Welcome to Economics & International Business!
“Economics” is the science that studies the choices of individuals, households, and organizations, in allocating scarce resources. Scarcity means that individuals and societies have limited resources.
Although many people don’t recognize it, we all make economic decisions every day – we decide what products or activities fit into our budgets and needs. Through these decisions, we define what we want to be available on the market and at what price. The economic system is the place, where goods and services are produced, distributed, and consumed.
Economists study how people make decisions about buying, selling, saving, and investing. We study how people interact with one another in markets. We also study the economy as a whole when we concern ourselves with total income, unemployment, and inflation.
For businesses, creating a long-term global strategy is a complicated but important task. As is evident throughout this course, no country is an economic island, and the economy truly is global. A growing number of businesses have become true multinational firms, with operating facilities around the world. They have figured out how to mitigate their risks both politically and economically, but they have also found how events in one nation can reverberate around the world.
As businesses contemplate and engage in global expansion, there are endless opportunities, but also potential risks. The home market is also attractive to foreign firms. For an organization to be successful in today’s global economy, its owners and stakeholders must look across borders and understand the global community.
Economics is the social science that studies how societies manage their scarce resources.
2. Ten Principles of Economics
Although the study of economics is complex, the field is unified by several central ideas. The famous Ten Principles of Economics by Gregory Mankiw are the principles of how the global economy works. These principles include basic concepts used by economists around the world.
How People Make Decisions
Principle 1: People face trade-offs.
Economists often say, “There ain’t no such thing as a free lunch.” This means that there are always trade-offs: To get one thing, you have to give up something else. For example, if you spend money on a new computer, you won’t be able to spend it on a new television. This principle also works for nations. There is the classic trade-off between “guns and butter”: if society spends more on national defense (guns), then it will have less to spend on social programs (butter). Recognizing that trade-offs exist does not indicate what decisions should be made.
Principle 2: The cost of something is what you give up to get it.
Making decisions requires comparing the costs and benefits of alternative courses of action. For instance, if a firm spends $100 on electrical power, they can’t use that money to buy new office equipment. Economists say the firm’s opportunity cost is $100. The opportunity cost of an item is whatever you give up to get that item. Thus, opportunity costs are not restricted to financial costs: By seeing a movie in a cinema, your opportunity cost is not just the price of the ticket, but the value of the time you spend in the theater. Put another way, opportunity costs are the benefits you could have received by taking an alternative action. When making decisions, managers should always consider the opportunity costs of each possible action.
Principle 3: Rational people think at the margin.
Economists generally assume that people are rational – that means, their decisions are based on facts and reasons. Rational people make decisions by comparing marginal benefits and marginal costs. For example, you should only attend college for another year if the benefits from that year of schooling exceed the cost of attending that year. Furthermore, a car company should only produce more cars if the benefit exceeds the cost of producing them.
Principle 4: People respond to incentives.
Because rational people weigh marginal costs and marginal benefits of activities, they will respond when these costs or benefits change. For example, when the price of cars rises, buyers have an incentive to buy fewer cars. Public policy can alter the costs or benefits of activities. Some policies have unintended consequences because they alter behavior in a manner that was not predicted.
How People Interact
Principle 5: Trade can make everyone better off.
Trade is not a contest in which one side wins and one side loses. Trade can make each trader better off. Trade allows each trader to specialize in the activities he or she does best, whether it be farming, building, engineering or manufacturing. By trading with others, people can buy a greater variety of goods or services. This is true for both individuals and countries. You are likely to be involved in trade with other individuals and companies on a daily basis: Most people do not make their own clothes or grow their own food – but by trading you are able to get all those products.
Principle 6: Markets are usually a good way to organize economic activity.
In a market economy, the decisions about what goods and services to produce and how much to produce are made by millions of firms and households in the marketplace. Political economist Adam Smith made the famous observation that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic well-being. Consequently, centrally planned economies have mostly failed because they did not allow the market to work.
Principle 7: Governments can sometimes improve market outcomes. When a market fails to allocate resources efficiently, the government can change the outcome through public policy. One kind of market failure is externality – it occurs when the actions of one person affect the well-being of other people. The second kind of market failure is market power – when a single actor has so much power, that he can influence the price. In these cases, the government may be able to intervene. Examples are regulations against monopolies. The government may also intervene to improve equality with income taxes and welfare.
How the Economy Works
Principle 8: A country’s standard of living depends on its ability to produce goods and services.
There is great variation in living standards across countries today as well as within the same country over time. These are largely attributable to differences in productivity. Productivity is the number of goods and services produced from each unit in a specific time period. As a result, public policy should improve education and improve access to the best available technology.
