Fundamentals of Microeconomics. Key Essentials of Demand and Supply Analysis

Inhaltsverzeichnis

OVERVIEW OF ECONOMICS

1.1 INTRODUCTION
1.2 DEFINITION OF ECONOMICS
1.3 DEFINITION OF MICROECONOMICS
1.4 DEFINITION OF MACROECONOMICS
1.5 EXPLANATION OF SOME KEY CONCEPTS IN ECONOMICS
1.5.1 Ends
1.5.2 Means
1.5.3 Scarcity
1.5.4 Choice
1.5.5 Scale of Preference
1.5.6 Opportunity Cost
1.6 ECONOMIC APPLICATION OF THE CONCEPT OF OPPORTUNITY COST
1.6.1 Opportunity Cost and the Individual
1.6.2 Opportunity Cost and the Firm
1.6.3 Opportunity Cost and the Government
1.6.4 Conditions under which Opportunity Cost is Zero
1.6.5 General Importance of Opportunity Cost
1.7 OPPORTUNITY COST AND THE PRODUCTION POSSIBILITY CURVE (PPC)
1.7.1 Production Possibility Curve (PPC)
1.8 IMPORTANCE OF THE STUDY OF ECONOMICS
1.8.1 Households
1.8.2. Firms
1.8.3 Government
1.9 THE SCOPE OF ECONOMICS
1.9.1. Production activities

ECONOMIC SYSTEMS AND THEIR FUNCTIONS
2.1 OVERVIEW OF ECONOMIC SYSTEMS
2.2 TRADITIONAL ECONOMY
2.2.1 Advantages of a Traditional Economy
2.2.2 Disadvantages of Traditional Economy
2.3 CAPITALIST ECONOMY
2.3.1 Features of a Capitalist Economy
2.3.2 Advantages of a Capitalist Economy
2.3.3 Disadvantages of a Capitalist Economy
2.4 SOCIALIST ECONOMY
2.4.1 Features
2.4.2 Advantages of Socialist Economy
2.4.3 Disadvantages of a Socialist Economy
2.5 MIXED ECONOMY
2.5.1 Features of a Mixed Economy (Using Ghana as a case)
2.5.2 Advantages of a Mixed Economy
2.5.3 Disadvantages of a mixed Economy
2.6. FUNCTIONS OF AN ECONOMIC SYSTEM
2.6.1 Primary functions of an Economy
2.6.2 Secondary Functions

DEMAND AND SUPPLY
3.1 DEMAND
3.1.1 Factors affecting Demand
3.1.2 Demand Schedule
3.1.3 The Law of Demand
3.1.4 Exceptional Demand Curves/Deviations from the Law of Demand
3.1.5 Changes in Demand
3.1.6 Consumer and Producer Surpluses
3.2 SUPPLY
3.2.1 Factors affecting Supply
3.2.2 Supply Schedules
3.2.3. The Law of Supply
3.2.4 Exceptional supply curves/deviations from the law of supply
3.2.5 Changes in Supply

PRICE DETERMINATION
4.1 INTRODUCTION: THE CONCEPT OF PRICE
4.1.1 Bargaining/Haggling
4.1.2 Auctioning
4.1.3 Tender
4.1.4 Government pricing/Price control
4.1.5 Demand and supply
4.2 ESTABLISHING EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY
4.3 EQUILIBRIUM PRICE DETERMINATION-CHANGES IN DEMAND AND SUPPLY
4.3.1 A Change in Demand and the Impact on Equilibrium Price
4.3.2 A Change in Supply and its Impact on Equilibrium Price
4.4 TYPES OF DEMAND
4.4.1 Competitive Demand
4.4.2 Complementary/Joint demand
4.4.3 Derived Demand
4.4.4 Composite Demand
4.5 TYPES OF SUPPLY
4.5.1 Competitive supply
4.5.2 Complementary or joint supply
4.5.3 Composite supply

ELASTICITY OF DEMAND AND SUPPLY
5.1 MEANING OF ELASTICITY OF DEMAND
5.2 PRICE ELASTICITY OF DEMAND
5.2.1 Definition
5.2.2. Measurement of Price Elasticity of Demand
5.2.3 Formulae for calculating coefficient of price elasticity of demand
5.2.3 Classification of price elasticity of demand
5.2.4 Importance of price elasticity of demand
5.2.5 Incidence of taxation
5.3 INCOME ELASTICITY OF DEMAND
5.3.1 Overview
5.3.2 Definition of Income Elasticity of Demand
5.3.3 Measurement of Income Elasticity of Demand
5.3.4 Formulae for Calculating Coefficient of Income elasticity of demand
5.3.5 Implication of the sign of the coefficient of income elasticity of demand
5.3.6 Classification of income elasticity of demand
5.3.7 Importance of Income Elasticity of Demand
5.4 CROSS ELASTICITY OF DEMAND
5.4.1 Introduction
5.4.2 Meaning of Cross Elasticity of Demand
5.4.3 Key Definition of Cross Elasticity of Demand
5.4.4 Measurement of Cross Elasticity of Demand
5.4.5 Formulae for calculating Coefficient of Cross Elasticity of Demand
5.4.6 Summary of the signs of the Coefficient of Income Elasticity of Demand
5.4.7 Classification of Cross Elasticity of Demand

CONSUMER BEHAVIOUR
6.1 OVERVIEW OF CONSUMER BEHAVIOUR
6.2 CARDINAL UTILITY APPROACH
6.2.1 The law of diminishing marginal utility
6.3 THE ORDINALIST’S APPROACH/INCOME AND SUBSTITUTION EFFECTS
6.3.1 Overview of income and substitution effect

BIBLIOGRAPHY

ABOUT THIS BOOK

Fundamentals of Microeconomics for Business Students is a unique textbook in the field of Microeconomics, which is a core subject for undergraduate and diploma students pursuing courses in Business and various other courses such as engineering, computer sciences, architecture, management and many more. This book is the first volume of a series and covers the meaning and scope of Economics as a discipline. It goes ahead to treat the key essentials of Microeconomics, ie demand and supply, market equilibrium, elasticity and consumer choice theory. The second volume will treat theory of production, Cost theory, theory of the firm-perfect competition, monopoly and monopolistic competition.

