I. ECONOMIC SYSTEMS
1. Definitions
An economic system is the system of production, distribution
and consumption of goods and services of an economy.
Alternatively, it is the set of principles and techniques by which
problems of economics are addressed, such as the economic
problem of scarcity through allocation of finite productive
resources
The econonic system is composed of people and institutions,
including their relationships to productive resources, such as
through the convention of property. Examples of contemporary
economic systems include capitalist systems, socialist systems, and
mixed economies. "Economic systems" is the economics category
that includes the study of respective systems. Currently capitalist
system is the world's most dominant form of economic system.
An economic system can be defined as a "set of methods and
standards by which a society decides and organizes the allocation
of limited economic resources to satisfy unlimited human wants.
At one extreme, production is carried in a private-enterprise system
such that all resources are privately owned. It was described by
Adam Smith as frequently promoting a social interest, although
only a private interest was intended. At the other extreme,
following Karl Marx and Vladimir Lenin is what is commonly
called a pure-communist system, such that all resources are
publicly owned with intent of minimizing inequalities of wealth
among other social objectives".
2. Type of Economic System
Three types of economic systems exist, each with their own
drawbacks and benefits; the Market Economy, the Planned
Economy and the Mixed Economy.
An economic system is loosely defined as country’s plan for its
services, goods produced, and the exact way in which its economic
plan is carried out. In general, there are three major types of
economic systems prevailing around the world.
2.1 Market Economy
In a market economy, national and state governments play a minor
role. Instead, consumers and their buying decisions drive the
economy. In this type of economic system, the assumptions of the
market play a major role in deciding the right path for a country’s
economic development.
Market economies aim to reduce or eliminate entirely subsidies for
a particular industry, the pre-determination of prices for different
commodities, and the amount of regulation controlling different
industrial sectors.
The absence of central planning is one of the major features of this
economic system. Market decisions are mainly dominated by
supply and demand. The role of the government in a market
economy is to simply make sure that the market is stable enough to
carry out its economic activities
2.2 Planned Economy
A planned economy is also sometimes called a command
economy. The most important aspect of this type of economy is
that all major decisions related to the production, distribution,
commodity and service prices, are all made by the government.
The planned economy is government directed, and market forces
have very little say in such an economy. This type of economy
lacks the kind of flexibility that is present a market economy, and
because of this, the planned economy reacts slower to changes in
consumer needs and fluctuating patterns of supply and demand.
On the other hand, a planned economy aims at using all available
resources for developing production instead of allotting the
resources for advertising or marketing.
2.3 Mixed Economy
A mixed economy combines elements of both the planned and the
market economies in one cohesive system. This means that certain
features from both market and planned economic systems are taken
to form this type of economy. This system prevails in many
countries where neither the government nor the business entities
control the economic activities of that country - both sectors play
an important role in the economic decision-making of the country.
In a mixed economy there is flexibility in some areas and
government control in others. Mixed economies include both
capitalist and socialist economic policies and often arise in
societies that seek to balance a wide range of political and
economic views.
II. SUPPLY AND DEMAND
Supply and demand is an economic model of price
determination in a market. It concludes that in a competitive
market, the unit price for a particular good will vary until it settles
at a point where the quantity demanded by consumers (at current
price) will equal the quantity supplied by producers (at current
price), resulting in an economic equilibrium of price and quantity.
Supply is the amount of product that a producer is willing
and able to sell at a specified price, while demand is the amount of
product that a buyer is willing and able to buy at a specified price.
Thus, the supply and demand model shows the relationships
between a product’s accessibility and the interest shown in it.
Unlike with general equilibrium models, however, this model does
not define the attributes that are responsible for supply schedules
Supply
Supply is The quatity of a good sellers wish to sell at each
convervable price. Supply is not a particular quantity but a complet
description of the quatity that sellers wouls like to sell at each and
every possible price.
Law of Supply
As the price of a product rises, ceteris paribus, suppliers will offer
more for sale. This implies that price and quantity supplied are
positively related. The major factor that influences supply is the
"cost of production", and includes:
1. Input prices - As the prices of inputs such as labour, raw
materials, and capital increase, production tends to be less
profitable, and less will be produced. This leads to a decrease
in supply.