Principle 9: Prices rise when the government prints too much money.
When a government creates large quantities of the nation’s money, the value of the money falls. In this process, called inflation, prices increase and consumers require more of the same money to buy goods and services. High inflation is costly to the economy. Policymakers wishing to keep inflation low should maintain slow growth in the quantity of money.
Principle 10: Society faces a short-run trade-off between inflation and unemployment.
In the short run, an increase in the quantity of money (inflation) stimulates spending, which raises production. The increase in production requires more hiring, which reduces unemployment. The result is a temporary trade-off between inflation and unemployment. Understanding this trade-off is crucial for understanding the short-run effects of changes in taxes, government spending, and monetary policy.
3. The Invisible Hand
Adam Smith’s famous book The Wealth of Nations, published in 1776, provides the basis for today’s market economy. Why do market economies work so well? Is it because all people treat one another with love and kindness? No, Smith argues that all participants are motivated by self-interest.
Although a marketplace with millions of participants may appear to be chaotic, the “invisible hand” of the marketplace guides this self-interest into promoting desirable social outcomes and general economic well-being.
In his book, Smith wrestled with a paradox:
“How is it that water, which is so very useful that life is impossible without it, has such a low price — while diamonds, which are quite unnecessary, have such a high price?”
The answer is connected to the principle of scarcity: Water is not a scarce item relative to diamonds. Smith recognized that “value in use” isn’t the same as “value in exchange.” Basically, we can’t price an item higher simply because it’s more useful. In fact, quite the opposite is true. A product’s highest price is determined by its marginal utility, which is the value of its last usable unit.
So, water has a relatively low price because it’s everywhere and is so useful. Diamonds, on the other hand, have a relatively high price because they’re scarce by comparison and not a necessity. You can take two rules away from this case:
If you produce very useful products (e.g. shampoo), the products will become commodities and the price will come down. Consequently, you have to sell in large volumes to make a profit.
If you produce products that are limited in their use (e.g. most luxury goods), the price will go up. You’ll probably sell fewer products, but you’ll make more money on each product.
The “invisible hand” is a term used by Adam Smith to describe the unintended social benefits of individual self-interested actions.
4. Micro and Macro
In every area of science, there’s a big picture and a little picture, the macro and the micro. Macroeconomics and Microeconomics are simply two different points from which the economy can be observed – just think about them as useful tools like a microscope and a telescope.
Microeconomics is the study of small economic units such as individual people, families, and firms. It tries to explain how individuals and firms respond to changes in price and why they demand what they do at particular price levels. Briefly speaking, microeconomics analyzes all the small parts that make up the whole economy.
Macroeconomics looks at the total output of a nation and the way the nation allocates its limited resources of land, labor, and capital in an attempt to maximize production levels and promote trade and growth for future generations. After observing the society as a whole, Adam Smith noted that there was an “invisible hand” turning the wheels of the economy: a market force that keeps the economy functioning.
Microeconomics is the study of small economic units, macroeconomics is the study of the whole economy.
Both approaches are interrelated, as macroeconomic issues help shape the decisions that affect individuals, families, and businesses. Therefore, we will cover the most important concepts of both fields in this course.
5. Supply and Demand
“Supply” and “Demand” are perhaps the most fundamental elements of economics and the market economy. Supply points to the willingness of sellers to provide goods and services for sale. Demand points to the ability of buyers to purchase goods and services.
Demand refers to how much (quantity) of a product or service is desired by buyers. Typically demand rises as the price of a product falls and demand decreases as prices rise.
The law of demand states, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa. The law of demand says that the higher the price, the lower the quantity demanded, because consumers’ opportunity cost to acquire that good or service increases, and they must make more tradeoffs to acquire the more expensive product.
Economists graphically represent the relationship between product price and quantity demanded with a demand curve:
The sensitivity of the changes in price and demand is called price elasticity. Products and services have different degrees of price elasticity. For example, if gasoline increases in price, overall demand may not be proportionately reduced, as people still need gas to fuel their vehicles (low degree of price elasticity). If, however, the price of airline travel increases greatly, it may be likely that demand for air travel will have a greater than proportionate decline (high degree of price elasticity).
Businesses need to carefully monitor the factors that may affect demand. If they aren’t keeping a careful eye on these different demand elements as related to their business, their competitors will find a competitive advantage that can affect an organization’s long-term survival.
Supply refers to the relationship between different prices and the quantities that sellers will offer: Generally, the higher the price, the more of a product or service that will be offered.
