FW1 - Mental Imagery
Look at the map:
310 days before opening.
Economics studies how scarce resources are allocated to meet the unlimited wants of the individuals. Except for free goods such as the air, most of goods and services are produced from limited resources.
Micro economy studies how individuals and firms allocate these scarce resources to produce and distribute goods and services
-In a market economy, resources are allocated by prices resulting of the supply and demand
-In a socialist economy, resources are owned by the government. The government decides the type and quantity of goods to be made.
-In a mixed economy, the two precedent allocations are combined in various proportions.
Regarding the global failure of the socialist economy, the present module only focuses on the market economy mechanisms.
This course follows the main updated US academic standards. Nevertheless, there are many discussions about these topics.
Lesson: 1,5 hour
External readings and quiz: 3,5 hours
Do it yourself: 0
Total: 5 hours
In this module, we shall introduce the fundamental notions in micro economy and show how they apply to any business. These knowledge's can also enable you to progress toward the discovery of your own business idea.
The objectives of the lesson are:
-To show you how the production possibility frontier illustrates scarcity, opportunity costs and choices.
-To give you the fundamental notions to increase productivity and investment.
-To train you with the price elasticity concept within the market analysis.
-By the end of the lesson, you will be able to apply these concepts to the creation of your new business.
Except for free goods such as air or the sun heating, most goods imply the use of resources. We shall describe these scarce resources and the choices they imply in order to produce different goods.
11-Factors of production
-Definition: The factors of production are the resources used to produce goods and services.
These factors include land, labor, capital, and management
-Land includes all the natural resources such as acreage and raw materials. In a primitive economy, land is the most important factor of production. For example, the Indians hunt, fish and collect honey or wild seeds. The forest is their main resource to produce the goods required for their survival.
This primitive form of economy now only applies to a few tribes in Amazonian, in Borneo or in Africa (the pygmies). Historically however, it was by far the most important. The hunting and gathering economy began 100,000 years ago when homo sapiens was born, and continued until 9000 BC. This date marks the appearance of a sedentary form of agriculture in a few areas of the planet.
-Labor includes all the physical work. Labor appears as a large factor of production with the sedentary form of agriculture.
-Capital includes tools, machines, factories, equipment and infrastructures. Capital exists in a primitive society. For example, our indians make a few tools out of bone: sabarcans and harpoons. Nevertheless, capital appears as a large factor of production only in the modern time, in connection with the expand of technical progress.
Some economists take in account the human capital. It represents all the skills and practical knowledge's embodied in a worker. It can be measured by the level of education and the number of schooling years.
-Management includes managers who organize the previous factors of production
Modern economists agree that technology is also a resource. Since the beginning of the 19th and in our developed countries, Land remains quite unchanged, labor increases slowly with respect to the growth of population and Capital raises rapidly: Look at the following drawing.
Economists mainly deal with the quantity of the resources because any quantitative data can be traduced in figures and then can enter in equations and models. I would like to emphasize on the quality of the resource. The next drawing shows that the same amount of capital applied to the same quantitative resource gives very different output according to the quality of the resource.
You have mainly to acquire two resources: Equipment and labor. Choices are not too much difficult for equipment because the market applies a ratio between price and quality.
On the contrary, the labor resource is very difficult to value because two persons with the same background can offer very different potentialities.
We shall give you further advices but right now we recommend you to be very careful about the quality of people you are going to recruit.
12-The law of diminishing returns
-Definition: When increasing amounts of one factor of production are employed with some fixed amounts of other factors of production, the resulting increases of output become smaller and smaller.
Let us suppose that the land is a set factor, and let us see what happens when we increase the labor resource:
When we increase the number of laborers from 1 to 4, production increases from 20 to 35 and the productivity of the work falls (from 20 to 9). If you increase again the number of laborers, the total production will begin to fall. The next drawing shows another example: Labor and land are unchanged and capital increases: The output rises and after a certain point begins to fall.
For example, when you use increasing units of fertilizers on a constant plot garden with unchanged labor, the first unit increases the crop, the following units bring smaller and smaller outputs and the las unit damages the plants and the crop falls!
