Utility and demand

The concept of 'utility' was innovated by Jeremy Bentham, founder of the last great school of philosophy to emerge from the Western period known as 'the Enlightenment'. For Bentham sense experiences involved a unit measure of pleasure and pain called the ‘utile’ from which the philosophical school of thought known as ‘Utilitarianism’ emerged.  The utiles would eventually, according to Bentham, be subject to physical measurement and he proposed a ‘felicitous calculus’ of human happiness. In simple terms, Bentham believed that human existence was simply the search for pleasure and the avoidance of pain.  This has been expressed as 'pleasure and pain are the sovereign rulers of the State'. Thus utilitarianism is radically materialistic at the root.

Another name for utilitarianism, as defined by Bentham, is 'ethical hedonism'. The search for pleasure was inhibited in Bentham's scheme by the assumption that human beings carried what today we would call genetic ethic of right and wrong - essentially the  Protestant work ethic.   Once that ethic faded, however, we were left with only 'Me-ism': only my pleasure counts, and anything I do to increase it, no matter the pain and suffering to others, does not matter!

Terms

a) Utility: a generalized term for the satisfaction obtained by an individual from the 'use' of a product (good or service) measured by the price the individual is willing to pay for the product where:

i - total utility - total satisfaction yielded by the product

ii - marginal utility - the additional utility yielded by an additional unit of the product

iii - diminishing utility - at some level of consumption an additional unit of the product yield less utility than the preceding unit, i.e. utility increases at a decreasing rate

iv - maximizing utility: rational individual will purchase that combination of products or commodities yielding the maximum utility subject to income constraint and prevailing prices

b) Consumption: the use of a product whereby its utility is destroyed, or 'negative production'.

c) Income: payment for work used to purchase products in order to obtain utility.

d) Work: physical or intellectual effort made not for any pleasure derived from itself but rather to earn income to purchase products to obtain utility.

e) Price: the current exchange rate of a product for the utility derived by a consumer.

2. Assumptions

a) Rationality: consumer chooses between alternative commodity combinations to maximize utility assuming -

 i - perfect knowledge, that is, aware of all alternative commodity combinations and their prices

 ii - competence, that is, capable of evaluating the alternatives

 iii - transitivity, that is, if A = B and B = C then A = C (which means that indifference curves do not intersect: see 3(b) below)

b) Ordinality: consumer is able to order commodity combinations by level of utility, 1st, 2nd, 3rd etc.  Does not require cardinality, that is, the ability to specify the actual numeric level of utility

a) Utility Function

                U = f (x, y) where:

i - U is the utility derived from consuming commodity combinations of x and y

ii - U is assumed to be continuous (and has first- and second-order partial derivatives) or there is continuity of commodity combinations of x and y, that is, there is an infinite number of combinations yielding the same level of utility, U is a dense set

iii - U is not unique, that is, any utility number - U' - assigned to a given commodity combination indicates only that it is preferable or superior to all combinations with a lower number and inferior to those with a higher number, in other words, U' does not possess any cardinal meaning

iv - U is defined for consumption within a specified timeframe - long enough to allow substitution among existing commodity combinations but short enough to insure constancy of taste

CONSUMER PREFERENCE

Generally, consumers prefer a certain number of commodities. Some of the goods are normal goods and can be substituted by others. The price of such commodities has an impact on demand. At the same time, the substitution of some normal goods is not possible. Such commodities are bought at fixed intervals and they are a part of the basic consumer basket such as food, water, gas, and power.

The consumer buys normal goods at a regular price, and as a proportion of their income.But the prices of goods can change so consumer’s income. The supply of commodities can also be affected by a number of factors. The consumer decides what to purchase and what not to purchase. A consumers’ preference changes when the consumer decides to maximize utility at a lower price level.

Preference relations

Any consumer preference has two important relations. The strict and weak preference relation decides the overall preference.

The strict preference is defined as

x>y→x≥y but y≥x

This means x is preferred to y. Note, here y is  considered equal to x. The consumer can either prefer x or y.

Completeness

Any commodity is always preferred to its close substitute.sThey are very different from each other in terms of characteristics.For e.g. Colgate toothpaste may be preferred to such substitutes such as close up, Pepsodent or sensodyne. The qualities of each toothpaste may differ in size, colour, shape, and price. But the real choice depends on the income and the taste of the same consumer.

Transitivity

Sometimes more commodities are available as substitutes.Transitivity is slightly different from completeness. It implies that it is impossible to face the decision maker with a sequence of pairwise choices in which preferences appear to be cyclical. For eg. An apple is as good as an orange and an orange is as good as a mango. But then an apple is preferred to a mango. Transitivity explains that consuming any goods will give equal satisfaction to a consumer.

Reflexivity

Reflexivity means any commodity is as good as any other commodity. There is no difference in consumer satisfaction when any commodity is consumed. For eg x>y≥z, then x>z. the preferences do not change. The consumer prefers a bundle and any bundle is preferred or is indifferent to it. In everyday consumption basket, a consumer often purchases different close substitutes of commodities based on taste, color, shape, size and on their income.

Nonsatiation

Nonsatiation adds more characteristics of a good because it is preferred by a consumer. Each consumer expects something different from the earlier purchased commodity. The consumer always search for something extra above what they usually buy from the market. It's here where the marketing strategies help in breaking the brand loyalty and help the companies make their way into the hearts of the consumers.

Continuation

Consumers always try to switch to different commodities or close substitutes. They get more satisfaction from consuming different commodities at lower prices.But other factors may make them worse off, such as changes in price, size etc. So, they prefer to continue with their earlier choices.

