Ten Principles of Economics by Mankiw, Relevance of Microeconomics, and Macroeconomics to Business World - Assignment Example

1. Do research and briefly summarize the Ten Principles of Economics as outlined by Gregory Mankiw. The ten principles of economics can be categorized into three main groups; how individuals behave, how individuals interact, and how the economy functions. How individuals behave. The first four principles of economics by Gregory Mankiw deal with how individuals make decisions and behave. 1. People face tradeoffs According to this principle, people are faced with difficult decisions that require one to give up something so as to get another thing. Decision making requires one trade off a given goal so as to achieve another. This principle proposes that individuals respond to incentives, think at the margins, and to get something, individuals must sacrifice another thing. 2. The cost of something is considered to be what you sacrifice to get it. According to this principle, one has to take into account the implicit and obvious costs of the decision they make. 3. Individuals who are rational think at the margin. This principle proposes that a decision maker who is rational will only take an action if the marginal benefit of that action is more than its marginal cost. 4. Individuals respond to incentives. According to this principle, the decisions that individuals make, change when the advantages or cost of something changes or varies. An excellent example to illustrate this principle is how people respond to changes in the prices of Gasoline. When the prices of gasoline are high, people buy more economic and smaller vehicles, whereas when the prices are lower people purchase big cars and vans (Mankiw 2008, p.45). How individuals react. The next three principles of economics summarize how people interact. The standards of living of a society rely on its production of services and goods. Inflation arises when the government prints excess money and the public will encounter short-term tradeoffs between unemployment, and inflation. 5. Trade can improve the welfare of everyone. Trade enables each individual to concentrate in activities that she or he does best. Through trade, individuals can acquire a wider variety of services or goods. 6. Markets are normally an appropriate means to organize economic activity. According to this principle, firms and households that interrelate in market economies behave as if they are controlled by an invisible hand that guides the market to apportion resources in an efficient manner. In markets, prices are settled, and agreements are made; which are thereafter communicated to the rest of the world. 7. The governments can at times better economic outcomes. This principle proposes that the government can intervene when a market fails to apportion resources in an efficient manner, through public policy. An example to illustrate this policy is when the government imposes regulations against pollution and monopolies (Mankiw 2008, p. 86). How the economy operates. 8. The standards of living of a country rely on the country’s ability to produce services and goods. Higher standards of living are found in nations whose public produce a larger amount of services and goods per unit of time. Likewise, as the productivity of a nation grows, the average income grows proportionally (Mankiw, Kneebone, McKenzie & Nicholas 2002, p.38). 9. When the government prints excess money, prices rise. When a government prints excess money, its value falls. This results in an increase, in prices because people require more cash to purchase goods or services. 10. A society faces a short-term tradeoff between unemployment and inflation. Decreasing inflation often results in a rise in unemployment temporarily. Therefore, a tradeoff is vital for comprehending the short-term effects of changes in monetary policy, government spending, and taxes (Mankiw 2008, p.106). 1. Define microeconomics and macroeconomics and explain why they are relevant to the business world. Microeconomics is a subdivision of economics that explains how the individual components of households, firms, and economy, make decisions to apportion scarce resources, particularly in markets where services or goods are being sold and bought. Microeconomics studies how these behaviors and decisions impact the demand and supply for services and goods, which establishes prices, and how prices, consecutively determine demand and supply of services and goods (Bowles 2004, p. 13). Macroeconomics is a subdivision of economics that deals with decision-making, behavior, structure, and performance of the whole economy, whether global, regional, or national economy (Blanchard 2000, p. 20). Microeconomics are relevant to the business world because it enable a government to analyze how a market operates so as to determine relative prices amongst service and goods, and the allocation of scarce resources amongst numerous alternative uses. Microeconomics are also vital in the business world because it can be used to study market failure, whereby markets are unable to produce effective outcomes. It is also crucial in describing the relevant conditions required for perfect competition (Frank 2006, p. 56). Macroeconomics is relevant in the business world as it is utilized in comprehending the consequences and causes of short-term variation in national income, and in understanding long-term economic growth determinants. 