13-Opportunity cost and Production possibility frontier
As factors of production are scarce and exposed to the law of diminishing returns, you have to make choices between different goods or services. Each choice implies an opportunity cost.
-Definition: The opportunity cost is the value of the best alternative that you have to give up because you have made your choice.
For example, with the same labor, you can fabricate two tables or four chairs. The opportunity cost of making two tables is four chairs and the opportunity cost of one table is two chairs:
Opportunity cost = Unit of good forgone / Unit of good produced.
These information's are illustrated by the production possibility frontier which shows the combination of outputs that you can get from a given number of inputs and the maximum production possible given existing resources and technology.
Let's suppose that with existing resource you can fabricate cars and houses
As we move along A B we get less and less cars.The opportunity cost of houses over cars increases. It means that we have certainly used in first the resources better suited for production of cars than for houses.
Any point such as the red one in the gray zone means that the optimum is not reached. On the contrary, any goal such as the blue one is unattainable with the existing resources and technology. A shift to the right of the production possibility frontier always implies a change in technology or an increase in resource.
This law is valuable for a firm as for the entire economy and the production possibility frontier is used frequently in the business world to calculate the highest combination of resources between different products.
Let us suppose that the farm has 4 laborers who are to produce wheat and barley over a fixed surface area.
We can draw up the following table:
The middle line represents the optimum and thus the frontier. To increase beyond 45, more land is needed. It would then be necessary to recalculate to see whether it might be advantageous to increase the number of laborers (previous table) to reach a new optimum.
Maximum profit (45 in this case) means that all production factors are combined in the most effective way.
In fact, these calculations are far complicated. When you start a business, it's easier to produce only one good or one service. You can diversify when you have gotten a good practice of the management (Of course, this advice does not apply to retail biz).
14-Private,public and merit goods
Among the choices, a community has to decide what type of goods it wants to produce: Private or public goods?
A private good has three characteristics:
-Excludability: It means that you have to pay to get the good and that you are excluded from the consumption if you do not buy it. For example, if you do not pay a flight ticket, you are excluded of the flight.
-Rivalry: It means than one consumer reduces the availability of the good. For example, when you buy a flight ticket, you occupy a seat and thus the number of seats available for the other passengers is reduced.
-Rejectability: When you do not like a good, you have the possibility to reject it. For example, you decide to never buy a flight ticket or to never consume soda.
Real life example
I would like to add marketability to these characteristics. As you have seen in my biography, I have invented a book keeping machine for illiterates ( french patent: INPI 8300095). When I met businessmen, they objected that illiterates are usually very poor and that it was not worth to launch a product with no market.
Although my machine could provide huge benefits for the customers in a country such as India, it was not a marketable good. Recall that a private good must meet people with private money.
They are available for every body. For example, a free road is a public good. It's not paid by the person who uses it. It's paid by the collectivity.
A public good is not a free good like the air or the heat of the sun. It has a cost which must be compensated by a tax. As a result a public good authorizes the free rider principle. A free rider is a person who benefits of a public good and who never contributes to its costs because he does not pay the taxes.
Real life example:
In France, highways have toll gates. A german who travels in France uses the highway as a private good because he has to pay a ticket to enter.
In Germany, the highways are for free. It means that the highway is a public good and its cost is compensated by the taxes paid by the german taxpayers whatever they use or don't use the good.
In these circumstances, when I use a german highway, I am a free rider because I don't contribute to the taxes and however I enjoy the benefit of the public good.
143-Merit and de-merit goods:
A merit good produces positive externalities. It means that a global benefit for everybody is added to the private benefit that you get in acquiring the good. For example, education services or health goods are merit goods: When you buy a course you get a private benefit but the community as a whole gets also a benefit because educated people contribute to the welfare of the society.
On the contrary, tobacco and drinks are de-merit goods because they produce negative externalities. When you consume tobacco, the negative externalities is the rising cost of health diseases for the entire community.
Normal and inferior goods: See further Price elasticity
Primary, secondary, tertiary goods: See further income elasticity.
Spiritual and material goods: Go to "new growth theory" in Global Leaders.
