Understanding Economics: Principles, Production, and Business

Posted on Dec 12, 2024 in Economy

Economy: Understanding Scarcity and Resource Allocation

Economics is the science that studies the allocation of scarce resources to multiple needs. The economy seeks to find the best allocation of resources (which are limited) to needs (which are infinite), given that the election process involves postponing the satisfaction of certain needs.

Economic Rationality

Economic rationality refers to the behavioral assumptions under which decisions are made in the economy. It assumes that individuals pursue certain goals and that their decisions are consistent with achieving them.

Goods: Satisfying Needs

A good is any means capable of satisfying a need, for both individuals and society. There are several types of goods:

• Supply Goods: Goods used to produce other goods. This category includes raw materials and intermediate goods.
• Capital Goods: Inputs used to produce other goods, but these persist over time.
• Final or Consumer Goods: Goods that have already undergone all the necessary changes for use or consumption by individuals or families.

Opportunity Cost: The Value of What’s Forgone

Opportunity cost is the value of the best alternative discarded. It’s what you give up to get something, whether by purchase, exchange, or production.

If a consumer pays a fee to receive a good, they are deciding, by implication, not to use that money to buy other assets that may give more or less satisfaction. If a company uses its resources to produce something, it misses an opportunity to devote those resources to the creation of other products.

The concept of opportunity cost highlights the idea of scarcity. It only makes sense to assess the various alternative actions when the available resources—time, money, commodities, etc.—are scarce.

Resources: Tradable Assets

Resources are physical, financial, or intellectual assets of agents that are tradable in the economic market.

Chance is not part of the economy.

The Economic Problem: Scarcity

Scarcity is the fundamental economic problem. Even if there were unlimited resources, we would not have enough time to enjoy them. When we add intangible assets such as power, love, and prestige, there will never be enough. Therefore, scarcity forces us to make economic decisions, such as where to work, what to produce, and how to sell, all to get what we most desire. The main economic activity is consumption, where we choose the goods that are most pleasing given our income and the price to be paid. Another activity is production, both by individuals and businesses. Any activity that increases the total goods available to society is considered production. This choice prioritizes the production of some goods over others, as desired.

Economic Agents

• Families: Consume goods and services and offer their resources (mainly labor and capital) to firms.
• State: Sets the legal and institutional framework in which economic activity takes place. It is also responsible for setting economic policy.
• Companies: Hire labor and purchase other factors to produce and sell goods and services.

The company is the economic and social unit, operating for profit, in which capital, labor, and management are coordinated to perform socially useful production, according to the requirements of the common good. The elements necessary to form a company are capital, labor, and material resources.

What is a Company?

1. Legal Approach: A legal entity established for profit and subject to commercial law.
2. Administrative Approach: Organization, functions, products, markets. Market and customer-oriented.
3. Matrix Approach: Processes, value chains. Allows for internal analysis.
4. Economic Approach: Markets vs. integration. Agency costs and transaction costs. Integration allows for decision-making.

The Company as an Economic and Production Unit

In economics, production creates value, defined as the ability to generate satisfaction through a commodity, good, or service via various modes of production.

Production Capacity

Production capacity is the maximum level of activity that can be achieved with a given productive structure. It is crucial for business management and for analyzing the degree of use made of each resource in the organization, thus providing an opportunity for optimization.

Increases and decreases in production capacity result from investment and divestment decisions (e.g., acquisition of an additional machine).

Production Possibilities Frontier (PPF)

The Production Possibilities Frontier (PPF) represents the set of combinations of factors of production or technology in which maximum production is reached. It indicates the maximum quantities of goods and services that a company can produce in a given period based on factors of production and technological knowledge. There are three possible situations in a country’s productive structure:

• Inefficient Production Structure: Below the PPF, meaning either not all resources are used or the technology is not adequate (lacking improvement).
• Efficient Production Structure: Situated on the border or close to it. No idle resources, and the best technology is being used.
• Unattainable Production Structure: Beyond the possibilities of production. It is theoretical because no country can produce beyond its means.

The Production Possibility Frontier is concave and decreasing. This form is due to two reasons:

• Decreasing: To produce a greater quantity of one good, we need to give up part of another good.
• Concave: The opportunity cost is increasing.

