Economics Study Set 18

Business

Quiz 9 :
An Introduction to Basic Macroeconomic Markets

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Quiz 9 :
An Introduction to Basic Macroeconomic Markets

Economic theory is broadly divided into two groups. They are- 1. Micro economics and 2. Macro economics Micro economics deals with an individual while macro economics is an aggregative concept. All individuals of the economy collectively considered in macro economics. In macroeconomics, economic units are broadly divided into three sectors. They are- 1. Household sector 2. Business sector and 3. Government sector Household sector owns factors of production like land, labor and capital. These factors are employed by business for manufacturing commodities, and the payment the factors of production receive is called factor payment. It includes rent, wages, interest and normal profit. Business sector produces commodities and in return it earns profit. Government like household also demand for goods and service in the economy, it incur expenditure for welfare purpose. Macro economy model will effectively function through different markets. They are- 1. Factor market 2. Commodity market 3. Loanable funds market and 4. Foreign trade market A market is a mechanism which connects buyers from sellers to undertake transactions. Buyers create demand of the subject matter of the market and sellers supply them. These two forces mainly depend upon price. They interact to determine market equilibrium price. Factor market: Subject matter of this market includes land, labor, capital and organization. Business sector demand such factors to produce commodities. Household sector supply them in lieu of factor price. Factor prices are determined on the basis of their demand and supply. Factor price is fixed where demand and supply are equal. Commodity market: It is a market where commodities are transacted. Business sector produce them and supply to household sector for consumption. Also a portion may be sold to government for welfare activities and some goods can be exported. Here also commodity price will depend up on interaction of market demand and supply. Loanable fund market : Business sector and government needs money which they can take on loan from this market. This fund is supplied by household from their saved income. Interest is the price of loanable fund which will depend up on demand and supply of this fund. Foreign market : It is a market outside the economy. Goods are exported and imported from such economies. If export exceeds import, then it is leakage of commodities. In opposite situation it is injection in the economy. The aggregate demand constitute of private consumption, investment, government expenditure and net export. The locus of aggregate AD curves depicts the relationship between price and real GDP. Here price is not relative price that we apply in microeconomics; it's a general price level of commodity in the economy. The movement along the AD curve represents the different level of real GDP at different prices, if price in the economy falls real GDP will rice, vice-versa. Further, shift in AD curve will occur when the composition of AD (consumption, investment, government expenditure, and net export) changes bought by the factors other than the price. For example, assume due to certain factor consumption in the economy increases. As the consumption increases aggregate demand AD increases and hence the income in the economy. Mathematically, aggregate demand curve is, img C is consumption, I is investment, G is government expenditure, and (X-M) is net export. img Following are the reasons behind negative slope of the demand curve- 1. Purchasing power: It is the real value of money. Number of units of a commodity that can be purchased by spending a dollar is known as purchasing power of money. When price of commodity decline, consumer can buy more units at same dollar. Thus purchasing power of dollar is going up. So real value of dollar is going up. With the increase in real income consumer will demand more. So demand will rise. Just opposite will happen when price is going up. It will reduce purchasing power and so demand will decline. 2. Interest impact: when price is reduced in general, consumer will require less money to satisfy their demand. So savings will rise. More loanable fund supply will be available in the economy. Business sector will also require less money to buy factors for producing required commodities. Thus demand of loanable fund will be less. Due to increase in the supply of loanable fund and decrease in demand of loanable fund, interest rate will fall. Now savings is less attractive to household. They will increase the consumption to get more satisfaction. Also business sector is now getting loan at low interest, the investment demand rises. Thus decrease in price lower interest rate. In effect increases aggregate demand. 3. Impact of international market: In commodity market, fall in price level will mean overall decrease in the price level of all commodities. Now domestic goods are available at cheap rate. People will substitute consumption of foreign goods by domestic goods. It will reduce total import of the country. Just opposite impact will be observed in the foreign country. They can get goods at lower price by importing them from our country. So export will go up. Thus domestic substitution and increase in export will raise aggregate demand of commodities when their prices are declining in the commodity market. Downward slope of specific goods demand curve: Demand curve of specific goods is also down ward sloping in nature. But the reason for its negative slope is not the same. It is due to the difference in their nature. In an economy non substitutable goods are rare. Thus when price of a commodity fall, consumer will prefer to consume the cheap commodity more by reducing the consumption of other substitutes. It will happen since substitutes are comparatively more costly now. It is known as substitution effect. Example : Rice and wheat are close substitutes. If price of rice is reduced, consumer will consume more rice and will consume less units of wheat. Thus demand of rice will increase and demand of wheat will decrease. Due to this substitution effect, demand curve of a specific commodity has a negative slope. This substitution effect is not observed when commodity market of the economy is taken as a whole. Decrease in the price of commodity market will mean price of all commodities in general are declining. Thus price of substitutes along with principal product will decrease. Hence there is no question of substituting demand of one product by another. Thus reason of downward price demand relationship for specific commodity and commodity market are different.