Public opinion more and more scrutinizes negative externalities such as pollution and so on. In a business, you are already exposed to some conflicts with the staff and the suppliers. In addition, don't be exposed to the public anger! Avoid to start a biz with negative externalities. Be very careful with pollution or toxic matters. Today, pollution is everywhere a very emotive topic.
2-HOW TO PRODUCE
When you have decided what goods or service to produce, you have to define:
-how to use the existing factors of production in order to get the maximum output. It means: How to rise the productivity.
-How to extend the factors of production in order to increase the production possibility frontier. It means that you have to invest.
-Definition: the productivity is the conversion of a defined resource into goods and services. It's usually expressed in ratio of a factor of production to outputs.
An improvement of productivity can be realized by achieving more output for the same input or by achieving the same output from less input.
-Land productivity: In situation 1, one ton of wheat is produced by one acre of land. We have: one ton of wheat/one acre = 1. In situation 2, two tons of wheat/one acre = 2. We can say that the productivity of one acre of land has doubled from situation 1 to 2.
-Labor productivity: In situation 1, the production of one ton of wheat requires 200 working days. In situation 2, the same production requires only 100 working days. We have: 1000kilos/200 = 5 and in situation 2, 1000kilos/100 = 10. We can say that the productivity of labor has doubled from situation 1 to 2.
-Capital productivity: In situation 1, a machine produces 1 boot in one hour. In situation 2, a machine produces 4 boots in one hour. We can say that productivity of capital has been multiplied by 4 from situation 1 to 2.
You have to take notice that in all these examples, we have not extended the factors of production. The productivity means that the existing and unchanged factors produce more inputs. The cause of this increase is just the creativity of the manager.
-Definition: Investment is the extend of the factor of production. Nevertheless, this concept only applies to the extend of land and capital. It's not applied to the extend in labor. When you recruit more laborers, you don't invest. On the contrary, when you purchase new tools or new machines, you are supposed to invest.
Of course the extend of capital always improves the productivity of labor. Moreover an extend of capital very often implies a high creativity (technical progress) and enables to make a jump in production. It means that capital and technology are linked and increase the production possibility frontier:
Follow the right lane!
-First you increase productivity of your existing factors of production. It does not cost you any money. It just costs you to think. Recall that thought is the sole unlimited resource! What is more, thought and creativity, thanks to education, benefit of the law of increasing returns!
Scrutinize your organization: Are your existing tools fully employed 24 hours/24? Is your staff idle or over busy? It's worthless to extend labor or to implement new machines while existing people and machines are not yet optimized.
-When you have improved productivity, you can expect to increase your revenue. Right now save this revenue and use it to invest. It's now time to extend your capital and may be your labor.
When you invest, do not search to extend one unit with the same added units. Make your best in order to benefit of change in technology. We have seen that creativity boosts the output of any investment. When you add a machine, benefit of the updated technology. When you add one unit of labor, lift the qualifications in order to benefit of the rising trend in human capital.
The next drawing illustrates this advice: When you add immediately capital to labor, you get a lower output than when you increase productivity before to invest.
-Definition: Specialization occurs when a firm concentrates in making one good or one service in order to improve its productivity.
Let us suppose that there are two farms, each producing 1.5 tons of wheat and 100 liters of milk with 250 hours of work. Each farm divides his time as follows:
In order to ensure the subsistence of these 2 farms, we need an overall total of 3 tons of wheat and 200 liters of milk, for which we have 500 hours of work available.
Given these figures, it would be in Mickey's best interest to specialize in wheat, whereas B should specialize in milk. Then, Mickey produces the required 3 tons of wheat in 200 hours while B produces the required 200 l of milk in 200 hours. Finally, the two farms spend 400 hours instead of 500.
Time is saved due to the fact that Mickey benefits from B's productivity for milk, and B benefits from Mickey's productivity for wheat.
This exchange spreads the results of productivity gained in one farm to the other farms.
We shall see the same phenomenon occurring in international exchange when all the production costs of a country have an absolute value that is higher than the production costs of the other country.
One frequent mistake for a new biz is to realize by itself all the tasks required to produce goods and services. For example, beginners buy expansive printer machine to make copy and so on. In general, rent the services that you need and specialize on your core business.
