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Economics as an academic discipline is divided into Mircroeconomics and Macroecoomics

Microeconomics is a branch of economics that studies how individuals, households and firms and some states make decisions to allocate limited resources, typically in markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and services, which determines prices; and how prices, in turn , determine the supply and demand of goods and services.

This is a contrast to macroeconomics, which involves the "sum total of economic activity, dealing with the issues of growth, inflation and unemployment, and with national economic policies relating to these issues". Macroeconomics also deals with the effects of government actions (such as changing taxation levels) on them.

One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, as well as describing the theoretical conditions needed for perfect competition.

Assumptions and definitions

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them has the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers have the ability to influence prices. Quite often a sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in simple situations.

Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard (highways are the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economists may attempt to find policies that will avoid waste directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed.

The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods and constraints, this set of choices is that one which makes the consumer happiest

Modes of operation

It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered.

  • A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
  • A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.
  • If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.
  • If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

Opportunity cost

Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money. The forgone profit of this next best alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm her or his land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit alone. Similarly, the opportunity cost of attending university is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment money for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of the city's decision to build the hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses—but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed.

One question that arises here is how to assess the benefit of dissimilar alternatives. We must determine a dollar value associated with each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose dollar value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications.

Market failure

In microeconomics, the term "market failure" does not mean that a given market has ceased functioning. Instead, a market failure is a situation in which a given market does not efficiently organize production or allocate goods and services to consumers.

The four main types or causes of market failure are:

  • Monopolies or other cases of abuse of market power where a "single buyer or seller can exert significant influence over prices or output". Abuse of market power can be reduced by using antitrust regulations.
  • Externalities, which occur in cases where the "market does not take into account the impact of an economic activity on outsiders." There are positive externalities and negative externalities. Positive externalities occur in cases such as when a television program on family health improves the public's health. Negative externalities occur in cases such as when a company’s processes pollutes air or waterways. Negative externalities can be reduced by using government regulations, taxes, or subsidies, or by using property rights to force companies and individuals to take the impacts of their economic activity into account.
  • Public goods are goods that have the characteristics that they are non-excludable and non-rivalrous and include national defenseand public health initiatives such as draining mosquito-breeding marshes. For example, if draining mosquito-breeding marshes was left to the private market, far fewer marshes would probably be drained. To provide a good supply of public goods, nations typically use taxes that compel all residents to pay for these public goods (due to scarce knowledge of the positive externalities to third parties/social welfare); and
  • Cases where there is asymmetric information or uncertainty (information inefficiency). Information asymmetry occurs when one party to a transaction has more or better information than the other party. For example, used-car salespeople may know whether a used car has been used as a delivery vehicle or taxi, information that may not be available to buyers. Typically it is the seller that knows more about the product than the buyer, but this is not always the case. An example of a situation where the buyer may have better information than the seller would be an estate sale of a house, as required by a last will and testament. A real estate broker buying this house may have more knowledge about the house than the family members of the deceased.

Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of a national or regional economy as a whole. Along with microeconomics, macroeconomics is one of the two most general fields in economics. It is the study of the behavior and decision-making of entire economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets.

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income).

Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy.

Macroeconomic schools of thought

The traditional distinction is between two different approaches to economics: Keynesian economics, focusing on demand; and neoclassical economics based on rational expectations and efficient markets. Keynesian thinkers challenge the ability of markets to be completely efficient generally arguing that prices and wages do not adjust well to economic shocks. Neither view is typically endorsed to the complete exclusion of the other, but most schools do emphasize one or the other approach as a theoretical foundation.

Keynesian tradition

Keynesian economics was an academic theory heavily influenced by the economist Keynes. This period focused on aggregate demand to explain levels of unemployment and the business cycle. That is, business cycle fluctuations should be reduced through fiscal policy (the government spends more or less depending on the situation) and monetary policy. Early Keynesian macroeconomics was "activist," calling for regular use of policy to stabilize the capitalist economy, while some Keynesians called for the use of incomes policies.

Monetarism, led by Milton Friedman, holds that inflation is always and everywhere a monetary phenomenon. It rejects fiscal policy because it leads to "crowding out" of the private sector. Further, it does not wish to combat inflation or deflation by means of active demand management as in Keynesian economics, but by means of monetary policy rules, such as keeping the rate of growth of the money supply constant over time.

Macroeconomic policies

In order to try to avoid major economic shocks, such as The Great Depression, governments make adjustments through policy changes which they hope will succeed in stabilizing the economy. Governments believe that the success of these adjustments is necessary to maintain stability and continue growth. This economic management is achieved through two types of strategies:

  • In economics, fiscal policy is the use of government spending and revenue collection to influence the economy.

    Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

    • Aggregate demand and the level of economic activity;
    • The pattern of resource allocation;
    • The distribution of income.

    Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

    • A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
    • An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
    • A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

  • Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.

    Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation

Credit: Wikipedia

 

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