular advantages may be based on
educational choices, which are in turn shaped
by interests and talents.
Second, workers who specialize in certain
tasks often learn to produce more quickly and with higher quality.
- This pattern holds true for many workers,
including assembly line laborers who build
cars, in salons, hospitals etc.
- In fact, specialized workers often know their
jobs well enough to suggest innovative ways
to do their work faster and better.
- This similar pattern often operates within
businesses.
- In many cases, a business that focuses on
one or a few products (referred as its “ core
competency ”) is more successful than firms
that try to make a wide range of products.
Third, specialization allows businesses to take
advantage of economies of scale ,
which means that for many goods, as the
level of production increases, the average
cost of producing each individual unit
declines.
- For example, if a factory produces only 100
cars per year, each car will be quite expensive
to make on average. However, if a factory
produces 50,000 cars each year, then it can
set up an assembly line with huge machines
and workers performing specialized tasks,
and the average cost of production per car will
be lower.
ECONOMIES OF SCALE - when the average
cost of producing each individual unit declines as total output increases.
Trade and Markets
- Specialization only makes sense, though, if
workers can use the pay they receive for
doing their jobs to purchase the other goods
and services that they need. In short,
specialization requires trade.
iPod or MP3 player, download the music, and listen. If you need a jacket—you just buy the jacket and wear it.
- Instead of acquiring all the knowledge and
skills involved in producing all of the goods
and services that you wish to consume, the
market allows us to learn a specialized set of
skills then use the pay we receive to buy the
goods and services we need or want.
John Maynard Keynes (1883–1946)
One of the greatest economists
of the twentieth century, pointed
out that economics is not just a
subject area but also a way of
thinking.
Keynes famously wrote in the introduction to a
fellow economist’s book: “[Economics] is a
method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.”
In other words, economics teaches you
how to think, not what to think.
TOPIC 3: THE CONCEPT OF SCARCITY MicroEconomics Scarcity of means to satisfy given ends is an almost ever present condition of human nature.
Budget
An estimate of income and expenditure for a set period of time.
Budget Constraint
All possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10. The relative price of burgers & bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets. Any point outside the constraint is what? not affordable , because it would cost more money than Alphonso has in his budget. Point Quantity of Burgers ($2) Quantity of Bus Tickets ($0.50) A 5 0 B 4 4 C 3 8 D 2 12 E 1 16 F 0 20 This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount. The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers). If we connect all the points between A and F, we get Alphonso's budget constraint. The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets.
Trade-off
A sacrifice that must be made to get a certain product or experience. A person gives up the opportunity to buy 'good B,' because they want to buy 'good A' instead.
Opportunity Cost
The potential forgone profit from a missed opportunity—the result of choosing one alternative and forgoing another.
The Concept of Opportunity Cost
Economists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. A fundamental principle of economics is that every choice has an opportunity cost. In short, opportunity cost is all around us and part of human existence.
Marginal Analysis
An examination of the associated costs and potential benefits of specific business activities or financial decisions. The goal is to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them.
For example, if a company has room in its budget for another employee and is considering hiring another person to work in a factory, a marginal analysis indicates that hiring that person provides a net marginal benefit. In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “$5 a day,” you might make different choices. Most choices involve marginal analysis. Examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics.
Marginal Utility
The concept of marginal utility is used by economists to determine how much of an item consumers are willing to purchase. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility. In simple terms, it means that the more of an item that you use or consume, the less satisfaction you get from each additional unit consumed or used.
- The absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources in this imaginary economy. If this were a real world example, that data would be available.
Sunk Costs
Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be reversed or recovered , should not affect the current decision. For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Production Possibilities Frontier & Social Choices The Production Possibilities Frontier (PPF) is a graph that shows all the different combinations of output of two goods that can be produced using available resources and technology. Suppose a society desires two products, healthcare and education. This production possibilities frontier shows a trade-off between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF. Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. What’s the difference between a budget constraint and a PPF?
- The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer are fixed, so the slope doesn't change.
- The PPF has a curved shape because of the law of diminishing returns. Thus, the slope is different at various points on the PPF.
Maximize society's satisfaction & reduce scarcity?