The law of supply states, all other factors being equal, as the price of a good or service increases, the amount of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale.
You can see the relationship between product price and quantity supplied in a supply curve:
The law of supply and demand states that prices are set by the intersection of the supply and the demand. The point where supply and demand meet identifies the prevailing market price at which you can expect to purchase a product:
This state where supply and demand are balanced is called the equilibrium price or market equilibrium. The market forces described here, working through the price mechanism, are the essence of Adam Smith’s “invisible hand”: Supply and demand come into balance without central planning.
The market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers.
When the supply and demand curves intersect, the market is in equilibrium. This is where the quantity demanded and quantity supplied are equal.
6. Economic Systems
In the twentieth century, there were primarily two economic systems that provided answers to the questions of what to produce and for whom, given limited resources: planned economies directed by a centralized government and market economies based on private enterprise.
The market economy (private enterprise system) is centered on the economic philosophy of capitalism and competition.
Capitalism is an economic system in which businesses are rewarded for meeting the demands of consumers. It allows for private ownership of all businesses. Entrepreneurs, desiring to earn a profit, create businesses that they believe will serve the needs of the consumers.
Economic decisions and the pricing of goods and services are guided solely by the interactions of a country’s individual citizens and businesses. There is little government intervention or central planning.
There are four different types of competition in a market economy:
Pure competition is a market or industry in which there are many competitors. It is easy to enter the market, as there are few barriers to entry and many people/firms are able to offer products that are similar to each other. Individual firms have very little control over the price.
Monopolistic competition means that there are fewer competitors, but there is still competition. In this market environment, it is somewhat difficult to enter the market. Due to the differentiation factor, individual firms are able to have some sort of control over the prices.
Oligopoly is a market situation with few competitors. The few competitors exist due to high barriers to entry. The products or services in this market may be similar (telephone companies) or they may be different (supermarkets). Here, firms do have some control over prices.
A monopoly exists in the private enterprise system when there is absolutely no other competition. That means that there is only one provider that exists to provide a good or service. In this case, it is often the government that regulates who can enter the market (e.g. public transportation).
A market economy has several advantages: Firstly, competition leads to efficiency because businesses that have fewer costs are more competitive. Secondly, innovation is encouraged because it provides a competitive edge and increases the chance for wealth. Thirdly, a large variety of goods and services are available as businesses try to differentiate themselves in the market.
However, market economies have also disadvantages: Firstly, the disparity in wealth exists because wealth tends to generate wealth. It is easier for wealthy individuals to become wealthier than it is for the poor to become wealthy. Secondly, there tends to be a reduced social safety net, because social programs are mostly funded by the government.
In addition to the private enterprise system, planned economies are another market structure in the world economy. In a planned economy, the government controls business ownership, profits, and resources. Countries that existed with planned economies, however, have not been highly successful. The most common theory of a planned economy is communism, which purports that all property is shared equally by the people under the direction of a strong central government.
It is an economic system that involves public ownership of businesses. Rather than entrepreneurs, the government decides what products consumers will be offered and in what quantities.
Communism was proposed by Karl Marx and developed and implemented by V. I. Lenin. In Marxist theory, “communism” denotes the final stage of human historical development in which the people rule both politically and economically. The communist philosophy is based on each individual contributing to the nation’s overall economic success and the country’s resources are distributed according to each person’s needs. The central government owns the means of production and everyone works for state-owned enterprises.
A planned economy has some advantages: Since the government has control over all factors of production, the risk of a monopoly are next to nil under a planned economy. Also, it may help in reducing the gap between the poor and the rich because all government policies are designed to bring social equality.
However, the planned economy has some big disadvantages: Firstly, it leads to the destruction of entrepreneurs and innovators which in turn leads to lower productivity and also lower growth for a country. Secondly, this system leads to dissent among the citizens as the basic right of free will is challenged under this system. Finally, this system suffers from government bureaucracy. Delay in decision making on the part of government officials leads to bottlenecks in production and inefficient use of resources.
History has proven that, worldwide, the central command-economy model has not sustained economic growth and was not able to provide long-term economic security for its citizens.
The majority of economies that we see today, however, are mixed economies. These are economic systems that display characteristics of both planned and market economies.
In the mixed economy, government-owned firms frequently operate alongside private enterprises. Good examples of this can be found in Europe where the respective governments have traditionally controlled certain key industries such as railroads, banking, and telecommunications.
Strictly speaking, all modern economies are mixed, though there are wide variations in the amount of mix and the balance between public and private influence.
Today, the majority of economies are mixed economies.
End of Part 1