Economics, the social science that scrutinizes the production, distribution, and consumption of goods and services, holds the key to understanding the underlying mechanisms driving prosperity and inequality.
The two branches of economics
This field can be categorized into two primary branches: microeconomics, which concentrates on the behavior of individual actors and the functioning of specific markets, and macroeconomics, which analyzes the overall functioning of the economy as a whole. Notably, economics places great emphasis on the optimal utilization of scarce resources. Whether it entails the allocation of limited funds for public services, the management of natural resources, or the distribution of wealth, economics provides a range of tools and frameworks to facilitate informed decision-making. These tools enable policymakers to attain a comprehensive understanding of competing needs and ensure equitable outcomes while taking into account the welfare of both present and future generations.
Microeconomics epitomizes the distinctive strand of economics that delves into the intricate mechanisms governing the decisions undertaken by individuals within distinct industries and markets. Its focal point lies in unraveling the intricacies surrounding consumers’ deliberations pertaining to the acquisition of goods and services, alongside the modus operandi of firms as they vie for dominance in the market by fashioning their production strategies.
Therefore, microeconomic scrutiny frequently entails a meticulous examination of the comportment of pivotal elements encompassing the notable realms of supply and demand, comprising the discernment of consumer predilections, the calculus of producer expenditures, and the fluctuating dynamics encapsulating market circumstances.
Key concepts in microeconomics
Demand and supply
Individuals’ insatiable desires and wants generate the pulsating heartbeat of the market known as demand. In economic terms, consumers’ willingness and ability to purchase a specific quantity of a good or service at a given price represent the manifestation of demand. Interestingly, this quantity showcases an inverse relationship with price: as the price of a product increases, demand diminishes assuming other factors remain constant. This phenomenon can be attributed to the law of diminishing marginal utility, which states that individuals derive decreasing satisfaction from each additional unit consumed. Consequently, an increase in price reduces purchasing power and subsequently weakens demand, resulting in a lower quantity demanded.
On the contrary, the ardent sibling of demand, commonly referred to as supply, assumes an equally prominent and vital position within the intricate fabric of the economy. Supply embodies the precise measure of a desirable commodity or service that manufacturers and service providers are eager and capable of offering to the market at a designated price point. Remarkably, in contrast to demand, supply exhibits a straightforward correlation with price, thus accentuating its inclining trajectory. As the price of a product escalates, a convergence of incentives materializes, compelling producers to amplify their production output, since higher prices yield greater profitability and serve as a resounding call to participate in manufacturing endeavors. Consequently, an elevated price instigates an upsurge in the quantity supplied, as producers strive to fulfill the burgeoning demands of the market.
Morever, there is a special moment when what people want (demand) and what can be made (supply) come together, wherein the two forces find consummate harmony. And this creates an important balance, called the “market price” (or equilibrium). So basically, it is at this point of confluence that the market purrs with satisfaction, akin to a symphony reaching its final cadence. All in all, it is also in this rarefied realm of equilibrium that economic efficiency thrives, as the market, free from distortions and surfeits, allocates resources with remarkable dexterity and precision.
Elasticity, that quintessential metric, refers to the sensitivity of demand or supply to fluctuations in economic factors such as price or income. Specifically, price elasticity of demand reflects the degree to which consumer purchasing decisions are influenced by modifications in pricing, whereas income elasticity of demand captures shifts in consumption patterns due to alterations in household earnings. Understanding the nature of these relationships is vital because they shed light on how the interplay between market participants responds to external stimuli.
Consumer and producer surplus
Consumer surplus alludes to the augmentation of value experienced by consumers during market transactions, denoting the discrepancy between the veritable price they tender for a commodity or service and the utmost sum they are inclined to relinquish. In other words, if a person pays $5 for a product with a maximum willingness to pay of $10, their consumer surplus amounts to $5. Whereas in market exchanges, producers derive value from the surplus they gain, known as producer surplus. This surplus is determined by subtracting the minimum price at which they are willing to sell a good or service from the actual price they receive for it. For instance, when a farmer sells crops for $4 per unit, despite being willing to sell them for a minimum of $2 due to high demand, the farmer’s producer surplus amounts to $2.
Production and cost
Firms aim to maximize profits by choosing the optimal combination of inputs to produce goods and services. The production function represents the relationship between inputs and outputs, while the cost function shows the relationship between the level of output and the associated costs of production. Understanding production and cost functions is crucial for firms to make efficient decisions on resource allocation.
