WHAT ARE THE CONCEPTS OF SUPPLY AND DEMAND ?

Supply and demand

Main article: Supply and demand

The supply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D₁to D₂ along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).

The theory of demand and supply is an organizing principle to explain prices and quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it refers to price and output determination in a perfectly competitive market. This has served as a building block for modeling other market structures and for other theoretical approaches.

For a given market of a commodity, demand shows the quantity that all prospective buyers would be prepared to purchase at each unit price of the good. Demand is often represented using a table or a graph relating price and quantity demanded (see boxed figure). Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income as the constraint on demand). Here, utilityrefers to the (hypothesized) preference relation for individual consumers. Utility and income are then used to model hypothesized properties about the effect of a price change on the quantity demanded.

The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy of it (other things unchanged). As the price of a commodity rises, overall purchasing power decreases (the income effect) and consumers move toward relatively less expensive goods (the substitution effect). Other factors can also affect demand; for example an increase in income will shift the demand curve outward relative to the origin, as in the figure.

Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied. Producers are hypothesized to be profit-maximizers, meaning that they attempt to produce the amount of goods that will bring them the highest profit. Supply is typically represented as a directly proportional relation between price and quantity supplied (other things unchanged).

In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the graph above, market equilibrium.

For a given quantity of a good, the price point on the demand curve indicates the value, or marginal utility^[61] to consumers for that unit of output. It measures what the consumer would be prepared to pay for the corresponding unit of the good. The price point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply and demand equate cost and value at equilibrium.^[62]

Demand and supply can also be used to model the distribution of income to the factors of production, including labour and capital, through factor markets. In a labour market for example, the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the demand for labour (from business firms etc. for production) and supply of labour (from workers).

Demand and supply are used to explain the behavior of perfectly competitive markets, but their usefulness as a standard of performance extends to any type of market. Demand and supply can also be generalized to explain variables applying to the whole economy, for example, quantity of total output and the general price level, studied in macroeconomics.

In supply-and-demand analysis, the price of a good coordinates production and consumption quantities. Price and quantity have been described as the most directly observable characteristics of a good produced for the market.^[63] Supply, demand, and market equilibrium are theoretical constructs linking price and quantity. But tracing the effects of factors predicted to change supply and demand—and through them, price and quantity—is a standard exercise in applied microeconomics and macroeconomics. Economic theory can specify under what circumstances price serves as an efficient communication device to regulate quantity.^[64] A real-world application might attempt to measure how much variables that increase supply or demand change price and quantity.

Marginalism is the use of marginal concepts within economics. Marginal concepts are associated with a specific change in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshallwere further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassicaltradition that emerged from British marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental rôle in analysis.

WHAT IS SPECIALISATION ?

Specialization

Main articles: Division of labour, Comparative advantage, and Gains from trade

Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful.

According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort, or correspondingly different types of capital equipment and differentiated land uses.^[53][54][55]

Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.^[56]

In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation offactors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by product or by design.^[57] Such specialization of production creates opportunities for gains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplusand producer profits) from specialization in production and resulting trade.^[58][59][60]

WHAT IS THE MARKET ?

Markets

Main articles: Production-possibility frontier, Opportunity cost, and Production theory basics

In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, warehousing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production. Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a "rate of output per period of time".

There are three aspects to production processes, including the quantity of the commodity produced, the form of the good created and the temporal and spatial distribution of the commodity produced. Opportunity cost expresses the idea that for every choice, the true economic cost is the next best opportunity. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice.".[51] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[52] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.

The inputs or resources used in the production process are called factors of production. Possible inputs are typically grouped into six categories. These factors are raw materials, machinery, labour services, capital goods, land, and enterprise. In the short-run, as opposed to the long-run, at least one of these factors of production is fixed. Examples include major pieces of equipment, suitable factory space, and key personnel.

A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the "long-run", all of these factors of production can be adjusted by management. In the short run, a firm's "scale of operations" determines the maximum number of outputs that can be produced, but in the long run, there are no scale limitations. Long-run and short-run changes play an important part in economic models.

Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.

Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if: No one can be made better off without making someone else worse off, more output cannot be obtained without increasing the amount of inputs, and production ensures the lowest possible per unit cost. These definitions of efficiency are not exactly equivalent. However, they are all encompassed by the idea that nothing more can be achieved given the resources available.

WHAT IS MICRO ECONOMICCS ?