2. Define the supply curve, the demand curve and the equilibrium of a market. Supply curve is a graph indicating the supposed supply of a service or product that producers are able and willing to sell at different prices, on the assumption that all the elements that determine supply such as the cost of factors of production and technology remain constant except the price of the product or service in question. The supply curve normally slopes upwards because the higher the price of a service or product the higher the incentive to increase the supply. Demand curve is a graph indicating the connection between the quantity of a given commodity that consumers are able and willing to buy and the price of such a commodity, assuming that all the determinants of demand such as the price of complementary goods, price of close substitutes, personal tastes, and income remain the same, except the price of that commodity. The demand curve usually slopes downwards because as the prices increase, the quantity of a commodity purchased decreases (Gravelle & Ray 2004, p.62). Market equilibrium refers to a condition whereby the quantity supplied equals the quantity demanded. The market equilibrium is illustrated by the point of intersection of supply and demand curve. It is a condition where the market price of a commodity is determined by competition, such that the quantity of services or goods that are required by buyers is equal to the quantity of services or goods that sellers have produced (Petri 2004, p. 10). 3. Find at least another equilibrium concept used in science and contrast it with the concept of market equilibrium used in Economics (hint: alternative equilibrium concepts are used in other sciences such as physics). In physics, equilibrium refers to a state of balance. When a system or body is in a state of equilibrium, there is no likelihood of change. Equilibrium in mechanics is concerned with the forces that act on a body. A body is said to be in translational equilibrium when there is no force causing a body to move in a line. Rotational equilibrium is achieved when there is no force causing a body to turn. Static equilibrium is achieved when a body is at rest. Nevertheless, a state of equilibrium does not necessarily mean that there are no forces acting on a body, but it simply means that the forces that are acting on a body are balanced. For instance, when a raised object is held up using a lever, forces are applied upward on a fulcrum and downward on the end of the lever, however, downward or upward forces balance to sustain translational equilibrium. Rotational equilibrium is maintained by the counterclockwise and clockwise forces on each end. The body’s stability is a determinant of its capability to return to equilibrium. It relies on the position of the center of gravity and shape of a body. A body that has a low center of gravity and large flat base will be extremely stable, and will go back to a position of equilibrium after it has been tripped. Why is the idea of equilibrium relevant in Economics? In economics, the concept of equilibrium is significant because equilibrium analysis is used to identify the factors that might cause change and the probable effects of these changes. Equilibrium analysis is crucial in studying cause and effect, and evaluation of the probable consequence of change. Comparative statistics of variables that shift equilibrium quantity and the price is crucial in determining the most appropriate market prices (Krugman & Robin 2006, p.72) 4. Explain in detail why free markets yield an efficient allocation of resources. A free market refers to a market without government intervention and economic regulation except when enforcing contracts and property rights. A free market is the exact opposite of a market that is controlled, whereby the government controls how labor, services, production, and goods are distributed, priced, and used. In a free-market economy, no parties regulate trade other that the players in a given market (Weimer & Aidan 2004, p. 162). Free markets yield an efficient resource allocation because the government plays a neutral role in the legislation and administration of the activities, in a market neither promoting economic activity nor limiting it. Efficient allocation of resources is achieved because property rights are willingly traded at a price that is determined exclusively by the mutual agreements of buyers and sellers. Sellers and buyers do not force one another, such that they get the property rights of each other without the use of fraud, threat of physical threat, physical force, or any form of coercion from external parties such as transfer payments by governments. The parties in a free market simply participate in trade because they believe and agree that whatever they acquire is worth more than they are giving up. In a regulated or controlled market, the government indirectly or directly regulates supplies and prices. This results in the inefficient allocation of resources according to the free-market theory. In a free market, price of service or product facilitate the communication of the demands of consumers to producers, and hence, directs