The 5 E's of Economics
- E CONOMIC growth
- Productive E FFICIENCY
- Allocative E FFICIENCY
- E QUITY
- E MPLOYMENT
Equity
The process to be fair in an economy that can range from the concept of taxation to welfare in the economy. It also means how the income and opportunity among people are evenly distributed. Equity is a "fair" distribution of income, or goods and services. (NOTE:) One problem with this definition is agreeing on what "fair" means. We know that equity is good for society. But we can't measure "fairness". This is a problem for economists. But we can DESCRIBE the actual distribution of income and I will also try to explain how equity does help society achieve the maximum satisfaction possible from its limited resources.
Employment
Refers to the state of having a job or being employed. If one has to employ someone, they must pay them. The person who hires people is known as an employer, and the person who is getting paid for providing the services is known as an employee. If we have full employment, we produce MORE. If we have unemployed resources, we produce LESS. This is why society's strive for full employment - it reduces scarcity and helps achieve the maximum satisfaction possible.
The PPF and Comparative Advantage
While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills. Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugarcane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane. When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries.
Comparative Advantage
An economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade.
Absolute Advantage
When a producer can provide a good or service in greater quantity for the same cost, or the same quantity at a lower cost, than its competitors.
Why must society choose?
We learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma. Every economy faces two situations to be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the l production possibilities frontier, it can have more of all goods (or atleast more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.
Demand
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants —if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter. PRICE - is what a buyer pays for a unit of the specific good or service. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service: almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. Economists call this inverse relationship between price and quantity demanded by the law of demand. The law of demand assumes that all other variables that affect demand are held constant. A demand curve shows the relationship between price and quantity demanded, with quantity on the horizontal axis and the price per gallon on the vertical axis. The law of demand tells us that if more people want to buy something, given a limited supply, the price of that thing will be bid higher.
Supply
Supply is the amount of some good or service a producer is willing to supply at each price. PRICE - is what the producer receives for selling o unit of a good or service
- A rise in price: almost always leads to an increase in the quantity supplied of that good or service. While a fall in price will decrease the quantity supplied. Economists call this positive relationship between price and quantity supplied, a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied, the law of supply. The law of supply states that, all other factors being equal, as the price of a good or service increases, the quantity of that good or service that suppliers offer will increase, and vice versa. In plain terms, this law means that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the number of that item that they sell.
Equilibrium—Where Demand & Supply Intersect
Equilibrium is the state in which market supply and demand balance each other, and as a result prices become stable.
Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Changes in Equilibrium Price and Quantity
Equilibrium is the state of the market in which quantity demanded equals quantity supplied, thus stabilizing at the corresponding market price. Just like quantities demanded/supplied and price, equilibrium is subject to change.
Price Ceilings
Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortage will result. (rent control, meat, rice etc.)
Price Floors
Price floors prevent a price from falling below a certain level. Governments can enact laws, known as price controls, that control market pricing of goods and services. Price floors and price ceilings are two examples of price controls. Price floor is the lowest price that one can legally charge for some good or service. (minimum wage) The price ceiling causes a shortage in the market whereas the price floor causes a surplus in the market. Also transfer some consumer surplus to producers, or some producer surplus to consumers.
Concept of Cost in Economics
Refers to the total expenditure a firm incurs when utilizing economic resources to produce goods and services. Resources in the economy are scarce, and the allocation of them in an efficient manner is an essential step toward maximizing the firm's profit.
Profit
firm's revenue - total cost A firm might experience high revenues, if the cost of production is high, it will shrink the firm's profit.
Accounting Costs
Accounting costs are explicit costs , also referred to as hard costs , that include business necessities like payroll, production costs and marketing budgets. Businesses can easily track explicit costs because they include specific dollar/peso amounts. Accounting costs include anything a business spends and needs to be deducted from revenues in an accounting period. This means accounting costs are real money that leaves the bank each accounting period and includes everything you spend to market, manufacture & deliver products. You're required to determine accounting costs before you can calculate the accounting profit.
- For instance, if a business plans on opening a storefront in a new market, it may first decide to make investments including hiring new employees, new computer software and equipment, product inventory and rent.