The rich experience of the writer in the teaching of Economics plays out in meeting the needs of the student throughout the pages of the book. The coverage and structure of the book have been designed taking into account the syllabi of Microeconomics courses prescribed by the higher education institutions/universities especially in Ghana. It is clearly written in a student-friendly manner, and replete with easy to-do exercises so that the first time learner of Economics can do a self-study with this book and excel in Microeconomics. The book will be useful for readers who often have difficulty in understanding microeconomic concepts. It is also specially designed to meet the needs of students studying economics first time at the tertiary level and for non-economists who want to appreciate the subject matter of Microeconomics.

This book is packed with illustrations, sketch graphs and diagrams that are altogether functional and relevant to the theories presented. Finally, the author hopes the reader is able to apply the basic theories, principles and concepts to help solve everyday economic and business problems that they encounter in everyday life.

Frank Frimpong Opuni

2017

ABOUT THE AUTHOR

The author is a Senior Lecturer in Marketing at the Business School, Accra Technical University Ghana.

He has vast experience in teaching Economics and Business courses in general at the tertiary level.

Frank holds B.ed in Economics from the University of Cape Coast, Ghana and is a Chartered Economist-A Fellow Chartered Economist (FCE) with the Institute of Chartered Economists, Ghana.

He holds an MBA from the Kwame Nkrumah University of Science and Technology.

Frank is a Fellow of the Global Strategic Institute Management institute and a PhD student in Business with the University of Bolton, UK

OVERVIEW OF ECONOMICS

Learning Objectives

After going through this chapter, the student should be able to:

- Give a comprehensive definition define Economics
- Explain the basic concepts in Economics
- Apply the concept of opportunity cost within international context
- Identify the key factors of production
- Distinguish clearly between Microeconomics and Macroeconomics

1.1 INTRODUCTION

The word economy comes from the Greek word ‘oikonomos’, which means “one who manages a household.” At first, this origin might seem peculiar. But in fact, households and economies have much in common. A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra dessert at dinner? Who chooses what TV show to watch? In short, the household must allocate its scarce resources among its various members, taking into account each member’s abilities, efforts, and desires.

Like a household, a society faces many decisions. A society must decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services that they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Ferrari and who will take the bus. The management of society’s resources is important because resources are scarce.

Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire.

Economics as a discipline deals with the prudent management of scarce resources to satisfy man’s numerous wants. Our wants are numerous and far exceed available resources. Therefore, we need to manage scarce resources wisely in order to satisfy our basic needs and wants. Economics exists as a subject because of the unlimited nature of man’s wants and the limited nature of resources.

1.2 DEFINITION OF ECONOMICS

Several definitions of Economics have been put forward by some Eminent Economists in the past. One of these Economists, Sir Lionel Robins defines Economics as the science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. Paul Samuelson defines Economics as the science that studies how man or society chooses from scarce productive resources that have alternative uses to produce goods and services for distribution and consumption now and in the future.

Taking a cue from the general introduction given earlier, and for the purposes of this treatise, Economics can be defined as a social science that studies individuals’ consumption behavior patterns among given alternatives, as well as how firms and governments trade-off choices in allocating limited resources which have different uses.

The broad subject of Economics is split into two disciplines: Microeconomics and Macro Economics. The main focus of this book is to look at the Basic principles, theories and concepts in Micro-Economics, and to create a solid foundation for students in the study of the broader aspects of Macroeconomics.

1.3 DEFINITION OF MICROECONOMICS

Microeconomics is the study of the behaviour of individual consumers, firms and industries. It is the branch of Economics which deals with individual units within the economy such as households, firms, and industries; and with individual markets, particular prices, and specific goods and services. The study of the level of output and employment for a particular factory will belong to microeconomics. The goal of microeconomics is to understand how the actions of consumers and producers affect price and output. Major topics under this branch of Economics are: demand and supply (of individual commodities), consumer behaviour, theory of production, theory of cost and theory of the firm (market structures).

1.4 DEFINITION OF MACROECONOMICS

Macroeconomics is the branch of Economics that deals with economic totals/aggregates or the performance of the economy as a whole. In macroeconomics, we do not place emphasis on the supply of and demand for individual goods and services in separate markets. The focus is on the total/aggregate supply of and total/aggregate demand for all goods and services produced in the country/economy. We do not, for example, talk only about the price of a bag of rice in a single market, but we talk about the prices of all goods and services produced and supplied in all markets in the economy. In terms of consumption, we do not consider not just individual consumption but all total/aggregate consumption by all consumers in an economy. The goal of macroeconomics is to identify the factors that the level of national output and national income. Examples of topics under this branch of Economics are national income, public finance, money and banking, inflation, balance of payments, international trade and unemployment.

1.5 EXPLANATION OF SOME KEY CONCEPTS IN ECONOMICS

1.5.1 Ends

Ends refer to our aims, objectives, goals or wants. What is before you at any point in time is your end. The end of a consumer is to maximize satisfaction from needs and wants. The objective or end of a firm may be to increase its profits by 50% of the previous year’s profits. The end of the government may be to provide hospitals, schools, electricity, roads, water, etc. It should be noted that the consumer, firm or government never get satisfied with their ends. We normally divide ends into wants and needs. Needs refer to things we cannot do without. They are the basic necessities or essentials of life which primarily refer to water, food, shelter and clothing. Education, energy and health have become more or less needs in modern society. Wants refer to all other things which we demand but which tend not to be ‘essential.’ Without wants we can still survive. However, man’s problem has been the insatiable desire to acquire wants which add to the pleasantries and luxuries of life. Everybody wants a plus car, a luxurious home, an exotic vacation, a complex mobile phone, etc. This leads us to the point where we need to have the means to acquire all these ends.