resource allocation towards both investor and consumer satisfaction. The price that is arrived at in a free market is as a result of numerous voluntary transactions, as opposed to the intervention witnessed in a controlled market. From free competition between sellers for the provision of services and products, prices tend to fall, while quality tends to improve (Heijdra & Ploeg 2002, p.92). Using your answer, explain why any form of government intervention is usually harmful to the economy. Advocates of free markets argue that government intervention can result in undesired outcomes. It can prove to be misplaced, inequitable, and ineffective. The pursuit of self interest by civil servants and politicians can result in the inefficient allocation of scarce resources. Pressures such as a looming election can result in the creation of an environment whereby unsuitable tax decisions are made and unnecessary government spending. Government intervention in markets can result in quick fixes and short-term decisions that do not consider complex economic problems and long-term effects. Such short-sighted decision making will only address short-term problems, but will not take care of the structural economic problems. Free markets advocates who are against government intervention argue that efforts by the government to lessen wealth and income inequalities might worsen productivity and incentives in an economy. Attempts by the government to control supply by for instance increasing taxes can result in an increase in tax evasion, smuggling, tax avoidance, and the rise of grey markets, whereby suppliers and consumers trade without paying taxes (Perloff 2007, p. 65). In addition, the law of unintended consequences argues that any government policy will at all times result to a reaction by producers or consumers that are unintended or unanticipated. 5. Define market failure. What role can the government play in such a situation? Market failure refers to a situation whereby the allocation of services and goods by a free market is inefficient. Market failure occurs when the quantity of a product or service that is demanded by consumers is not equal to the amount supplied by producers. Market failure is an express consequence of the lack of definite economically crucial factors that hinder equilibrium (Ledyard 2008, p. 136). The government is economically justified to intervene in some given forms of market failure. The government has a role to protect the interest of the public and can intervene where markets not operating optimally. A market might be allocating scarce resources inefficiently and therefore, might not be attaining the highest level of social welfare. In the provision of public goods such as the maintenance or railways and roads, public beaches and parks, lighthouse protection, and street lighting, the private sector might be unable or unwilling to provide such service. The government will have to finance such service through taxation. Market failure can also arise from the existence of inequality in an economy. There might be wide differences in wealth and income between diverse groups in an economy. This will result in a wide gap, in terms of the standards of living between the poor and the affluent societies in an economy. The government will have to intervene with policies such as minimum wage and changes to benefits and tax system. 6. Why do you think governments tend to interfere in economic activity more than what economic theory recommends? The government might interfere in economic activity more than what economic theory recommends because of the seriousness of some issues. Some issues that require excessive interference are issues on the imposition of hefty pollution tax, regulation of cartel or oligopolies behavior, introduction of price controls on utilities that have been recently privatized (Sullivan & Steven, p. 122). 7. Do some research on the Index of Economic Freedom and explain what it measures. Find 4 countries that have moved up the scale and 4 countries that have moved down the scale in 2010. The index of economic freedom was created by the wall street journal and the heritage foundation. It calculates the extent of economic freedom in a given country in terms of factors such as informal market activity, regulation, property rights, prices and wages, finance and banking, foreign investment and capital flows, monetary policy, fiscal burden of a government, trade policy, and government intervention in an economy (De Haan & Strum 2006, p. 410). Economic freedom is the basic right to manage her or his property and labor. In a society that is considered economically free, people are allowed to invest, consume, produce, and work in any way they like, with this freedom being unconstrained and protected by the state. Governments in societies that are economically free allow goods, capital, and labor to move freely, and desist from constraint or coercion of freedom the extent mandatory to maintain and protect freedom itself (Holmes & Miller 2010). Countries that have moved up the scale include Sweden, Rwanda, Mauritius, Switzerland, and countries that have moved down include the United States, Estonia, China, and Zimbabwe. (Miller 2009) 8. Where does Australia stand on the Economic Freedom Index scale? What in your opinion can be