How to calculate Accounting Costs?
add all business expenses together (Manufacturing costs) + (Labor, salaries& taxes) + (Facility costs) + (Any additional expenses) = Accounting cost Manufacturing costs (Raw materials, utilities, maintenance), Labor, Salaries, Taxes, Rent or Mortgage
Steps for Calculating Accounting Cost
- Determine materials and manufacturing costs
- Calculate labor, salaries and taxes
- Determine costs for the facility-(RMUI)
- Define any additional costs
- Add all accounting expenses Sunk cost examples: To understand sunk cost, it's helpful to relate it to real- life circumstances. Here are four examples of sunk cost: Marketing, Research&development, Training&Hiring, Supplies Economic cost involves all the expenses those it can manage, and those beyond the company's control. (capital, labor, and raw materials) However, the company may use other resources, some of which have expenses that are not as readily apparent but are still significant.
Economic Cost Formula (Implicit & Explicit)
- Explicit costs refer to the money a firm spends on input costs. (Accounting Cost)
- Explicit costs involve a transfer of money and can be recorded on a balance sheet. E.g. Salaries, rent payments, raw materials, etc.
- Implicit costs refer to the costs that do not require an explicit outflow of money.
- Implicit costs are related to the opportunity cost of one course of action that leads to lower income. - Implicit costs are decisions which lead to lower income, not usually recorded. E.g. A company that owns a factory and doesn't pay rent faces the implicit cost of not renting out the factory but using it for production purposes instead.
How to Calculate Economic Costs?
total accounting costs and add/subtract the monetary value of choosing an alternative option. Calculating an economic cost can help you determine which strategic option to pursue by comparing alternative costs against the accounting cost.
1. Calculate the accounting costs Using the formula for calculating accounting costs, determine the total amount of expenses you have. Consider all aspects of design, labor, manufacturing, production and distribution. Adding up all business expenses allows you to determine how much you're currently spending versus the amount of profit you're rendering. 2. Calculate the implicit costs Once you've calculated the explicit costs, you can calculate the implicit costs or the costs that an alternative option would yield. - Perhaps in an alternative option, you would only need three store managers versus six, affecting the total labor costs. - Alternatively, the business option you're considering may include entering a new market, in which case you can add up all potential business expenses and investments involved in this process. 3. Subtract implicit costs from explicit costs You can calculate the economic cost to find out which business option is the right choice. To calculate the economic cost, subtract the projected implicit costs from the pre-determined accounting cost. With this calculation, you may determine if an alternative business option could save the company money. This may help you decide whether to pursue an alternative business venture. - Economic costs are important for businesses because they help them determine long-term strategies and summarize the company's actual and potential values. - Business leaders can use economic costs to determine which markets to exit or enter and car give investors the confidence that the company has reconfirmed long-term value. - The benefit of economic cost analysis is finding the difference in cost among business options. Example, if a business has determined the accounting costs to open a storefront in a new market are $400,000, then accounting costs may allow them to consider: - What if they opened a storefront in a new market? - What if they leased their storefront to another business once they purchased it? - What if they invested the $400,000 into their original storefront rather than opening a new one? - Economic costs include accounting costs and implicit costs, which are hypothetical expenses used when making a business decision to forecast potential profit. This means that economic costs include both explicit and implicit costs. - Accountants and business leaders use economic costs when creating financial projections or determining the best strategic outcome, such as reallocating funds or using a more efficient mode of production.
Profit
- It is important to note that profit is calculated the same way in both economics and accounting. The main difference between profit in accounting and profit in economics lies in the costs included.
Profit
SALES - COSTS = PROFIT
- All the money spent by the firm is referred to as total production costs , and all the money (sales) made by the firm is referred to as total revenue.
Accounting Profit
AP = REVENUE – EXPLICIT COSTS
- Also referred to as financial profit or bookkeeping profit , is a company’s net income, or total revenue minus explicit costs. Accounting profit is used to assess a company’s performance and compare its financial position to competitors.
Total Revenue
TOTAL REVENUE = PRICE (P) X QUANTITY (Q)
In economic terms, total production costs refer to all the costs the firm incurs to employ inputs. On the other hand, Total revenue refers to the quantity of products sold by the firm multiplied by the price per unit of product.
Economic Profit
EP = REVENUES - EXPLICIT COSTS
EP = ACCOUNTING PROFIT
- OPPORTUNITY COST
- Economic profit is the difference between the revenue received from sales and the explicit costs of producing its goods and services, as well as any opportunity costs.