1.5.2 Means

Means are the resources that enable us to obtain our ends. They include all those valuable items that can help in the production of goods and services to satisfy human wants. Therefore, the means or resources of the nation are the factors of production, namely: land, labour, capital, and entrepreneurship. These means are limited (inadequate) in supply relative to the demand for them. We

have unlimited ends to satisfy but we do not have an unlimited supply of the means or resources to satisfy all our wants; hence we say means/resources are scarce.

1.5.3 Scarcity

Scarcity as a concept arises because of the limited nature of resources in relation to the unlimited nature of human wants. All resources: land, capital, labour and entrepreneurship are scarce relative to the demand of every individual, firm, and government. The central or fundamental problem of Economics is scarcity. In fact, it is the problem of scarcity that gives rise to the subject of Economics. If resources were abundant relative to ends, the study of Economics would not arise. Scarce resources have alternative uses which can be combined in various proportions. As a result of the scarcity of resources, it is necessary for us to choose from their alternative uses or applications. Therefore, society must choose what to produce; how to produce; where to produce; when to produce; and for whom to produce. It is evident that scarcity leads to the concept of choice.

1.5.4 Choice

Choice refers to the act of selecting from given alternatives. Choice is made possible for two major reasons. The first reason is that means are scarce and for that matter we cannot get all that we want.

Secondly, means have alternative uses and therefore we can use a particular resource to accomplish a more important end and forgo a less important one. A limited piece of land can be used for a cocoa farm or a fish pond. If the fish pond can bring in more profits than a cocoa farm, then the owner of the land will choose fish rearing over cocoa farming. If resources were used for only one purpose, there would not be any choice open to individuals, firms or government. In order to make an appropriate choice, one needs to draw what Economists call ‘a scale of preference’.

1.5.5 Scale of Preference

The scale of preference refers to an arrangement of wants in order of importance with the most pressing needs on top of the scale followed by less pressing ones. A first year student in a University may have this scale of preference:

- laptop
- textbooks
- lecture notes
- New pair of shoes
- Provisions

The most important item is laptop; followed by textbooks; etc in that descending order.

It should be noted that the scale of preference differs among individuals, firms and governments because of differences in tastes, culture, race, political ideology, etc. For example, due to differences in tastes, the student may place textbook at the top of his scale of preference whiles another student may prefer lecture notes at the top of their scale of preference. A capitalist government may allocate scarce revenue towards encouraging the setting up of private businesses whilst a communist government may allocate resources towards creating more public or government enterprises.

The concept of Scale of Preference is important for the following reasons:

- It helps an individual to maximize satisfaction from his limited resources/income.
- It helps us to make reasonable choice from given alternatives since resources are limited and we cannot get all that we want. It helps us to make the best choice and forgo less important ones. It therefore enhances effective decision making.
- It helps the firm to rank potential projects and allocate resources towards the project that bring in maximum profits. Scarce resources such as land, labour and capital are effectively utilized.
- It helps the nation to maximize the welfare of her people, since the government implements those projects that are of higher priority.

When a choice is made from the scale, some item(s) are sacrificed. The item(s) sacrificed which are of equal value to the item(s) chosen are known as opportunity cost.

1.5.6 Opportunity Cost

Since means have alternative uses as indicated by Sir Robins’ in his definition of Economics, it becomes possible to make a choice and forgo other uses. Opportunity cost therefore refers to the alternative satisfaction or gain forgone when a choice is made. Another name for opportunity cost is real cost/implicit cost.

In our earlier example, where the piece of land could be used for fish farming or cocoa farming, the farmer chose to use the scarce land for fish farming and sacrificed cocoa farming. To the Economist, the real cost of the fish farm is the profit that could have been derived from the forgone cocoa project. If profits from the fish farm exceed the profits which could have been realized from the cocoa farm, then the land owner would have made a rational/judicious/economic decision. The Economist would think of the total cost of the fish farm as the actual cost (accountant’s cost/explicit cost) incurred in starting the fish project plus the opportunity cost/implicit cost. TC=Explicit Cost+Implicit Cost. Economists are not interested in the money cost (price) of a commodity but rather the alternative that has to be sacrificed to enable us get what we want. The item(s) sacrificed must be:

- relatively equal in value to the chosen item(s)
- the one or those next to the chosen item(s)

It therefore follows that, the opportunity cost of a Samsung Galaxy Note 5 mobile phone cannot be a Toyota Sienna family car because the resource (money) used in buying the phone cannot buy the car.

1.6 ECONOMIC APPLICATION OF THE CONCEPT OF OPPORTUNITY COST

The concept of opportunity cost is relevant to the three basic units of an economy: the individual, the firm and the government. The concept of opportunity cost helps these three basic units in an economy to solve the problem of scarcity. Let’s find out how.

1.6.1 Opportunity Cost and the Individual

The objective of the individual is to maximize satisfaction or utility given his/her limited resource. He employs the concept of opportunity cost to achieve this objective. Given the scale below;

Table 1.1 Scale of Preference

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If this student has a limited income of USD500.00, he would buy the most important item on the scale of preference which is a laptop. The opportunity cost of buying the laptop would be textbooks and lecture notes forgone which his nominal income (USD500.00) could have bought but not the rest of the items. If he had USD200 he would have bought lecture notes and forgone new pair of shoes and provisions. We therefore realise that the concept of opportunity cost helps the student to make the best choice and maximize satisfaction given his limited income.

1.6.2 Opportunity Cost and the Firm

The objective of the firm or entrepreneur is to maximize profits given limited resources, i.e. capital, labour, land and available technology. An entrepreneur who wants to start a firm would have to use scarce capital (e.g. a loan contracted from a bank) to undertake the kind of project that brings in the highest profits or returns to compensate for the risk taken. The money capital has lots of alternative projects: a transport business, a poultry farm, a provisions store, etc. In applying the concept of scale of preference, the entrepreneur can rank the projects as follows:

- Provisions store
- Transport business
- Poultry farm

We realize that the entrepreneur’s priority choice is the provisions store. The opportunity cost will be the next best alternative forgone, which is the transport business. If the provisions store actually brings in the much anticipated high profits, then the concept of opportunity cost would have helped the entrepreneur to make an economic decision and realize his objective in business. The problem of scarce resources would have been managed effectively.