done to improve the Australian business environment? Australia is ranked third in the index of economic freedom with as freedom score of 82.6, and had a zero change from the previous year. From the analysis of individual economic freedoms, fiscal freedom and government spending had the lowest percentage with Fiscal freedom having 61.4% and government spending having 64.9%. The total expenditure by the government including transfer payments and consumption are moderate. The government needs to improve its spending because it only amounts to 34.2% of the GDP (Holmes & Miller 2010). The ambitious stimulus plan implemented increased spending on infrastructure and this resulted in the shift of the fiscal balance from positive to a deficit. The government has also to reduce its goods and services, corporate, and income taxes. 10. Assume the market for grocery shopping in Australia is characterized by perfect competition. Using economic theory, describe the equilibrium of a firm in the short run. Explain why a positive economic profit will trigger entry by new firms and the impact on market equilibrium. What are the welfare implications for consumers of perfect competition? In a competitive market, price for a given firm is usually fixed. In addition, each firm can make only normal profits as per its average cost of production. Nevertheless, in the short-run the degree of efficiency of firms may differ, the structure of costs may also differ. The firms that are more efficient may earn super normal profits temporarily. The less efficient businesses will earn normal profits, while firms having optimum efficiency will make normal profits. (Nicholson 2007, p.103) Even though, the profit of a firm relies on the marginal revenue equals marginal cost condition, the profits of such a company rely on the difference between the average cost and average revenue. When the average revenue is greater than the average cost, a company will earn super normal profits. When the average revenue equals average cost, a firm will earn normal profits. When the average revenue is greater that the average cost, a company will earn sub-normal profits. When a firm is making super normal profits, it will attract other firms that will be attracted by the high profits. The increase in the number of firms will reduce the average revenue of individual firms, with time the average revenue will equal average cost and the firms will earn normal profits. Perfect competition improves the welfare of consumers because no firms enjoys monopoly in setting its prices. 11. Assume the market for grocery shopping in Australia is controlled by two firms only. Using economic theory, explain what the likely equilibrium on this market is if the two firms cannot collude, and the welfare implications for consumers. Using game theory, explain what the likely equilibrium on this market is if the two firms can collude but the game is played only once. Using game theory, explain what is the likely equilibrium on this market is if the two firms can collude and the game is played indefinitely. When there are two firms an oligopoly exists, and there is imperfect competition. This means that for a competitor to acquire greater market share and revenue, it has to use non-price competition. According to classical economic theory, a producer who seeks to maximize his profits will set marginal revenue to be equal to marginal cost. Any change in the marginal revenue or cost structure will result in a new quantity and/or price of a commodity. In an oligopolistic market, firms can not increase their prices because even a slight raise will result in the loss of customers. Competitors will normally disregard price increases because they hope to acquire a larger market share by having prices that are comparatively low. (Mulhearn, Vane & Eden 2001, p.48) When the two firms collude, this is referred to as a cooperative game. In a cooperative game, the two companies will form binding commitments and adhere to their promises. When two firms collude and play once, they can raise the prices of goods in order to increase their revenue. This will worsen the welfare of consumers because of the increase in prices. However, with time the temptation to increase market share will tempt firms to reduce their prices and the prices will return to normal, hence restoring equilibrium. (Kevin & Yoav 2008, p. 38) In a case where the two firms collude and play indefinitely, a new monopoly will be created. The prices of commodities or services will not be determined by competitive forces; rather the prices will be set by the two firms. 12. How different is the concept of Nash equilibrium from that of market equilibrium? Nash equilibrium is an optimal strategy concept for games with two or numerous players, where each player is considered to understand the equilibrium strategies that other players can use, and there is no player who can gain by altering her or his own strategy in a unilateral manner. Under Nash equilibrium, no player can gain by altering her strategy, whereas the other players maintain their strategy unaltered. The concept of Nash equilibrium is different from the market equilibrium in that in market equilibrium is not dependent on the strategies adopted by other players. 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