For example: let' suppose that your business is to sell hamburgers: You will not cultivate wheat to make up your own bread; you will not pay people to produce meat; you will not transport the stuff; you will not have your own advertisement and accounting staff! I hope you will focus on your core business: Selling hamburgers to the customers. Look at the next drawing:
The best businessmen are those who just assemble different inputs to provide an output. In so doing, they benefit from the productivity accumulated along the value chain. Of course it means that you choose very carefully your suppliers in order to get the best quality price ratio available on the market.
I just mention it because it does not interest to much a new business.
-Definition: Concentration improves productivity when the most productive units acquire the less productive's.
In fact mergers are not always effective and some of them result in decrease in specialization and then in productivity.
25-Division of labor
-Definition: Division of labor is a type of specialization inside the firm: The production of a good is divided into separate tasks each performed by specialized unities.
As a result, the productivity of labor is increased because each unity is better trained and because the global organization follows up a logical process: Assembly line.
As you know, there are a lot of criticisms against Division of labor but you are not obliged to take them into account! In many industrial business, division of labor and assembly line are the best ways to reduce the costs per unit and to offer a competitive price on the market. When you create your business neglect fads and only concentrate on your goals!
26-Economies of scale and costs
-Definition: When productivity, specialization, concentration, and division of labor result in a fall of the cost per unity produced, it is said that the firm realizes an economy of scale.
The economy of scale depends on the structure of costs. There are two types of costs:
-Variable costs: They depend on how many goods are being made. They include the wages paid to the shop floor workers, the cost of raw materials and parts used in the manufacturing process and the cost of fuel, and energy.
-Fixed costs are independent of the amount of production. Fixed costs include the manager salaries, the rent, insurance, and interest paid on loans, and the amount of depreciation put aside to replace work out equipment.
-Average cost or unit cost is calculated by dividing the total cost by total output.
When the production increases, the average cost decreases. For example, let us suppose you product 10000 bottle of soda. Your variable cost per bottle is $2. Your fixed costs are $10000. When you increase the production, your average cost evolves as follow:
Of course, the average cost cannot go below the variable cost. In this example, the variable cost remains constant. It means that there is not any productivity. The fall of the average cost is only due to the economy of scale.
The next drawing shows two situations with the same output and variable costs. As you can see, profits are delayed when the fixed costs are high.
Clearly, it shows the importance to limit the fixed costs especially in a new business.
Never be stuck on fixed costs! I would like to see you in a little office rented for few bucks, making your own back office, and working on a table instead of a luxurious desk.
Too much people who create a business just want to get a social statute. They are just eager to look big. These guys would have better to leave business right now. Business means profits: Fixed costs are the worst enemies of profits.
Go to www.accel-team.com . This web site focuses on the labor productivity and contains a lot of interesting readings, notably about the Taylor's scientific management. It provides also many tips to improve motivations and productivity.
3-HOW TO DISTRIBUTE: THE MARKET
The market is the meeting of supply and demand in a free economy.
31- Supply, demand and price.
Supply is the amount of a good that the producers are willing to sell at a given price. The law of supply holds that other things equal, the quantity supplied will rise as the price rises and will decrease as the price decreases.
This law is illustrated by the supply curve (SS) that has two different moves: A change in price results in a movement along the curve. It means an increase in quantity as the price rises and a decrease on the contrary:
A shift means that a change in cost results in a new supply curve:
Demand is the amount of a good that the consumers are willing and able to buy at a given price. The law of demand holds that other things being equal, the quantity demanded will rise as the price decreases and will decrease as the price rises.
This law is illustrated by the demand curve (DD). A change in price results in a movement along the curve:
A shift in the demand curve means that a change in income or taste results in a new demand curve:
The equilibrium occurs at the price in which quantity demanded equals quantity supplied. It is the equilibrium market price.
For example, let us suppose that the intentions to buy and sell wheat can be summarized as follows:
The graph below illustrates the equilibrium based on the data in the table above:
Supply and demand even out when the two curves meet, for a price of 100$ per ton.
A surplus occurs when quantity supplied exceeds quantity demanded. A shortage occurs when quantity demanded exceeds quantity supplied .r
Consumers surplus appears in the blue zone: It means that consumers who were prepared to pay $130 or $150/ one ton enjoy a price of $100.