The Production Possibilities Frontier can shift, meaning that unattainable points can be reached. This shift may be due to technological improvements, a capital increase, an increase in workers, or the discovery of new natural resources.

Classical economics uses three factors, each of which participates in the result of production through a bounty set by the market:

• Land (compensated by rent).
• Capital (awarded interest).
• Work (rewarded by wages).

These factors remain classic in current economic science but are in the process of evolution. A fourth factor of production, often called R&D or R+D+I, is now considered.

For some, the new factors of production can be simplified to:

• Structural Capital
• Physical Capital
• Working Material
• Intangible Capital (know-how, organization, incorporeal assets, etc.).

Investment increases the volume of production factors.

Profit and Benefit in Business

Profit, in law, is the intent of a person to increase their assets through a legal act.

Benefit is the difference between the value of the property resulting from the production process and those used in the same, minus also the other operating expenses.

In the long term, in a perfectly competitive market, company profits tend toward zero (excess profits).

However, this rarely happens due to various situations, such as the existence of monopolies or oligopolies that prevail in the markets. Economic benefit is, therefore, an indicator of wealth creation and value generation in the economy. When a production unit generates no economic benefit, meaning it incurs a loss, it is destroying wealth.

Production Costs

As outlined at the beginning of the chapter, costs are all resources used by firms in production processes and are given by:

Total Cost = (Pl x L) + (Pk x K) + (Pi x I)

Where:

• Pl: Price of labor
• L: Amount of work done
• Pk: Capital Price
• K: Amount of Capital used
• Pi: Price of inputs
• I: Number of inputs

Cost analysis is performed using two approaches:

• Accounting: Costs are analyzed according to the rules and procedures of accounting.
• Economic: All resources are a source of cost, including entrepreneurship. The cost in this case is given by the opportunity cost of resources.

In the economic approach, the costs of inputs, labor, and capital are financed according to their market price. Entrepreneurship is funded to the value of the best business opportunity discarded or delayed. There are a variety of ways of defining and measuring production costs, with some concepts and measures more appropriate for certain tests than others. The most relevant concepts and measures are reviewed below.

• Fixed Costs: Costs that do not vary with the firm’s production level. They are related to factors or inputs whose recruitment is not modifiable in the short term. Examples are patents, infrastructure, and equipment leases.
• Variable Costs: Costs that change with the level of production. They are related to factors and inputs that a firm can change in the short term to support a change in production. Examples are labor, inputs, and raw materials.

The distinction is important because fixed costs are paid regardless of whether production occurs, while variable costs will grow as production increases. In the long term, all factors and inputs are considered variable, and therefore so are costs. Total cost can be defined as the sum of fixed costs plus variable costs.

TOTAL COST = Fixed Costs + Variable Costs

On the other hand, we can also define marginal cost as the increase in total cost necessary to produce an additional unit of a good.

MC = Change in Total Cost

Variation in Production

In response to changes in production, marginal and average costs can exhibit three types of behavior:

• Decreasing Costs: The increase in costs is at a lower rate than the increase in production.
• Constant Costs: The increase in costs is at the same rate as the increase in production.
• Increasing Costs: The increase in costs is at a higher rate than the increase in production.

In general terms (see example), companies tend to have decreasing costs initially, then constant, and finally increasing costs. However, this does not limit the possibility that firms may exhibit other behaviors. This consideration is based on the idea that the behavior of costs is the opposite of productivity performance. For example, if there are increasing returns on the production side, it means that costs will have a decreasing trend.

Legal Classification of Companies

Given the company’s ownership and the legal responsibility of its owners, we can distinguish:

• Individual Companies: Belong to one person. The owner can respond to others with all their property (unlimited liability) or only up to the amount of the contribution to its establishment (sole proprietorships or limited liability EIRL). This is the easiest way to establish a business and is often used for small or family businesses.
• Corporate Companies or Partnerships: Formed by several people. This classification includes corporations, general partnerships, limited partnerships, and limited liability companies.
• Cooperatives or other social economy organizations.