2. Technology - Technology relates to methods of transforming
inputs into outputs. Improvements in technology will reduce
the costs of production and make sales more profitable so it
tends to increase the supply.
3. Expectations - If firms expect prices to rise in the future, may
try to product less now and more later.
Supply Curves and Schedules
The relationship between the price of a product and the quantity
supplied, holding all other things constant is generally sloping
upwards. Supply is represented by the entire curve and not just one
point on the curve. When the price of the product changes, the
quantity supplied changes, but supply does not change. When cost
of production changes, supply changes, and the entire supply curve
will shift.
Market Supply is the summation of all the individual supply
curves, and is the horizontal sum of individual supply curves. It is
influenced by the factors that determine individual supply curves,
such as cost of production, plus the number of suppliers in the
market. In general, the more firms producing a product, the greater
the market supply.
When quantity supplied at a given price decreases, the whole curve
shifts to the left as there is a decrease in supply. This is generally
caused by an increase in the cost of production or decrease in the
number of sellers. An increase in wages, cost of raw materials, cost
of capital, ceteris paribus, will decrease supply. Sometimes
weather may also affect supply, if the raw materials are perishable
or unattainable due to transportation problems.
Demand
Demand is the quantity of a good buyers wish to purchase at
each conceivable price. Thus demand is not a particular quantity,
such as six bars of chocolates, but rather a full description of the
quantity of chocolate the buyer would purchase at each and every
price which might be charged.
Law of Demand
The Law of Demand states that other things held constant, as the
price of a good increases, the quantity demanded will fall. Other
factors that can influence demand include:
1. Income - Generally, as income increases, we are able to buy
more of most goods. When demand for a good increases
when incomes increase, we call that good a "normal good".
When demand for a good decreases when incomes increase,
then that good is called an inferior good.
2. Price of related products - Related goods come in two types,
the first of which are "substitutes". Substitutes are similar
products that can be used as alternatives. Examples of
substitute goods are Coke/Pepsi, and butter/margarine.
Usually, people substitute away to the less expensive good.
Other related products are classified as "complements".
Complements are products that are used in conjunction with
each other. Examples of complements are pencil/eraser,
left/right shoes, and coffee/sugar.
3. Tastes and preferences - Tastes are a major determinant of
the demand for products, but usually does not change much
in the short run.
4. Expectations - When you expect the price of a good to go up
in the future, you tend to increase your demand today. This is
another example of the rule of substitution, since you are
substituting away from the expected relatively more
expensive future consumption.
Law of Supply and Demand
In free markets, surpluses and/or shortages tend to be temporary
and obey the law of supply and demand, since actions of buyers
and sellers tend to match prices back toward their equilibrium
levels.
While the economy is becoming more global, some factions in
developing countries are against the merging of markets. This has
lead to violence in some parts of the world. Ambassadors and other
officials traveling to foreign nations are normally supplied with
body armor and a convoy for protection against hostile groups.
2.3 Disting wish “want” and “need”
A need is something you have to have, something you can't
do without. A good example is food. If you don't eat, you won't
survive for long. Many people have gone days without eating, but
they eventually ate a lot of food. You might not need a whole lot of
food, but you do need to eat.
A want is something you would like to have. It is not absolutely
necessary, but it would be a good thing to have. A good example is
music. Now, some people might argue that music is a need because
they think they can't do without it. But you don't need music to
survive. You do need to eat.
These are general categories, of course. Some categories have both
needs and wants. For instance, food could be a need or a want,
depending on the type of food.
You need to eat protein, vitamins, and minerals. How you get them
is up to you (and your family). You can eat meat, nuts, or soy
products to get protein. You can get fruits and vegetables to get
vitamins and minerals. You can eat yogurt or cheese to get other
vitamins and minerals. You can eat bread to get still more vitamins
and minerals. These basic kinds of foods are needs.