- Opportunity costs are a type of implicit cost determined by management and will vary based on different scenarios and perspectives POSITIVE ECONOMIC PROFIT NEGATIVE ECONOMIC PROFIT or ECONOMIC LOSS
- It is important to note that since firms aim to make as much profit as they can, a firm stays in business as long as it is making a positive or zero economic profit.
- Economists say that a firm is making normal profit when the economic profit is equal to zero. Normal profit means that the firm has put its resources to the best possible use at the time, and this means normal profit is not a bad thing.
- If economic profit comes out to zero, the company is said to be in a state of " normal profit ." Economic profit is used by economists, accounting profit only looks at explicit cost, whereas economic profit looks at both explicit cost and implicit cost (opportunity cost). When to use accounting versus economic costs?
- You can use accounting costs to determine the total expenses and compare this to the overall gross profit. Accounting costs allow you to understand how much the company is spending versus how much profit it's making.
- Economic costs can allow you to determine if an alternative option yields a higher profit or minimize spending in particular areas. You can use economic costs when deciding between two different business approaches, allowing you to decide which choice is best for the company. Types of Costs Fixed Cost (FC) A company's expense regardless of its production level.
- A firm is required to make payments toward expenditures known as fixed costs, regardless of the particular commercial activity it engages in. It does not change as a firm's output level changes. Examples: rental and lease payments, certain salaries, insurance, property taxes, interest expenses, depreciation, and some utilities.
Variable Cost (VC)
A company's expense that varies as output varies.
- When the volume of a firm's production or sales changes, the variable costs of that company also change.
- Variable costs go up when the amount of production goes up, and they go down when the production volume goes down. Example: physical materials, production equipment, sales commissions, staff wages, credit card fees, online payment partners & packaging/shipping costs.
Total Cost
TOTAL COST = FIXED COST + VARIABLE COST Total cost is the total economic cost of production.
Average Cost (AC)
AVERAGE COST = TOTAL COST
/ QUANTITY OF OUTPUT
- Equals the per-unit cost of production.
- Average cost is also often called the total cost per unit or the average total cost.
Marginal Cost (MC)
MARGINAL COST = CHANGE IN TOTAL COST
/ CHANGE IN QUANTITY OF OUTPUT
The additional cost of producing one more unit of a good or service. Simply put, marginal cost is the change in the cost for production when you decide to produce one more unit of a good. Theory of Cost in Economics According to the theory of cost in economics, the costs a firm faces determine how much money they charge for a product or service and the amount supplied. The theory revolves around the idea that the costs that a firm faces significantly impact the firm's supply of goods and services and the price for which it sells its products. A firm's cost function adjusts itself according to several factors, such as the scale of the operation, the quantity of the output, the cost of production, and several other factors. Operate of Shut-down
- A shut-down decision is that the firm is temporarily suspending production. It does not mean that the firm is going out of business. The shut Down decision depends on Shut Down Point. The shutdown point denotes the exact moment when a company's revenue is equal to its variable costs. - A shutdown point is a level of operations at which a company experiences no benefit for continuing operations and therefore decides to shut down temporarily—or in some cases permanently. - It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs. - Shutdown points are based entirely on determining at what point the marginal costs associated with operation exceed the revenue being generated by those operations. Types of Shutdown Points The length of a shutdown can be temporary or permanent, this depends on the nature of the economic conditions which is leading to the shutdown. For the non-seasonal goods, in an economic recession, this may reduce the demand from the consumers, after forcing a temporary shutdown (partially or totally) until the economy recovers from this. Yet at other times, the demand dries up completely for the changing consumer preferences, also for the technological upgrade. For example, nobody produces the cathode-ray tube (CRT) televisions or computer monitors any longer, and thus this would be a losing prospect to open a factory such as these days to produce the same. - The shutdown point denotes the exact moment when a company's revenue is equal to its variable costs. Variable costs such as wages, production supplies, etc. It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs. Reasons of shut down production: - Financial problem - Fall in demand - Change in technology - Inadequate availability of raw material - High rate of taxes - Recession in market - Mismanagement - A shutdown point can apply to all the operations a business participates in or just a portion of its operations.
- Companies can maximize profits by increasing the price or reducing the production cost of the goods.
- Firms adjust influential factors like selling price, production cost, and output levels to realize their profit goals.