Corporate Companies

In a corporate company, two or more persons bind themselves in agreement to make contributions (kind, money, or industry), with the aim of distributing profits among themselves. In this case, society refers to the group of persons engaged in private activities, typically commercial. Its members are called partners. In economic contexts, it is a synonym for company or corporation, especially in legal and economic contexts, figure or entity:

• Corporation
• Limited Partnership
• Cooperative Society
• Limited Partnership

Legal Person

A legal person is a subject of rights and obligations that exists physically, not as a human individual but as an institution created by one or more individuals to play a role. Therefore, it has the capacity to act as a subject of law, meaning the ability to acquire and hold property of all kinds, incur obligations, and sue.

There are legal persons:

• With corporate profit or
• Nonprofit, which are divided into corporations and foundations.

Gain, in law, is the intent of a person to increase their assets through a legal act.

Economic benefit is, therefore, an indicator of wealth creation.

Types of Business Organizations

• Group: Its main feature, unlike other companies, is that liability for debts is unlimited (members respond with their own assets to creditors).
• Anonymous: Owners hold a participation in the social capital through securities or shares, which can be differentiated by their different value or privileges linked to them (such as a minimum dividend). Liability is limited to the capital contribution.
• Ltd. Liability: Partners have liability limited to their contribution. The shares are not equivalent to the actions of the SA, do not qualify as “value,” and cannot be represented by certificates or book entries.
• Partnership: Personal, characterized by the coexistence of general partners, with unlimited liability for debts. They have partners involved in the management of the company, and limited partners who do not participate in the management and whose liability is limited to the capital contributed or committed.

Business Financing

Funding is the act of giving money and credit to a company, organization, or individual. It involves obtaining resources and means of payment for the purchase of goods and services required for the development of the appropriate roles. Funding sources can be classified as:

• According to maturity: Short-term and/or long-term.
• By source: Internal/external.

Various funding sources include:

• Loans
• Issuing Shares
• Bond Issue (companies, state)

Loans

Loans can be classified:

• By the nature of the goods supplied: money, personal property, and fungible securities lending.
• For the purpose of the loan currency: In domestic or foreign currency.
• For the interest rate: Fixed or variable, prepaid or postpaid.
• For the system of repayment: At the end of the loan, according to a French, German, American, etc. system.
• On the ensuring of compliance with obligations: Can be real (pledges, mortgages, deposits, etc.) or personal (collateral).
• Syndicated loan: Funds received by the borrower come from a plurality of lenders (union), although this plurality does not mean that there are several lenders; from the legal point of view, it is a single contract.
• Equity loan: The lender, regardless of the covenant of interest, agrees with the borrower to share the net benefit that it obtains.
• Loan cash trading: Connected to a purchase or sale of securities.

Issuing Shares

In economics, a financial market is a mechanism that allows traders to exchange financial assets. Financial markets are affected by the forces of supply and demand. Financial markets in the financial system provide:

• The increase of capital (capital markets).
• The transfer of risk (in the derivatives markets).
• International trade (in the currency markets). They are used to gather those who need financial resources with those who have them.
• Establish mechanisms to facilitate contact between the participants in the negotiations.
• Pricing of financial products based on its supply and demand.
• Reduce intermediation costs, allowing greater movement of goods.

Bonds

A bond is one of the ways that convey debt securities, with fixed or variable interest. It may be issued by a public institution, a State, a regional government, a municipality, or a private institution, industrial, commercial, or service. They are bearer securities normally dealt in on any market or stock exchange. Here, the issuer promises to repay the principal plus interest (coupon). Interest may be fixed or variable.

Business Risk

The enemy of any investor is “risk,” an element of instability in investments, which are nothing but a commitment to the future in environments with greater or lesser uncertainty. We must distinguish risk within the financial risk of financial risk. Financial Risk:

• The risk from interest rate changes.
• The risk from changes in the exchange rate.
• The risk for non-payment.

Country Risk

Each country, according to its economic, social, political, natural, and geographical characteristics, generates a level of risk for the investments made in it. The risk of a financial investment due only to specific factors common to a certain country can be understood as an average risk of the investments made in that country. Country risk is defined as the possibility that a sovereign state is unable or incapable of fulfilling its obligations to a foreign agent, for reasons beyond the usual risks arising from any credit relationship. A risk assessment will express the level of probability of suffering a loss. If the expected return on investing does not exceed the reward, the entity will look for another alternative for investing.