Ice cream is a want. You don't really need to eat ice cream to
survive. You can eat it to get some vitamins and minerals, but
other foods like cheese and yogurt give you more of those same
vitamins and minerals without giving you the fat that ice cream
does. Still, ice cream tastes good to many people. They like to eat
it. They want it, but they don't need it. They like it, but they don't
have to have it to survive.
III. INGLATION
3.1 Definition
In economics, inflation is a rise in the general level of prices of
goods and services in an economy over a period of time. When the
price level rises, each unit of currency buys fewer goods and
services; consequently, inflation is also an erosion in the
purchasing power of money – a loss of real value in the internal
medium of exchange and unit of account in the economy. A chief
measure of price inflation is the inflation rate, the annualized
percentage change in a general price index (normally the
Consumer Price Index) over time.
3.2 Types of Inflation
There are four main types of inflation. The various types of
inflation are briefed below.
Wage Inflation: Wage inflation is also called as demand-pull or
excess demand inflation. This type of inflation occurs when total
demand for goods and services in an economy exceeds the supply
of the same. When the supply is less, the prices of these goods and
services would rise, leading to a situation called as demand-pull
inflation. This type of inflation affects the market economy
adversely during the wartime.
Cost-push Inflation: As the name suggests, if there is increase
in the cost of production of goods and services, there is likely to be
a forceful increase in the prices of finished goods and services. For
instance, a rise in the wages of laborers would raise the unit costs
of production and this would lead to rise in prices for the related
end product. This type of inflation may or may not occur in
conjunction with demand-pull inflation.
Pricing Power Inflation: Pricing power inflation is more often
called as administered price inflation. This type of inflation occurs
when the business houses and industries decide to increase the
price of their respective goods and services to increase their profit
margins. A point noteworthy is pricing power inflation does not
occur at the time of financial crises and economic depression, or
when there is a downturn in the economy. This type of inflation is
also called as oligopolistic inflation because oligopolies have the
power of pricing their goods and services.
Sectoral Inflation: This is the fourth major type of inflation.
The sectoral inflation takes place when there is an increase in the
price of the goods and services produced by a certain sector of
industries. For instance, an increase in the cost of crude oil would
directly affect all the other sectors, which are directly related to the
oil industry. Thus, the ever-increasing price of fuel has become an
important issue related to the economy all over the world. Take the
example of aviation industry. When the price of oil increases, the
ticket fares would also go up. This would lead to a widespread
inflation throughout the economy, even though it had originated in
one basic sector. If this situation occurs when there is a recession
in the economy, there would be layoffs and it would adversely
affect the work force and the economy in turn.
Other Types of Inflation
Fiscal Inflation occurs when there is excess government
spending. This occurs when there is a deficit budget. For instance,
Fiscal inflation originated in the US in 1960s at the time President
Lydon Baines Johnson. America is also facing fiscal type of
inflation under the presidentship of George W. Bush due to excess
spending in the defense sector.
Hyperinflation: Hyperinflation is also known as runaway
inflation or galloping inflation. This type of inflation occurs during
or soon after a war. This can usually lead to the complete
breakdown of a country’s monetary system. However, this type of
inflation is short-lived. In 1923, in Germany, inflation rate touched
approximately 322 percent per month with October being the
month of highest inflation.
3.3 Consequences of inflation
The impact of inflation on individuals and businesses depends
in part on whether inflation is anticipated or unanticipated:
Anticipated inflation: When people are able to make accurate
predictions of inflation, they can take steps to protect themselves
from its effects. For example, trade unions may exercise their
collective bargaining power to negotiate with employers for
increases in money wages so as to protect the real wages of union
members. Households may also be able to switch savings into
deposit accounts offering a higher nominal rate of interest or into
other financial assets such as housing or equities where capital
gains over a period of time might outstrip general price inflation.
In this way, people can help to protect the real value of their
financial wealth. Companies can adjust prices and lenders can
adjust interest rates. Businesses may also seek to hedge against
future price movements by transacting in “forward markets”. For
example, most of the major airlines buy their aviation fuel several
months in advance in the forward market, partly as a protection
against fluctuations in world oil prices.