Aggregate supply curve of a commodity market is the total quantity of commodities supplied at different price. The nature of the supply curve depends upon the time dimension. Time wise it can be divided into- 1. Short run supply curve and 2. Long run supply curve. Short run is a period when time is insufficient to adjust everything according to the requirements. Long run on the other hand is a period where time is sufficient for adjustment. In short run commodity market supply curve is rising upward. So with the rise in price supply will rise. In long run it will be vertical. Factors affecting long run supply curve: Following factors will affect the long run supply curve: 1. Expectation about profit: With the rise in price of commodities business expected profit from the sale of product will rise. The rise in expected profit will induce to increase the supply of commodity. 2. Price adjustment in the factor market: Expected profit will go up only when price of factors used in the production of commodities do not change sufficient enough to neutralize the effect of price rise of commodities. 3. Time: Another important factor is time. If the time available is sufficient then whatever gain is expected from rise in the price of commodities will be totally offset by the rise in prices of factors used in the production. 4. Availability of factors: Resources are scarce. Economic system will allocate scarce resources in producing those commodities which will maximize satisfaction level. Availability of scarce resources is another crucial factor affecting supply curve. In long run resources should be used to the best possible extent. It is known as full employment situation. 5. Technology: technology should be adequate enough to satisfy demand of the commodities. Long run supply curve: Considering the overall impact of these entire factors, supply curve will be vertical. So if price changes quantity supplied will remain unchanged. In short run when price of a commodity increases, factors prices do not increase to the same extent. Result is the producers profit will increase. It will induce them to produce and supply more units. Thus with the rise in price, supply of commodities will also rise. Supply curve will rise upward. A portion of the factor cost in the short run is contractually fixed. Wages of most of the workers are contractually fixed at the time of appointment. Factory building or land are taken on rent or lease for a specific period of time. During this period their cost will not change. In short run due to existence of these contractually fixed factor cost, the price of factors will not rise to neutralize the impact of rise in commodity price. Thus profit will be more when price of commodities are raised. Hence supply of commodity will be raised in short run. But it will not happen in the long run. Now time is sufficient enough to change contractual payments terms and conditions. So price of factors will go up and it will adjust with the change in factor price. Thus positive effect of price rise on profit will be neutralized by a corresponding increase in factor price. Only normal profit is earned. Further due to sufficient time, economy will utilize all available scarce factors of production effectively in the manufacturing of commodities. Thus no unutilized resources will exist under ideal environment. Economy will produce to the extent of its potential output. No further production is possible. Also production should not be less than potential output. As normal profit is earned, production below the potential level will reduce actual profit below normal profit. In long run no production is possible if normal profit is not realized. Thus production in the long run will remain always at the potential level. Price may change but supply will not change. Hence supply curve will be vertical as shown below- img

Aggregate supply is the total value of commodities produced and supplied in an economy during the year. It is related with the general price level of commodities. Therefore supply curve indicates quantity supplied at different price. The nature of relation between price and supply depends upon time. It can be of two types- 1. Short run and 2. Long run Short run is time when the available time is not sufficient enough to change everything according to requirements. But it is possible in the long run. In the short run price and supply has a direct relation. If price of commodities are moving up, then the supply will also rise. Thus short run supply curve will slope upward to the right as shown below- img Reasons: The reasons for upward slope in the supply curve are explained below When price of commodity increase, the possibility of profit increase, considering that the input cost does not rises at the same time, or even if rises, it does not erased the profit potential. High expected profit will encourage producers to increase production and raise the supply. In the short run price of factors will not rise to the extent of increase in the price of commodities. It is due to the presence of contractual cost. Price of some inputs is contractually fixed for instance wages of labor are fixed for a period. Then it may change due to change in the terms and conditions of the contract. When land or buildings are hired or taken on lease a contract is made for a specific period of time. Interest on loan taken is also contractually fixed. During this period price stated in the contract will not change. Thus in spite of rise in commodity price, factor price of contractually agreed factors will not change. Hence rise in cost will be less than the rise in commodity price. Result is an increase in supply of commodity. Just opposite will happen when price of commodity fall. Price of contractually agreed factors will not decrease. Hence expected profit will come down. Supply will also decrease. Situation when factors price and commodity price changes by the same percentage: Consider the diagram above. Let initial price of commodity is P 0 and quantity is Q ₀. Suppose price has moved up to P 1. Due to presence of contractually agreed fixed cost, factor cost will not go up to the desired extent. So, expected profit after price rise will be high. More units will be produced. Thus supply will go up to Q ₁. img Now consider the situation when price of both commodities and input factors increasing at the same percentage. Thus whatever extra profit producer is expecting from price rise of commodity will be totally offset by the price rise in factors of production. Hence expected profit will not change. When there is no change in the expected profit, producer will not increase the production. They will maintain the same quantity which they have produced before price rise. Thus price will rise but supply will remain constant. Hence supply curve will be vertical as shown below. In the above diagram initial price was P 0. It has increased to P 1. But factor price has also moved up by the same percentage. Hence there is no increase in the expected profit. Production will remain at Q ₀ although price has moved up to P 1.

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