1.6.3 Opportunity Cost and the Government

The government’s objective is to maximize the welfare of the people given limited resource, i.e. revenue. The government has to judiciously use limited revenue to provide social infrastructure that help the people enjoy higher standards of living. The government is faced with lots of projects but it cannot meet all of them within its limited mandate and before the next elections. It has to rank the projects in order of priority and use scarce revenue to provide those services that are most important and forgo other less important ones. Given developmental projects such as education, roads, hospitals, energy, etc, the government can come out with this scale of preference.

- Education
- Energy
- Roads
- Hospitals

The table shows that the government attaches much importance/priority to education and commits scarce resources to it in the first year and forgoes the rest. In the second year, it will commit scarce resources towards energy provision and forgo the rest. It will then go in for roads in the third year. By ordering its development agenda this way, scarce resources could be used judiciously to develop a country.

1.6.4 Conditions under which Opportunity Cost is Zero

- When resources are abundant to satisfy all our wants. In this situation, choice making would not arise and hence no sacrifice would be made.
- When a resource has only one (1) use. E.g. a wrist-watch. In this situation, there is no other alternative use for this resource apart from using it to tell the time. The alternative function is zero and hence the opportunity cost is zero. Sewing machine, machete, etc have zero opportunity cost. Land does not have zero opportunity cost because it has alternative (different) uses.

1.6.5 General Importance of Opportunity Cost

- The concept of opportunity cost equips individuals to know how to choose the combination of goods that will yield the highest satisfaction from their scarce income.
- The concept helps the producer to choose the best project that will yield the highest profit given scarce resources and technology.
- The knowledge of opportunity cost helps the government to make the right choice in terms of which projects it should expend scarce revenue in order to maximize welfare of the people.

It therefore helps government to plan well within its limited time.

1.7 OPPORTUNITY COST AND THE PRODUCTION POSSIBILITY CURVE (PPC)

The Production possibility of an economy shows the optimum/maximum combination of goods that a country is capable of producing given its current level of resources and technology or state of the art. The Production possibility curve is also termed production possibility frontier.

1.7.1 Production Possibility Curve (PPC)

Under the field of Macroeconomics, the production possibility frontier represents all the points at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best possible way. If it happens that the economy is not producing the quantities indicated by the PPC, then it implies that resources are being managed inefficiently and therefore the productive capacity of society will fall.

The production possibility frontier shows that there are limits to production. Therefore, for an economy to achieve efficiency it must decide which combination of goods and services to produce. Let's take a look at Fig 1.1 below. Imagine an economy producing only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present level of resources.

Fig 1.1 Production Possibility Curve

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In Fig 1, in order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the chart shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C represent the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production.

Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology whiles the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.

Fig 1.2 Shifts in Production possibility

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When the PPF shifts outwards, we know there is growth in the economy. Alternatively, when the PPF shifts inwards, there is shrinking in the economy as a result of a decline in the allocation of resources and productive capacity. A shrinking economy could be the result of a decrease in aggregate supply or deficient technology. An economy could be producing on the PPF only in theory. In reality, economies always struggle to reach an optimal production capacity. And because scarcity forces an economy to choose one resource and forgo the other, the slope of the PPF will always be negative. Thus, if production of product A increases, production of product B decreases.

1.8 IMPORTANCE OF THE STUDY OF ECONOMICS

We can now summarise the importance of the study of Economics under the following headings:

1.8.1 Households

- The study of Economics helps individuals to get the highest satisfaction from their limited resources.
- The study of Economics also makes the individual know that it is wise to save part of his income so that he can gain access to higher consumption in future.
- The study of Economics enables the individual to realize that it is the combined efforts of all households or individuals that make the nation as a whole prosper since such combined efforts lead to an increase in total demand and supply, thereby boosting the level of economic activities.

1.8.2. Firms

- It helps firms to allocate scarce resources toward projects that bring maximum profits.
- It helps firms to employ quality productive resources, at least in costing and managing them effectively to come out with maximum output.
- It helps firms to come out with products that meet consumers’ demand, knowing that consumers will not use their incomes to patronize goods that will not give them utmost satisfaction.
- Economics helps firms to fully employ resources for optimum output. It thus helps to reduce unemployment.

1.8.3 Government

- It helps government to use its scarce resources effectively to implement the most important needs of the people at any point in time.
- It helps the government to avoid wastage of resources by embarking on development programmes that directly link to productivity.
- The concepts of opportunity cost and production possibility help government to increase the productive capacity of the nation’s inputs so as to produce more output to meet increased demand.
- The concept of opportunity cost helps government to specialize in the production of commodities of comparative advantage and forgo commodities of comparative disadvantage.

1.9 THE SCOPE OF ECONOMICS

The scope of Economics refers to any legal set of activities in an economy for which an economic unit receives an income. The scope of Economics includes mainly production activities and distribution activities.

1.9.1. Production activities

Production involves all those activities which lead to the creation of goods and provision of services to satisfy human wants. In simple terms, production is the creation of utility. Thus, apart from creating a physical good like canned tomato, services like: a lawyer offering a client legal services; a lecturer delivering a piece of lecture in a lecture theatre, musician performing live in a theatre; etc all constitute production. So long as the client receives satisfaction or utility at the end, a productive activity is deemed to have taken place.

However, we must note that production is not complete without the good or service reaching the consumer. In other words, production is not complete without distribution. Put in another way, distribution is part of production. When physical goods are produced, they are distributed or they reach the final consumer through mainly road transportation, rail transportation and air transportation. On the other hand, the production of intangible goods (services) does not require physical intermediaries as the consumer receives the services directly. The consumer utilizes the output simultaneously as it is produced. Unlike a physical good, a service offer is intangible and therefore cannot be stored. It is therefore a perishable offer and is consumed at the same point in time that it is produced. The Barber’s service, for example, is highly perishable because the consumer experiences the offer in real time or at the same moment as it is delivered.

