Economic Principles: Systems, Market Dynamics, and Firm Production
Core Economic Objectives
The primary objectives include:
- Stable growth of national output.
- Full employment of resources and their efficient allocation.
- Price stability.
- Equitable distribution of income.
Public Sector Economic Tools
The basic tools used by the public sector and the state to influence private economic activity are: taxes, spending, and regulation. Taxes are established on income, economic activity, and property. Public spending includes purchases of goods and services, infrastructure investments, and salaries for officials and other employees.
Economic Systems Explained
An economic system describes how individuals in society organize to solve their fundamental economic problems.
Fundamental Economic Decisions
Basic Economic Problems
Societies must answer three basic questions:
- What to produce?
- How to produce?
- For whom to produce?
Core Economic Mechanisms
Two main economic mechanisms exist to answer these basic problems: the market economy system and the central planning system.
Major Economic Doctrines
Economic doctrines represent the set of ideas or opinions held by leading economists. Two major doctrines are:
- Liberalism: Relies on the functioning of the market. Adam Smith is considered the founder of economic liberalism.
- Marxism: Relies on state intervention and centralized planning. Karl Marx provided its deepest critique of market systems.
How a Market Economy Functions
A market is a place or system where goods, services, and factors of production are exchanged.
Market Economy Principles
In a market economy, the basic economic problems are resolved freely in the markets through the interplay of supply and demand. Buyers and sellers interact in markets to determine prices.
Understanding Asset Prices
The price of an asset is its exchange relationship for money; it represents the number of currency units (e.g., euros) needed to acquire one unit of the good.
The Circular Flow of Income
This concept illustrates the circular flow of income: the flow of goods, services, and payments between households and businesses within an economy.
The Concept of the Invisible Hand
The market mechanism, often referred to as the invisible hand, is responsible for guiding key decisions in a market economy.
Market Economy Limitations
The market economy system has limitations:
- Income is not distributed evenly.
- Market failures can occur.
- Advertising can be used to manipulate consumers.
- Market economies tend to experience instability (e.g., business cycles).
Defining Market Failure
A market failure occurs when the market fails to allocate resources efficiently, often due to the existence of imperfect competition, externalities, or imperfect information.
Centralized Planned Economies
This is a mode of economic organization where the state performs the core economic functions.
Role of Bureaucracy
Its large bureaucracy and associated inefficiencies ultimately contributed to the failure of many centrally planned systems.
Understanding Mixed Economies
The mixed economy is the dominant type of economic organization in many countries today. It primarily relies on the price system for organization but incorporates government intervention.
Keynesian Economics Influence
Keynesian economics, influenced by John Maynard Keynes, takes the market as its starting point but relies on state intervention, especially through fiscal policy, to manage the economy.
Neoliberal Perspectives
The neoliberal trend represents a renewed theoretical focus on the efficiency of markets, often advocating for reduced state intervention compared to Keynesian approaches.
The Company and The Entrepreneur
The company is the entity responsible for production. The entrepreneur organizes, plans, and controls the company, making key decisions about what and how to produce.
Defining Technical Efficiency
Technical efficiency means achieving the maximum possible output with a given set of production factors.
Production Fundamentals
Production involves using production factors (like labor and capital) and intermediate inputs to create goods and services.
Short-Term Production Analysis
This section focuses on production when at least one factor is fixed.
Defining the Short Term
The short term is a period where production output can be adjusted by changing variable factors (like labor), while fixed factors (like factory size) cannot be fully adjusted.
Total Product Explained
Total product refers to the total quantity of a good or service produced with varying levels of a variable input (e.g., labor), holding other inputs constant.
Understanding Marginal Product
Marginal product measures the change in total production resulting from using one additional unit of a variable input (e.g., one more worker).
Law of Diminishing Returns
The law of diminishing returns states that if at least one factor of production is fixed, the marginal product of a variable factor will eventually decrease as more of that factor is employed (output per worker begins to decrease after a certain point), holding other factors constant.
Long-Term Production Concepts
This section considers production when all factors can be varied.
In the long term, the quantity of all production factors can be adjusted; there are no fixed factors.
Returns to Scale Explained
Returns to scale describe the change in total output when all factors of production are increased proportionally.
Types of Returns to Scale
Increasing returns to scale occur when increasing all inputs by a certain proportion results in output increasing by a larger proportion. Decreasing returns to scale occur when output increases by a smaller proportion. Constant returns to scale occur when output increases by the same proportion.
Analyzing Production Costs
This examines the costs associated with production in both the short and long term.
Explicit vs. Implicit Costs
Financial (Explicit) Costs
Financial costs or explicit costs are the direct, out-of-pocket payments made by firms for the use of resources (e.g., wages, rent, materials). They require a cash outlay by the company.
Implicit Costs
Implicit costs represent the opportunity cost of using resources that the firm already owns. These are cost factors that do not require a direct cash outlay by the company (e.g., the forgone salary an owner could have earned elsewhere).
Short-Term Cost Considerations
Short-term costs are the costs incurred during the short-term production period, that is, when at least one factor of production is fixed. These include both fixed costs and variable costs.