Microeconomics

Main article: Microeconomics

Microeconomics looks at interactions through individual markets, given scarcity and government regulation. A given market might be for aproduct, say fresh corn, or the services of a factor of production, say bricklaying. The theory considers aggregates of quantity demandedby buyers and quantity supplied by sellers at each possible price per unit. It weaves these together to describe how the market may reach equilibrium as to price and quantity or respond to market changes over time.

This is broadly termed supply and demand analysis. Market structures, such as perfect competition and monopoly, are examined as to implications for behavior and economic efficiency. Analysis of change in a single market often proceeds from the simplifying assumption that behavioral relations in other markets remain unchanged, that is, partial-equilibrium analysis. General-equilibrium theory allows for changes in different markets and aggregates across all markets, including their movements and interactions toward equilibrium.^[49][50]

Chicago School of economics

Chicago School of economics

Main article: Chicago school (economics)

The Chicago School of economics is best known for its free market advocacy and monetarist ideas. According to Milton Friedman and monetarists, market economies are inherently stable if left to themselves and depressions result only from government intervention.^[45]Friedman, for example, argued that the Great Depression was result of a contraction of the money supply, controlled by the Federal Reserve, and not by the lack of investment as Keynes had argued. Ben Bernanke, current Chairman of the Federal Reserve, is among the economists today generally accepting Friedman's analysis of the causes of the Great Depression.^[46]

Milton Friedman effectively took many of the basic principles set forth by Adam Smith and the classical economists and modernized them. One example of this is his article in the September 1970 issue of The New York Times Magazine, where he claims that the social responsibility of business should be “to use its resources and engage in activities designed to increase its profits...(through) open and free competition without deception or fraud.” ^[47]

Keynesian economics

Keynesian economics

Main articles: Keynesian economics and Post-Keynesian economics

John Maynard Keynes (above, right), widely considered a towering figure in economics.

Keynesian economics derives from John Maynard Keynes, in particular his book The General Theory of Employment, Interest and Money (1936), which ushered in contemporary macroeconomics as a distinct field.^[39][40] The book focused on determinants of national income in the short run when prices are relatively inflexible. Keynes attempted to explain in broad theoretical detail why high labour-market unemployment might not be self-correcting due to low "effective demand" and why even price flexibility and monetary policy might be unavailing. Such terms as "revolutionary" have been applied to the book in its impact on economic analysis.^[41][42][43]

Keynesian economics has two successors. Post-Keynesian economics also concentrates on macroeconomic rigidities and adjustment processes. Research on micro foundations for their models is represented as based on real-life practices rather than simple optimizing models. It is generally associated with the University of Cambridge and the work of Joan Robinson.^[44]

New-Keynesian economics is also associated with developments in the Keynesian fashion. Within this group researchers tend to share with other economists the emphasis on models employing micro foundations and optimizing behavior but with a narrower focus on standard Keynesian themes such as price and wage rigidity. These are usually made to be endogenous features of the models, rather than simply assumed as in older Keynesian-style ones.

Neoclassical economics

Neoclassical economics

Main article: Neoclassical economics

A body of theory later termed 'neoclassical economics' or 'marginalism' formed from about 1870 to 1910. The term 'economics' was popularized by such neoclassical economists as Alfred Marshall as a concise synonym for 'economic science' and a substitute for the earlier, broader term 'political economy'.^[34][35] This corresponded to the influence on the subject of mathematical methods used in the natural sciences.^[2]

Neoclassical economics systematized supply and demand as joint determinants of price and quantity in market equilibrium, affecting both the allocation of output and the distribution of income. It dispensed with the labour theory of value inherited from classical economics in favor of a marginal utility theory of value on the demand side and a more general theory of costs on the supply side.^[36]

In microeconomics, neoclassical economics represents incentives and costs as playing a pervasive role in shaping decision making. An immediate example of this is the consumer theory of individual demand, which isolates how prices (as costs) and income affect quantity demanded. In macroeconomics it is reflected in an early and lasting neoclassical synthesis with Keynesian macroeconomics.^[37][38]

Neoclassical economics is occasionally referred as orthodox economics whether by its critics or sympathizers. Modern mainstream economicsbuilds on neoclassical economics but with many refinements that either supplement or generalize earlier analysis, such as econometrics,game theory, analysis of market failure and imperfect competition, and the neoclassical model of economic growth for analyzing long-run variables affecting national income.