Market structures are comprised of distinct attributes that exert an influence over the conduct of both enterprises and consumers involved. These market structures can be categorized into four primary types, namely perfect competition, monopolistic competition, oligopoly, and monopoly. Perfect competition is established as a market structure featuring an abundance of minuscule firms that vend indistinguishable products, thereby lacking any substantial sway over the market. Monopolistic competition, on the other hand, represents a market structure where numerous enterprises exist, each offering differentiated products and wielding a certain level of influence within the market. Oligopoly embodies a market structure wherein only a limited number of major corporations dominate the market, exercising considerable market power. Lastly, a monopoly denotes a market structure in which a solitary enterprise stands as the sole provider of a distinctive product, granting them complete control over the market.
Externalities refer to the costs or benefits associated with a particular good or service, which do not find direct manifestation in the prevailing market price. Negative externalities denote costs that are unjustly inflicted upon third parties, such as environmental pollution. But positive externalities signify benefits that are bestowed upon third parties, like the dissemination of knowledge through education. The existence of externalities has the potential to culminate in market failure, primarily due to the market price’s failure to accurately encompass the genuine social cost or benefit derived from a specific good or service.
Key concepts in macroeconomics
Aggregate demand (AD) and supply (AS)
At the core of macroeconomics lies the interplay between aggregate demand and aggregate supply, two pivotal concepts that shape economic performance. Aggregate demand represents the total expenditure on goods and services within an economy, while aggregate supply denotes the total production output. Understanding the intricate dynamics between these concepts offers a lens through which to comprehend fluctuations in output, price levels, and employment rates.
National output, often measured by GDP, is a key macroeconomic concept that represents the total value of goods and services produced within a country over a specific period of time. It is an essential indicator of an economy’s health and growth potential. Macroeconomists analyze national output to understand the overall performance of an economy and to make informed decisions about economic policies and strategies.
Unemployment, a persistent scourge, casts a shadow over economic prosperity. As individuals find themselves without gainful employment, societies bear the burden of lost output and social distress. Thus analyzing unemployment through the lenses of frictional, structural, and cyclical factors enables policymakers to devise strategies that foster job creation and promote economic well-being.
Inflation embodies the kinetic velocity at which the aggregate price level of commodities and services in an economy undergoes expansion over the course of time. This foundational macroeconomic notion exerts substantial sway as it directly affects the buying potential of the currency, the tangible value of wages, and the competitiveness of an economy in the global market realm. Central banks and policymakers vigilantly scrutinize inflation to uphold price steadiness and guarantee enduring economic progress.
Fiscal policy plays a pivotal role as an essential component of economic policy by employing government spending and taxation to exert influence on the economy. Governments utilize this significant tool to attain macroeconomic objectives, including economic growth, price stability, and full employment. Depending on the prevailing state of the economy, fiscal policy can assume an expansionary or contractionary stance.
Now in order to stimulate economic growth and boost aggregate demand, expansionary fiscal policy entails the increase of government spending and reduction of taxes. This policy is commonly implemented during periods of recession or economic slowdown. But contractionary fiscal policy involves the decrease of government spending and increase of taxes to mitigate inflationary pressures and reduce aggregate demand. This policy is typically employed during periods of economic boom or when inflation rates are high.
Governments also utilize monetary policy as a significant tool to exert influence on the economy. This policy encompasses the manipulation of interest rates, money supply, and other monetary instruments with the aim of attaining macroeconomic objectives like price stability, full employment, and economic growth. The implementation of monetary policy and the preservation of financial stability fall under the purview of the central bank.
And yeah, monetary policy can be expansionary or contractionary, depending on the state of the economy. And when employing expansionary monetary policy, central banks often engage in activities that seek to propel economic growth by increasing accessibility to credit through a reduction in interest rates and the expansion of the money supply. These actions aim to strengthen aggregate demand as well as create new opportunities for businesses and individuals alike. During instances of financial turmoil such as recessions or periods marked by sluggish activity within key sectors, this approach helps galvanize recovery efforts by encouraging investment and fostering renewed consumer spending.
On the flip side, contractionary monetary policy encompasses a set of measures characterized by the elevation of interest rates and the curtailment of the money supply, thus effectuating the amelioration of inflationary pressures and the reduction of aggregate demand. This particular policy trajectory is conventionally pursued during episodes of economic upturn or when inflation reaches worrisome levels.