Producer surplus appears in the red zone: It means that producers who were prepared to sell at $50 or $80/one ton enjoy a price of $100.
The description applies to a large number of sellers faced with a lot of buyers. None of the players are able to develop an individual strategy to alter the supply and demand diagram. Nevertheless we can find some specific situations:
Monopoly: If there is a single seller, selling only one product. This situation is very rare in liberal countries. In state countries, the regulations authorize a single public company to produce a certain item. He has no competitors and therefore fixes an arbitrary price and levies an income from the consumers.
Oligopoly: There is only a small group of sellers. They can either agree to maintain high prices or have a price war, that finally benefits the consumer (for example, price war between airlines).
Prices which result from government regulations bring the following consequences:
Price ceiling: The government prohibits the sale of a product above a certain price. This kind of practice results in a decrease in offer, chronic shortages and queues.
Price floor: The government prevents a price from dropping below a certain level. This policy results in a surplus of the product concerned. For example: having a minimum wage prevents employers from recruiting all job seekers, which in turn results in unemployment.
All these measures of price control have harmful effects on the citizens.
Of course, never enter a sector which is under price control or State monopoly.
External readings and quiz:
About supply and demand we recommend four readings:
Go to www.econweb.com . Click on"intromacro", then on "intro macro sample site", then on "courses topics" and finally on "supply and demand". You will find here animated graph and an on line quiz.
Go to ecedweb.unomaha.edu . Click on"lesson and standards", then on "direct links to lessons" and finally on "demand and supply on line" by Kim Sosin.
Go to aem.cornell.edu . Click on "course list" then scroll to 415 and click on "chapter". You will find here a power point presentation with a lot of interesting slides.
Price expresses the equality of supply related to demand but does not help to understand why consumers are prepared to pay this price. Then we must take a look at the notion of utility
-Definition: Utility can be defined by the amount of the product that saturates a requirement.
For example, let's suppose that 4 items of food are usually required to saturate the requirement of eating. In fact the consumer does not attach the same value to the first item as he does to the 4th. The first is essential to his survival whereas the 4th is simply an improvement.
It means that for a given amount of a product which saturates the requirement (total utility), the value of each unit of the product (marginal utility) decreases as the requirement gradually becomes saturated
To express this decreasing utility, we use a conventional measure called the util. Then we, can evaluate the decrease of 4 items of food which satisfy the total requirement.
First item: 3 utils, second item: 2 utils, Third item: 1,5 util, Fourth item: 0,5 utils. Since the first item is worth 3 utils, the total utility should be 12 utils. In fact the consumer is only prepared to consume 7 utils.
Let 'us now suppose that a consumer has a choice between books and food: One book costs $8 and an item of food $2. Moreover, one book represents 4 utils and the second book still 4 utils.
The consumer will go on demanding more items of food as long the number of utils of an item of food remains higher than the ratio of its price divided by the price of a book multiplied by the number of utils of the book.
First line: 3 utils = $2 / $8 * 4 utils = 1
Here, the consumer gains 2 utils (3-1) by consuming one item of food.
The last line we see: 0,5 utils = $2 / $8 * 4 utils = 1
Here the consumer loses 0,5 util. It is therefore not in his interest to demand any more item of food.
When we consider the economy in general , we realize that the marginal utility of goods which correspond to the basic requirements like foods drops rapidly. This phenomenon explain the difference in price elasticity and income elasticity.
33-Marginal profit analysis
In the same way, we have now to explain why a producer is prepared to sell at a given price.
-Definition: A company has interest to produce and to sell an additional unit as long as its selling price is above or equal to its marginal cost.
For example, in the next drawing you can see that the marginal cost increases rapidly because of the law of diminishing return. When this marginal cost is equal to the price (line 3) a competitive firm must stop to sell because its global profit is going to fall.
As you can see in the drawing above there is yet a global profit line 5 when you sell one unit more but it is lower than line 4. Be careful because many people are just interested in the increase of your turnover, and notably staff, sale force paid on commissions and suppliers. They often push you to increase the turnover arguing that the company is yet making profit. Recall that your goal is to maximize your profit and not your turnover.
