Key Economic Concepts and Theories
Institutions: Social arrangements created to satisfy the needs of the people in the long run. Adam Smith studied different institutions over time: language, morals, justice, property rights, the division of labor, money, and the market. According to Smith, the institutions most appropriate to a period of commercial interdependence would provide for the governing authority to pursue a laissez-faire (let alone) policy in relation to the economy.
Economics: The social science that studies the production, distribution, and consumption of goods and services.
Money: Any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. Commodity money has an intrinsic value, meaning it is worth something in its own right rather than simply being a token of financial value, such as a banknote.
Legal Tender: Legal tender is any form of payment that must be accepted for a debt, according to the laws of the area.
Supply Chain: A supply chain is a system of organizations, people, technology, activities, information, and resources involved in moving a product or service from supplier to customer. It is the movement of materials as they flow from their source to the end customer.
Rate of Interest: Interest rates are the price of credit (not of money). It is a fee paid on borrowed assets. By far the most common form these assets are lent is in money, but other assets may be lent to the borrower, such as shares, consumer goods through hire purchase, and even entire factories in finance lease arrangements. In each case, the interest is calculated upon the value of the assets in the same manner as upon money. The cost of money depends on interest rate and inflation.
Prices and Purchasing Power
Natural Price: According to Adam Smith, it is the cost of production of an item, and it remains constant in time, depending on wages, profits, and the rent of the land. It is the price of a commodity that is sufficient to pay the production value. The natural price need not function as the actual cost of a good in the marketplace.
Market Price: Market price is the price that a good or service is offered at, or will fetch, in the marketplace. In classical economics, the market price of a good or service is established in relation with demand, and in inverse relation with supply, which is to say the market price decreases as supply increases; increases as supply decreases; increases as demand increases; and decreases as demand decreases. The actual market price will establish a particular price point, valid for a short period which is the meshing of current demand and supply.
Nominal Price: It is the monetary value of a commodity. It refers to an economic value expressed in fixed nominal terms in a given year or series of years. So, it is the money value which changes along the time.
Real Price: The real value adjusts nominal value to remove effects of general price level changes over time. For example, changes in the nominal value of some commodity bundle over time can happen because of a change in the quantities in the bundle or their associated prices, whereas changes in real values reflect only changes in quantities.
Purchasing Power Parity (Rate of Exchange): The rate of exchange is the price of one currency in terms of another currency. However, purchasing power parity is the theory based on Fisher’s law that defends that, in the long run, identical products and services in different countries should cost the same.
Consumer Price Index (CPI): CPI is a statistical estimate of the level of prices of goods and services bought for consumption purposes by households. The change in the CPI is a measure of inflation and can be used for indexation (or evaluation) of wages, salaries, pensions, or regulated or contracted prices. Two basic types of data are required to construct the CPI: price data and weighting data.
Inflation and Economic Systems
Inflation: Inflation is measured as the growth of the money supply in an economy, without a commensurate increase in the supply of goods and services. This results in a rise in the general price level, as measured against a standard level of purchasing power. There are a variety of measures of inflation in use, related to different price indices because different prices affect different people. Mainstream economists’ views of the causes of inflation can be broadly divided into two camps: the “monetarists,” who believe that monetary effects dominate all others in setting the rate of inflation, and the “Keynesians,” who believe that the interaction of money, interest, and output dominate over other effects. Keynesians also tend to add a capital goods (or asset) price inflation to the standard measure of consumption goods inflation.
There are two causes for inflation:
- Cost-push inflation: when costs are higher, and this produces a rise in prices.
- Demand-pull inflation: occurs when the demand for a product or service increases and the firm raises the prices of that product/service. This type of inflation produces a profit for the firm.
Disguised Unemployment: When the labor marginal productivity is zero due to the fact that there are employed workers that do not produce at all.
Mercantilism: It is the economic system prevalent from the sixteenth to eighteenth centuries. The main goal was to increase a nation’s wealth by imposing government regulation concerning all of the nation’s commercial interests. It holds that the prosperity of a state is dependent upon its supply of capital, that the global volume of international trade is “unchangeable,” and that one party may benefit only at the expense of another. It was believed that national strength could be maximized by limiting imports via tariffs and maximizing exports. This school of thought was very important in France in the 17th century. These economists were called Colbertists, and they thought that the state was something like a merchant and that it would be wealthier if it had more gold and silver.
Key features of Mercantilism:
- National strength
- Zero-sum economy
- Money is wealth
- Positive Balance of Trade
- Preference of industry over agriculture
- Protect infant industry
- Royal Factories
- Utility of poverty
- Population policies
- Colonialism
Economic Growth and Limitations
Specie Flow Mechanism: The price–specie flow mechanism is a logical argument by David Hume against the mercantilist (1700–1776) idea that a nation should strive for a positive balance of trade, or net exports. When a country has a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeds the value of imports. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of imports exceeds the value of exports.
Growing Path (Growth): The growing path occurs when an economy is growing. Capital is being accumulated, and people progressively have more to consume, and population growth is also increasing due to welfare. Smith identified three major sources of growth:
- Improvement in the efficiency with which capital is used in labor through greater division of labor and technological progress.
- Promotion of foreign trade that widens the market and reinforces the other two sources of growth.
- Growth in the labor force and stock of capital. The growth of the labor force is largely dependent of the rate at which population grows in a country.
The Stationary State: The stationary state is the state that an economy reaches when it reaches the extent of its market. It is impossible to keep accumulating capital to invest because people aren’t demanding more in the whole economy. It happens after a growing path.
Malthusian Restriction: Concept that since food production can increase at only an arithmetic rate whereas populations tend to grow at a geometric rate, the number of people would increase faster than the food supply. Malthus made some psychological assumptions:
- Food is necessary for life.
- Attraction between sexes will not disappear.
And two technological assumptions:
- Food increases in an arithmetic ratio.
- Population increases in a geometric ratio.
Enclosure Movement: Is the process in which, under England’s federal system, most rural areas had open fields and forests designed for works. The workers would therefore use these fields to raise their own grain and livestock.
Engel’s Law: An economic theory stating that as income rises, the proportion of income spent on food falls.
Agricultural Production and Financial Instruments
Intensive Versus Extensive Increase of Production: Referred to farming and agriculture, intensive production is an agricultural production system characterized by a low fallow ratio and the high use of inputs such as capital, labor, or heavy use of pesticides and chemical fertilizers relative to land area, while extensive is an agricultural production system that uses small inputs of labor, fertilizers, and capital, relative to the land area being farmed.
The Rent of the Land: Established by the influential economist David Ricardo, is the proportion of the produce of the land that is paid to the landlord for the use of the original and indestructible powers of the soil. When the supply of food is greater than the demand, then the question of raising rent does not arise.
Bill of Exchange Versus a Promissory Note: A bill of exchange is an unconditional order issued by a person or firm (the drawer) which directs the recipient (the drawee) to pay a fixed sum of money to a third party (the payee or holder) at a future date. While a promissory note is a written promise to repay a loan or debt under specific terms, usually at a stated time, through a specified series of payments.