- It is the prime target of every firm and is necessary for their progress.
- Profit maximization means increasing profits by the business firms using a proper strategy to equal marginal revenue and marginal cost. This theory forms the basis of many economic theories.
- It is more present in a monopoly and perfect competition market.
- The profit maximization formula depends on / Profit = Total revenue – Total cost. / Therefore, a firm maximizes profit when / MR = MC /
- The MC = MR rule is quite versatile so that firms can apply the rule to many other decisions. Elasticity and Its Application
- The effect of price on demand is studied under the price elasticity of demand which relates to the law of demand wherein demand has an inverse relation to changes in price. Elasticity
- The ability of an object or material to resume its normal shape after being stretched or compressed.
- Elastic suggests that an item can be stretched.
- In economics, when we talk about elasticity, we’re referring to how much something will stretch or change in response to another variable. PRICE ELASTICITY OF DEMAND Measures the sensitivity of the quantity demanded to changes in the price.
- Therefore, elasticity is a key concept in economics and holds substantial importance.
- It signifies how responsive consumers are to price changes, impacting pricing strategies for businesses. Inelastic Demand
- A term that economists use to refer to a situation where demand for an item remains the same, no matter how far its price rises or falls.
- Inelastic demand in economics occurs when the demand for a product doesn't change as much as the price.
- When price changes on these items, demand doesn't fluctuate much because these items are required in the everyday lives of most consumers.
- Even if prices rise, the quantity demanded remains relatively stable, and if prices drop, the quantity demanded changes only slightly. - Inelastic demand applies to products that are hardly responsive to price changes. - A business will price the product much more comfortably in such a market condition. Elastic Demand
- An economic concept that states that the demand for a good or service changes significantly with the fluctuations in its price. - Consumers demand for such products highly sensitive to changes in prices. - it will have more buyers when its price goes down and vice-versa. Inelastic Demand Elastic Demand Low changes in demand with price changes. High changes in demand with price changes.
- Utilities
- Gas
- Prescription drugs
- Other essentials
- Luxury items
- Non-essential items
- Consumer durables
- If a small change in price creates a large change in the quantity demanded, then we would say that the demand is very elastic —that is, the demand is very sensitive to a change in price.
- If, on the other hand, a large change in price results in a very small change in demand in the quantity demanded, then we would say the demand is inelastic.
- Demand is in elastic when consumers are in sensitive to changes in price. Determinants of Elasticity of Demand
- Except for or along with price , various other factors contribute to the change in demand for goods or services. 1. Consumer Income A downfall in the consumers’ income results in decreased demand for a product or service. 2. Substitute Goods The commodities with substitutes experience volatile demand since the consumer can always switch to substitutes if the product’s price increases. 3. Complementary Goods If the price of a good rise, it will also affect the demand for its complementary. 4. Necessity Even when the price of necessary goods like flour or rice goes up, their demands do not vary much. On the other hand, if luxury products or services such as royal vacation packages rise in price, their demand falls. 5. Time Time is another essential factor; many times, a product’s demand doesn’t fall in the short run even after its price rise like iPhone’s paid applications. 6. Customer taste and preference If consumers prefer a product, say a particular brand of clothing, they will keep buying it despite the price rise.
- The rate at which quantity purchased goes down can vary a lot from one product category to another, for different market segments, due to the degree of competition & from one brand to another.
- As economists or entrepreneurs, the degree of price elasticity (pricing sensitivity) affecting your product(s) makes a big difference to your marketing and pricing efforts. Computing the Price Elasticity of Demand
- The price elasticity of demand formula is a method used to measure the sensitivity of the change in the demand of goods and services due to change in the price of the same. Price Elasticity Of Demand Formula Explained
- The absolute price elasticity of demand formula explains the effect of change in price on demand of goods and services. It shows the responsiveness of demand to changes in price of goods in the market and is very useful in production planning, resource allocation and future expansion.
- It shows the relationship of price to the demand in the market. Type of Elasticity
Perfectly Elastic Any very small change in price results in a very large change in quantity demanded.
Relatively Elastic Small changes in price cause large changes in quantity demand.
Unit Elastic Any change in price is matched by an equal change in quantity
Relatively Inelastic Large changes in price cause small changes in quantity demanded
Perfectly Inelastic Quantity demanded does not change when price is changed