Nevertheless, it can be wise to maximize the turnover when you want to take a bigger share of the market in order to dissuade new competitors to enter: See marketing module.
Price elasticity is a fundamental concept in microeconomics.
341-Price elasticity of demand.
Definition: Price elasticity of demand measures the change in demand to a given change in price.
It is measured by the following equation:
For example, the price of a ton of wheat increases from 80 $ to 100 $. The percentage of price change is 20 %.
The amount of wheat demanded falls from 4 000 to 2 000 tons. The percentage of change in quantity is 100 %.
A coefficient above 1 indicates products for which demand is elastic: The quantity demanded drops more than proportionally compared to the price increase. A coefficient below 1 indicates an inelastic demand: when you are suffering, you buy drugs even if the price goes up.
342-Price elasticity of supply.
Definition: Price elasticity of supply measures the change in supply to a given change in price
The equation is the same as for demand:
Percentage change in quantity supplied / Percentage change in price.
Elasticity depends of the good. For example, fresh fish product are inelastic because if their prices fall, the supplier has to sell instead to lost all its production. On the contrary, product which can be stocked are elastic because suppliers may wait in order to get better prices.
343-Cross elasticity of demand
Definition: Cross elasticity of demand measures a change in demand for one good to a given change in the price of a second good
Percentage change in quantity demanded of good A / percentage change in price good B.
If the result is positive, the two goods are substitutes. If it is negative, the goods are complements.
344-Income elasticity of demand.
Definition: Income elasticity of demand measures the change in demand to a given change in income.
Once again the equation is:
Percentage change in quantity demanded / Percentage change in income.
If the result is negative, the good is said inferior. Thanks to a rise in income, people buy less of this good and more of a superior substitute. If the result is positive the good is said normal. People use an increase of income to buy more of the good.
The Engel law is an application of the income elasticity as a whole.
Definition: When Income increases, the relative value placed on primary goods ( farming, mining, fishing) decreases, the relative value placed on secondary goods (clothing, housing, cars) remains constant, and the relative value placed on tertiary goods ( Services, insurance, education) increases.
For example, the relative value of goods which corresponds to quickly saturated requirements, like food or clothing, drops rapidly. On the other hand, cultural items or items linked to education (books, television etc.) are much less rapidly saturated and therefore retain a high relative value.
Now, let us suppose that a country's GDP increases from 100 to 375. The value of primary, secondary and tertiary sectors changes as illustrated below.
This evolution is quite important for a new business:
-If you start a farm or a business related to food or primary goods, you must know that you are entering a market where the prices are constantly decreasing and which occupies a relative part less and less important in the economy as a whole.
-If you enter in the secondary market in producing some goods like appliances or furniture's coming from the industry, your expected market will grow at the same pace than the whole economy and will keep a constant relative place.
-We recommend you to start a biz related to tertiary goods, such as hostels, tourism, leisure's, sports, education. In so doing, you will enter in a market which is constantly growing at a pace higher than the whole economy.
It's easier to get a slice in a growing cake than in a decreasing one. Recall that general observation before to make up your mind.
For any given income, the knowledge elasticity measures a change in demand to a change in the level of education: To know more about this relation illustrated by the Pince Curve, go to "new growth theory" in global leaders.
External readings and quiz.
Visit www.tutor2u.net . Click on "elasticity" and then on the different modules regarding price elasticity.
The production possibility frontier shows the maximum possible production with existing resources. Each resource is exposed to the law of diminishing returns.
Productivity, investment, and creativity raise the input coming from resources. Firm strategy and organization such as specialization, concentration, division of labor result in economies of scale and contribute to lower the costs.
Free market organizes the distribution of production. The equilibrium price occurs on a market at a price in which quantities demanded equal quantities supplied.
Price elasticity measures the change in demand or in supply to a given price. Income elasticity measures the change in demand to a given change in income. Knowledge elasticity measures the change in demand to a given change in education.
DO IT YOURSELF
Just use these readings for stimulating your creativity. For example use the Reversal technique and state that the resources are not scarce but unlimited. Examine all the consequences of such a statement. Then go to "New growth theory" in "Global leader" and see how this idea is developed!
The time required has been already counted in the creative session of " FW3-Creativity".
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