The advent of the internet has facilitated the delivery of both tangible and intangible goods to the final consumer. Easy accessibility to hand-held mobile phone devices has greatly enhanced the delivery of goods and services to final consumers in the modern economy.

The three main sub-activities/sectors under productive activities are primary, secondary and tertiary activities. Let’s take a look at the diagram below.

Fig 1.3 Main Economic Activities

The Economy

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Some productive activities in any economy include: farming, fishing, mining, manufacturing, construction, computer repairs, banking, teaching, mobile phone repairs, etc. These productive activities can be classified under primary activities, secondary activities and tertiary activities. For example, Farming, fishing, quarrying, etc are grouped under primary activities. Manufacturing and construction form part of secondary activities. Teaching, banking, mobile phone repairs, etc come under services or tertiary activities.

An economy or a country develops as it progresses from primary to secondary production to tertiary production (check the arrows in the diagram). A country which has lots of its productive activities found in primary production is termed ‘less developed’ or placed in a ‘third world’ category. In other words, a less developed country will have the greater part of its productive activities concentrated in primary activities compared to secondary and tertiary activities. As a country shifts productive activities from primary to manufacturing, it is called a developing or middle income country. A country like Ghana in West Africa is presently considered as a lower-middle income country. Its development target is to strive towards becoming a higher middle income country by the year 2020. A developed or advanced country will have majority of its economic activities in the tertiary or services sector, e.g. the U.S.A.

ESSAY QUESTIONS

A.1. Give one definition of Economics and explain it.

2. What is the importance of the study of Economics to individual households?

B. 1. Explain the concept of scale of preference.

2. What is the importance of the concept in Economics?

C. 1. Why is scarcity a fundamental problem in Economics?

2. Give one reason each why Economics is a

i. Science

ii. Social science

3. How do governments solve the problem of scarcity?

DATA QUESTIONS

A. The table below shows the various combinations of military (guns) and civilian (television sets) goods that can be produced in country K. Given the table below;

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1. What is the opportunity cost of producing

a. 30 television sets; b. 100 television sets; c. 300 guns; d. 550 guns?

2. If TV sets sell at USD500 per unit, and Guns sell at USD50 per unit on the market, what will be the total gain/loss for producing 150 units of TV sets?

3. Sketch the production possibility curve for the schedule above

ECONOMIC SYSTEMS AND THEIR FUNCTIONS

Learning Objectives

By the end of the chapter, the student should be able to:

- Give the definition of an economic system
- Outline the key functions of an Economic System
- Distinguish clearly between the main types of Economic Systems
- Discuss the key merits and demerits of the main types economic systems

2.1 OVERVIEW OF ECONOMIC SYSTEMS

An economic system is the type of ownership of resources existing in any country at any given time. It is identified as the methods and institutions put in place to implement or carry out economic activities in a country. An economic system is simply referred to as “an economy.” Therefore, in the normal Economics parlance, we often hear of U.S. economy, Ghana’s economy, etc. Globally, Economists identify four main types of Economic systems; traditional, capitalist (free market, market, laissez faire, free enterprise, etc), socialist (planned, command, controlled, etc) and mixed (dual) economies.

2.2 TRADITIONAL ECONOMY

A traditional economic system is one in which each new generation retains the economic position of its parents and grandparents. Traditional economies rely on the historic success of social customs. South America, Asia and Africa support some traditional economies of thriving agricultural villages. Tradition decides what an individual does for his living, so industry, clothing and shelter are the same as in previous generations.

2.2.1 Advantages of a Traditional Economy

Production of goods for people’s survival
The traditional economy is more about producing basic goods and services for the ordinary man. This economic system supplies sufficient amount of foods to the people. It greatly reduces the amount of surplus or waste that typically would have occurred.

Knowing People’s Role
In this particular economy, people can already recognize what their role in the society or community is. They need not to exert effort on a role which is not suitable for their skills and abilities thus no duplication of role or effort is evident on it.

Less Destructive
Since traditional economy is more on the culture and belief systems of the people, it will always sustain an environment friendly surrounding that aims to give the people their needs effectively and accordingly without affecting the nature of the environment. This part of Ghana’s traditional economy that has helped to sustain some part of the natural environment. For example in some regions, key virgin forests, rivers, eco-systems have been kept intact because of cultural belief systems that prevent local folks from exploiting such natural resources for economic gains.

Harmony among the People
A traditional economy promotes cooperation and harmonious relationships. It provides people with equal opportunities to practice working with other people harmoniously and with utmost cooperation.

2.2.2 Disadvantages of Traditional Economy

Vulnerable type of Economy
A traditional economy is more prone to vulnerability due to the continuous changes in the weather conditions. The economy is just not ready to counter external economic shocks and also take advantage of advances in global technology. This greatly affects the supply of foods and services to the people. As this economy continues to become vulnerable, there would be a greater possibility of shortages in the supply of foods and services.

Susceptibility to change
Since traditional economy is greatly based on customs and other society’s beliefs, there would be a greater chance for this economy to change as these aspects also change. All the aspects that were just taught by some of their ancestors would be the only important things that people would be using. They will no longer adopt new aspects in the society for their own improvement.

Lower Standards of Living of the People
People in the traditional economy are not highly specialized in living a wealthy life. The low standards that they practise can be seen when people get hooked on to menial occupations and jobs even when there are bigger opportunities for them to take on highly skilled and rewarding jobs. The people see such jobs to be beyond their skill, capabilities and cultural heritage. They would only want to rely on their ancestors’ customs and traditions.

2.3 CAPITALIST ECONOMY

The capitalist economy is a system in which productive resources are owned by private individuals and decisions as to what to produce, how to produce, how much to produce, where to produce and when to produce are taken by these individuals with the motive of making profit. In this system, it is the price mechanism which allocates resources to various uses. United States of America is an example of a capitalist economy.