Unanticipated inflation: When inflation is volatile from year to
year, it becomes difficult for individuals and businesses to
correctly predict the rate of inflation in the near future.
Unanticipated inflation occurs when economic agents (i.e. people,
businesses and governments) make errors in their inflation
forecasts. Actual inflation may end up well below, or significantly
above expectations causing losses in real incomes and a
redistribution of income and wealth from one group in society to
another.
Money Illusion: It is a fact of life that people often confuse
nominal and real values in their everyday lives because they are
misled by the effects of inflation. For example, a worker might
experience a 6 per cent rise in his money wages – giving the
impression that he or she is better off in real terms. However if
inflation is also rising at 6 per cent, in real terms there has been no
growth in income. Money illusion is most likely to occur when
inflation is unanticipated, so that people’s expectations of inflation
turn out to be some distance from the correct level. When inflation
is fully anticipated there is much less risk of money illusion
affecting both individual employees and businesses
The Main Costs of Inflation
What are the main costs of inflation? Why is the control of
inflation given such a high priority in macroeconomic policymaking? Supporters of tough inflation control would support the
arguments made in this quote in a speech delivered in 2002 from
Mervyn King.
The case for maintaining price stability
‘It is clear that very high inflation – in extreme cases
hyperinflation – can lead to a breakdown of the economy. There is
now a considerable body of evidence that inflation and output
growth are negatively correlated in high-inflation countries. For
inflation rates in single figures, the impact of inflation on growth is
less clear.’
Source: Mervyn King, Governor of the Bank of England
In explaining and assessing the costs of inflation, we must be
careful to distinguish between different degrees of inflation, since
low and stable inflation is perceived to have less of a damaging
effect than hyper-inflation where prices are out of control. Another
important part of your evaluation is to be aware that inflation will
have differing effects both on individuals and also the performance
of the economy as a whole.
Impact of Inflation on Savers: Inflation leads to a rise in the
general price level so that money loses its value. When inflation is
high, people may lose confidence in money as the real value of
savings is severely reduced. Savers will lose out if nominal interest
rates are lower than inflation – leading to negative real interest
rates. For example a saver might receive a 3% nominal rate of
interest on his/her deposit account, but if the annual rate of
inflation is 5%, then the real rate of interest on savings is -2%.
Inflation Expectations and Wage Demands
Inflation can get out of control because price increases lead to
higher wage demands as people try to maintain their real living
standards. Businesses then increase prices to maintain profits and
higher prices then put further pressure on wages. This process is
known as a ‘wage-price spiral’. Rising inflation leads to a build-up
of inflation expectations that can worsen the trade-off between
unemployment and inflation.
Arbitrary Re-Distributions of Income
Inflation tends to hurt those employees in jobs with poor
bargaining positions in the labour market - for example people in
low paid jobs with little or no trade union protection may see the
real value of their pay fall. Inflation can also favour borrowers at
the expense of savers as inflation erodes the real value of existing
debts. And, the rate of interest on loans may not cover the rate of
inflation. When the real rate of interest is negative, savers lose out
at the expense of borrowers.
Business Planning and Investment
More generally, inflation can disrupt business planning. Budgeting
becomes difficult because of the uncertainty created by rising
inflation of both prices and costs - and this may reduce planned
capital investment spending. Lower investment then has a
detrimental effect on the economy’s long run growth potential
Competitiveness and Unemployment
Inflation is a possible cause of higher unemployment in the
medium term if one country experiences a much higher rate of
inflation than another, leading to a loss of international
competitiveness and a subsequent worsening of their trade
performance. If inflation in the UK is persistently above our major
trading partners, British exporters may struggle to maintain their
share in overseas markets and import penetration into the UK
domestic market will grow. Both trends could lead to a worsening
balance of payments. The UK government believes that monetary
stability (i.e. low inflation) is a precondition for sustained
economic expansion. As the chart below demonstrates, the UK has
made progress in reducing the volatility of its inflation rate in the
last decade. The era of high and volatile inflation may have come
to an end.
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