2.3.1 Features of a Capitalist Economy

Resources are Owned and Controlled by Individuals

In a capitalist economy, resources are mostly owned by individuals. The state owns just a little part. The decision to produce which or good or service is determined by demand. The goods or services in demand get produced whiles those not in demand are discarded. In other words, private individuals use their resources to produce goods demanded and not goods needed by society in general. Here, the business of government is not to do business but to create a stable political and infrastructural environment for private businesses to thrive.

There is Free Competition/Perfect Market/Perfect Competition

A capitalist economy allows for the operation of perfect competition or a perfect market. There is free and open competition by all firms in the economy. Prices are not determined by government or any single seller or buyer but by demand and supply. Free competition promotes the production of quality goods and services for society. Resources are efficiently allocated in a perfect competition.

Demand and Supply Determine Price

This is the most important feature. Price of a commodity or service is determined by the free interplay of demand and supply. The government plays the minimal role of creating a conducive environment for demand and supply forces to operate freely. When quantity demanded of a good by a buyer meets quantity supplied by the seller, there is a meeting of minds (‘consensus ad idem’) between the buyer and the seller and an equilibrium price is established.

Consumer Sovereignty is Enhanced

The consumer is ‘king’ in this type of economy. It is what the consumer demands that gets produced. We therefore say there is efficient allocation of resources in a market economy. Resources are not used to produce goods not demanded. Consumer sovereignty is the basic principle of a marketing oriented company. The desires of the consumer are incorporated into the manufacturing or designing of the product before it comes out.

There is a Wide Income Gap

There is a wide income gap between the rich and the poor. The motive for production is profit and not social welfare. When demand rises, it is the rich who are able to buy the factors of production needed to produce the good in demand. Having produced the goods, they make profits and rechannel some of them to produce goods in demand. They make more profits again and the process goes on and on. The poor are not able to assemble resources to engage in production. The rich get richer and the poor get poorer. A social gap is created between the elitist rich and the poor or downtrodden.

2.3.2 Advantages of a Capitalist Economy

Efficient Resource Allocation

In a capitalist economy, economic resources are switched to the areas most needed by society. This is because producers supply what consumers want. Resources are not made to lie idle. They are moved from areas/sectors where demand is low to sectors where demand is high. There is efficient resource allocation.

Resources Allocation is done without cost to Society

In a socialist economy, a central planning committee is hired/employed by government and assigned to determine what to produce, how to produce, etc. In a free market system, the invisible forces of demand and supply interact to determine what to produce, how to produce, when to produce and for whom to produce. All these are achieved without any cost to government or society.

Optimal Satisfaction from Income

In a capitalist economy, consumers are able to distribute their income optimally to maximize their consumption. That is, given the market price of the commodities, consumers are free to decide how much of each commodity to buy depending on their income level. They achieve this by drawing a budget which meets the satisfaction level to be derived from a combination of goods or services.

A wide variety of commodities are produced in a Capitalist Economy

Producers are free to enter into the production of any good which they believe consumers would patronise. With the greater variety of commodities, consumers have a wide range of choice to enhance their welfare. The power of choice helps consumers to maximize satisfaction given their limited income.

The Consumer is King/Consumer Sovereignty

In a capitalist economy, the consumer is “the king” or supreme because it is he who decides what is produced through his demand pattern. Resources are used to produce only what the consumer wants or demands and not what the society as a whole needs.

Entrepreneurial Initiatives are Enhanced

Private initiative and creativity are encouraged which also lead to inventions and technical innovations. It promotes self-confidence and enables business-minded people to channel resources into starting their own business rather than wait to be employed by government or others. The capitalist economy therefore leads to the creation of more self-engaged jobs thereby reducing significantly the problem of unemployment.

Production of Quality Goods

A free market economy brings about production of quality goods because of free competition among producers. Competition leads to the development of state of the art technology in production which results in the creation of high quality goods and services all to the benefit of the consumer.

2.3.3 Disadvantages of a Capitalist Economy

It widens Income Inequality

When demand for goods increase, the rich who have access to resources produce and enjoy the profits. The poor are unable to secure productive resources. They thus fall out of industry and production. Having obtained profit, the rich will still go ahead to produce goods in demand. The rich therefore get richer and the poor get poorer.

There could be Price Instability

In a capitalist economy, prices are determined by demand and supply. Demand is not static but changes due to changes in taste and fashion, population size, etc. Thus prices could change every now and then leading to unpredictability and instability in prices.

Private Benefits come at a Social Cost

Private individuals may produce goods and services for profits but this could be at a cost to society. For example, an increase in demand for meat may lead to hunters setting fire to bushes and destroying arable farm lands. The continuous rise in the price of gold has led to many mining firms depleting and wasting natural environments without let. The society loses!

It may lead to Wastage of Resources

Certain basic goods and services may not be produced because producers are profit motivated. For instance, currently in Ghana, major farmlands are being converted into the production of bio-diesel/energy crops like sugarcane and jetropha which are hotly demanded. The production of major food crops like yam, maize, etc may fall drastically in the coming years. Resources may therefore not be optimally allocated. The profit motive may seriously harm society.

2.4 SOCIALIST ECONOMY

The socialist economy is a system in which resources are mostly owned by the state and it is the state or the central government which takes decision as to what, how, when, where and how much to produce. China, North Korea and Cuba are best examples of socialist economies.

2.4.1 Features

The State Owns and Controls Resources

The greater part of resources is owned by the state. Individuals own just a little part. The state determines the allocation of resources in the production of goods and services. It is what the state deems needed by society that is produced.

There is a Central Planning Committee

The government always appoints a central planning committee at a high cost. This committee fixes the prices of goods and services and determines the allocation of resources. The central planning committee advises government on major economic decisions.

Social Welfare is Enhanced

The motive of governance is to make sure that the social welfare of the all the populace is achieved, hence the term “socialist economy”. The government strives to distribute the national cake so that everyone is catered for so that poverty is reduced to the minimum. This is hardly achieved because the public services become inefficient and corruption creeps into the central administration system.

There can be Lack of Competition

There is no free competition in the system. Innovation is stifled since the government takes control of the system and individuals become onlookers. The quality of and quantity of output can be reduced, unless the government encourages foreign direct investment.

2.4.2 Advantages of Socialist Economy

Stability of Price & Income

Prices are fairly stable so that the value of the workers’ income is stabilized over time. This situation saves the economy from continuous economic instability. Economic stability will attract further investment from foreign companies. Perhaps this explains why China has attracted lots of foreign investment.

Fair Distribution of Income

Unlike the capitalist economic system where unfair income distribution exists, there is a fair distribution of income in the socialist economy. This is because the distribution of resources is carried out by the central planning committee and it is usually done in such a way that income is redistributed in favour of the poor. The income gap is therefore bridged.

Reduction in Wastage of Resources

Another advantage of the socialist economy is that wastage of resources is reduced because duplication of effort is controlled. It makes sure that resources are used in production to meet the needs of all sections of society. Resources are not used in repeat production of highly demanded goods. They are also used for other goods and services needed by the disadvantaged in society.

High rate of Economic Growth

A centrally planned economic system can be associated with a higher rate of economic growth. A higher growth rate usually requires political direction and heavy investment in particular sectors of the economy which are possible under central planning. This is manifested in the consistent growth of China’s economy. The governments of social democratic states like Sweden, Norway and Switzerland pay heavily for education and research at all levels. These economies have seen consistent economic development over the years.

Less Exploitation of Consumers

The consumer is not exploited since commodities are offered to him at affordable prices. This is possible because of the absence of profit motives. The needs of the greater part of consumers, especially lower and middle income earners are served, and not just a few rich consumers who have higher demand levels.

2.4.3 Disadvantages of a Socialist Economy

- The lack of competition in this economy could lead to the production of shoddy goods.
- The consumer’s supremacy is limited because what to produce is decided by central planning authority.
- There is high administrative cost since it requires administrative machinery to allocate the resources. This could drain the coffers of the economy.
- In a socialist economy, the consumer is not exposed to a variety of goods and therefore the power of choice is curtailed. The basic right and welfare of the consumer might be compromised.
- Personal incentives and interest on the part of individuals may be absent. Resources are owned by the state and this can curb personal initiative, creativity and enterprise. Political leaders and public official may rather channel resources to their areas of interest and neglect other important areas. Typically, communist states are characterized by unbalanced regional development.
- It may be fraught with bribery, corruption and inefficiency. This is because public officials who manage the state and public institutions feel accountable to no one and amass wealth meant for the people. At the end of the day, the ordinary masses in society rather become poorer.

2.5 MIXED ECONOMY

A mixed economy is an economic system where some of the resources are owned by individuals who make decisions based on price and cost conditions and the government also gets involved in the production and distribution of some goods and services. In reality, most countries have assumed mixed economic status since both government and individuals own productive resources in the modern economy. Countries like Ghana, Nigeria, Sierra Leone, Britain, etc are typical examples of mixed economies. The United States has now evolved to become in reality a dual economy as the state sponsors some aspects of education, transportation and distribution. For example the United States Postal Services (USPS) is owned by the state.

2.5.1 Features of a Mixed Economy (Using Ghana as a case)

A country is a mixed economy if it exhibits features of both capitalist and socialist economies. We discuss these features with specific reference to Ghanaian economy.

The government is not solely responsible for production and investment

The government and private individuals run in tandem transport services, broadcasting services, hospitals, schools, etc. For instance, the government in Ghana owns Korle-bu Teaching Hospital, Ghana Water Company, Ghana Broadcasting Corporation, etc. There are similar private companies like County hospital, OA Transport Services, Multi Media Systems, etc which serve the public. These compete freely with government bodies and it all ends up in improved quality of goods and services for the consumer.

Ownership of resources is shared by the state and the private individuals

Resources in the form of land, labour, capital and entrepreneurship are in the hands of both the government and private individuals. The government of Ghana has sole ownership of some plots of lands, forest reserves, mineral reserves, etc. Government also owns a greater part of labour, having employed them under government pay-role in the public services. Private people also employ labour at specific wage rates different from what is offered by government. Therefore, both government and private people own factors of production.

Prices of goods and services are determined by government and market forces

The government determines the prices of utilities like water and electricity provided by government companies like the Electricity Company of Ghana (ECG) and Ghana Water Company (GWC). However, in the open market, the prices of both capital and consumer goods are not fixed. They are determined by the forces of demand and supply. If market demand exceeds market supply, the item will be scare and price shoots up. Whiles prices of government utilities remain relatively fixed, the prices of goods produced by individuals keep fluctuating depending upon the interplay between demand and supply.

The decision as regards how to produce is not dictated by the state

Producers choose methods which minimize cost and maximize output. The government normally chooses to invest in both labour-intensive enterprises and highly capitalized ventures which provides essential services to the people. Typical examples include the construction of roads and harbours. Private people tend to adopt labour-intensive or capital-intensive methods based on the costs of these methods and demand patterns. If demand for a service is high and it requires a capital-intensive method of production, the private sector may go in to produce this service. The telecommunication sector in Ghana is capital-intensive yet it has about 95 % private participation.

2.5.2 Advantages of a Mixed Economy

Encouragement to Private Sector:

The most important advantage of mixed economy is that it provides encouragement to private sector and it gets proper opportunity to grow. It leads to an increase in capital formation within the country.

Freedom

In a mixed economy, there is both economic and occupational freedom as found in capitalist system. Every individual has a liberty to choose any occupation of his choice. Similarly, every producer can take decisions regarding production and consumption.

Optimum Use of Resources

Under this system, both private and public sectors work for the efficient use of resources. Public sector works for social benefit while private sector makes the optimum use of these resources for maximization of profit.

Competition and Efficient Production

Due to competition between both private and public sectors, the level of efficiency remains high. All factors of production work efficiently in the hope of profit.

Social Welfare

Under this system, the main priority is given to social welfare through effective economic planning. The private sector is controlled by the government. Production and price policies of private sector are determined to achieve maximum social welfare.

Economic Development

Under this system, both government and private sector join their hands for the development of socio-economic infrastructures, Moreover, government enacts many legislative measures to safe guard the interests of the poor and weaker section of the society. Hence, for any underdeveloped country, mixed economy is a right choice.

2.5.3 Disadvantages of a mixed Economy

Ineffectiveness of Sectors

Under this system, both sectors many become ineffective in nature. The private sector does not get the full freedom it requires because of government restrictions and regulations, hence it becomes ineffective. In a true sense, both sectors are not only competitive but also complementary in nature.

Delays in Economic Decisions

In a mixed economy, there are always delays in making certain decisions, especially in the case of public sector. These delays always lead to a great hindrance in the path of the smooth functioning of the economy.

More Wastage

Another problem of the mixed economic system is the wastage of resources. A part of the funds allocated to different projects in public sector goes into the pocket of intermediaries. Thus, resources are likely to be misused or misappropriated.

Corruption and Black Marketing

There is always corruption and black marketing in this system. Political parties and self- interested people take undue advantage of the public sector. Hence, this leads to emergence of several evils like black money, bribe, tax evasion and other illegal activities. All these ultimately result in red-tape within the system.

2.6. FUNCTIONS OF AN ECONOMIC SYSTEM

An economic system functions to solve the basic problem of scarcity. How the functions of the economic system are performed depends on the type of economic system. In a capitalist system, it is the price mechanism that performs the functions. In a socialist economy, it is the government that performs the functions. The government and the private sector come together to perform the functions in a mixed economy. The functions of an economic system are grouped primary functions and secondary functions.

2.6.1 Primary functions of an Economy

What to produce

As a result of the problem of scarcity, not all goods and services get produced. In a market/capitalist economy, the type of goods and services produced are determined by demand. It is the good that is demanded that is produced. If fresh yoghurt is in demand, then fresh yoghurt will be produced mostly. As consumers demand more of a particular commodity, it sends signals to producers to channel scarce resources towards producing more of that commodity.

In a socialist economy the function of what to produce is determined by the government. The government sets up a central planning committee which decides on the kinds of goods to be produced in the economy. Normally, they look at the basic needs of the masses and create industries to produce those items needed by society.

For a mixed economy both government and demand and supply forces interact to determine what is produced. The government normally provides essentials like water and electricity whiles the private sector provides highly demand services like telecommunication, media, information technology, etc.

How much to produce

How much to produce relates to the quantity or output level of goods and services to produce. If Milo is in demand, then how much or what quantity of Milo should be produced? If resources were abundant, unlimited quantities of Milo would be provided to satisfy everybody. Because of the problem of scarcity, society cannot produce unlimited quantities. In a capitalist economy, the demand for a good or service once again determines the output level that will be produced. In a free market economy, when price of a commodity rises, it is a signal that demand exceeds supply and therefore more of it will be produced. On the other hand, when price is falling, it shows that supply exceeds demand and less of it will be produced. Again, the rational producer will produce quantities of a commodity up to the level where profit is maximized such that marginal cost (MC) equals marginal revenue (MR). The firm will not produce an output level or quantity where cost exceeds revenue, i.e. MC>MR. On the other hand, so long as MR>MC, it means more revenue can be realized if sales increase. The firm will therefore produce more of the commodity until MC=MR.

In a communist system, the government determines how much of goods and services to produce. This is based on the gathering of information about the quantities of goods and services needed by society. The forces of demand and supply do not determine the quantity of goods produced.

In a mixed economy, both government and the private sector determine the quantity of goods and services produced. Demand levels determine the quantity produced by the private sector whiles the central planning committee determines the quantity produced by government.

How to produce

How to produce relates to the method of production to adopt in producing a good or service. Again, resources are scarce and producers cannot get unlimited access to the factors of production, especially labour and capital. Scarcity of resources implies that producers should make a choice as to whether to adopt capital intensive or labour intensive methods of production? In a capitalist economy, since the producer aims at minimizing cost and maximizing profit, he considers the relative prices and the productive capacities of the inputs. If labour is cheap and efficient, labour intensive method will be used. Conversely, if capital is cheaper and efficient, capital intensive method of production is adopted. In addition, if capital is expensive yet more efficient than labour, capital intensive method may be used and vice versa.

The central planning committee determines the method of production to adopt based on the economic policy of the government. If the government wants to adopt technology and employ more capital in production, then capita- intensive method of production is adopted. On the other hand, if government wants to employ more workers, then labour-intensive method of production is used.

In a mixed economy, the private business sector adopts labour-intensive or capital-intensive based on the relative prices of capital and labour. The government on the other hand likes to adopt capital-intensive methods of production especially in the provision of essential services like construction of roads, provision of electricity, etc. Such services require huge capital outlay which is normally beyond the reach of private individuals.

Where to produce

The problem of scarcity of resources implies that producers cannot site their firms just at any place. They have to locate their firms at places where they can get easy access to raw materials, power, labour, transport, etc. In a competitive economy, demand patterns once again determine where to locate a firm. Local investors will site their firms in places where they get easy access to demand or market. Foreign investors will locate their firms in a country where they will obtain demand for their products apart from easy access to raw material, labour, etc. The question of where to produce therefore boils down to cost minimization and effective demand for goods and services produced.

In a socialist economy, the government sites industries in areas where it deems fit to help provide services to the people and to improve the economy. There is however consideration as regards access to power, market, etc.

In a mixed economy, major factors as nearness to market, access to power, political stability, access to raw materials, etc strongly influence private businesses’ decision to locate an industry in a particular area. The government normally sites highly capitalized service industries in the cities and urban centres, where there is access to power, communication, etc.

When to produce

The problem of scarcity of resources implies that producers cannot produce at any time. They have to produce at a time when resources are cheap and available and when there is demand for goods and services. When commodities are produced at the wrong time, consumers may not buy such goods and producers lose. In a free market economy, to minimize the wastage of scarce resources, producers through the price mechanism, decide when to produce.

In a communist economy, when to produce is not dictated by demand. The government can produce at any time so long as it meets the needs of the masses. The central planning committee decides when it is appropriate to produce.

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