Labor economics

What is Labor Economics?

Labor economics seeks to understand the functioning and dynamics of the market for labor. Labor markets function through the interaction of workers and employers. Labor economics looks at the suppliers of labor services (workers), the demanders of labor services (employers), and attempts to understand the resulting pattern of wages, employment, and income.

Compensation and measurement

Wage is a basic compensation for paid labor, and the compensation for labor per period of time is referred to as the wage rate. Other frequently used terms include:

Wage = payment per unit of time (typically an hour)

Earnings = payment accrued over a period (typically a week, a month, or a year)

Total compensation = earnings + other benefits for labor

Income = total compensation + unearned income

Economic rent = total compensation - opportunity cost

Economists measure labor in terms of hours worked, total wages, or efficiency.

Labor Demand

Labor demand is a derived demand; that is, hiring labor does not desire for its own sake but rather because it aids in producing output, which contributes to an employer's revenue and hence profits. The demand for an additional amount of  depends on the Marginal Revenue Product (MRP) and the marginal cost (MC) of the worker. The MRP is calculated by multiplying the price of the end product or service by the Marginal Physical Product of the worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker since doing so will increase profit. The firm only employs however up to the point where MRP=MC, and not beyond, in economic theory.

Wage differences exist, particularly in mixed and fully/partly flexible  markets. For example, the wages of a doctor and a port cleaner, both employed by the NHS, differ greatly. There are various factors concerning this phenomenon. This includes the MRP (see above) of the worker. A doctor's MRP is far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than that of becoming a port cleaner. To become a doctor takes a lot of education and training which is costly, and only those who excel in academia can succeed in becoming doctors. The port cleaner, however requires relatively less training. The supply of doctors is therefore significantly less elastic than that of port cleaners. Demand is also inelastic as there is a high demand for doctors and medical care is a necessity, so the NHS will pay higher wage rates to attract the profession.

The MRP of the worker is affected by other inputs to production with which the worker can work (e.g. machinery), often aggregated under the term "capital". It is typical in economic models for greater availability of capital for a firm to increase the MRP of the worker, all else equal. The education and training noted in the last paragraph are counted as "human capital". Since the amount of physical capital affects MRP, and since financial capital flows can affect the amount of physical capital available, MRP and thus wages can be affected by financial capital flows within and between countries, and the degree of capital mobility within and between countries.

There are two sides to labor economics. Labor economics can generally be seen as the application of microeconomic or macroeconomic techniques in the labor market. Microeconomics techniques study the role of individuals and individual firms in the labor market. Macroeconomic techniques look at the interrelations between the labor market, the goods market, the money market, and the foreign trade market. It looks at how these interactions influence macro variables such as employment levels, participation rates, aggregate income and Gross Domestic Product.

LABOR MARKET

The labor market holds very important place in the world of economics. An important macroeconomic variable is the total amount of labor that is used in certain period of time. The amount of labor and amount of capital are variables for total production and GDP. Amount of labor is related to unemployment rate.

Classification of unemployment

There are different ways of classifying unemployment.

·     Frictional unemployment- 
Individuals are temporarily unemployed while transiting between jobs or just entering the labor market.This kind is typically short in duration and is always present in the economy.

·     Structural unemployment-
Individuals are unemployed because their skills are no longer in demand where they live. This normally leads to longer spells of unemployment and may require the unemployed to acquire new training to survive.

·      Cyclical unemployment-
Unemployment due to recession

·      Classical unemployment-
Unemployment due to real wages being too high.

The natural rate of unemployment is defined as the sum of the rates of frictional, structural, and classical unemployment excluding the cyclical unemployment. We say, we have full employment when the unemployment rate is equal to the natural rate (and cyclical unemployment is zero)

   Please note, cyclical unemployment is zero in a boom. In a recession, the observed unemployment rate exceeds the natural rate by the cyclical unemployment rate.

Diagram

Wages

Nominal wages-The nominal wage is the wage per unit of time in the currency used in the country- commonly called as call wage. Wage is a flow that we typically measure in units of currency per hour.

Wages and income

Wages and income are two distinct variables.Wage means what we typically receive for working an hour, while income is the total revenue from all sources over a longer period of time. Your income depends on the wage as well as the total number of hours you work.

Real wage

Consider the following scenario. You work full time and during January 2014 you make 2000 euro after tax. A particular basket of goods and services costs 100 euro in January, which means you can buy 20 such baskets.

In February, you receive a 10% wage increase and you make 2200 euro after tax. Does this imply that you can buy 10% more baskets, 22 in February? No, Not necessarily.

The number of baskets you can buy in February depends upon the possible changes in price.If the price of the basket increase by 3% to 103 euro, your 2200wage will buy you 2200/103=21.36 baskets of goods, i.e. 7%more than in January. So even though your wage has increased by 10%, you can only increase consumption of baskets by 7%. We say the real wage has increased by 7%.

We define real wage as the nominal wage divided by a price index (CPI). In the above eg, real wage was 20 in january and 21.36 in February. Nominal wage will tell you your wage in units of currency, while real wage will tell you your wage in basket of goods and services.

INTEREST RATES

What is an interest rate?

When you borrow money, you usually have to pay a fee for the loan. This fee is often called interest, particularly if the fee is proportional to the amount you borrow. It is commonly expressed as a percentage of the size of the loan per unit of time. The interest rate may be fixed or floating. If it’s fixed, you will pay the same percentage for the entire duration of the loan. While with floating interest rate, the interest rate will change regularly depending on market conditions.

Market interest rates

The most important interest rates from a macroeconomic point of view are the interest rates that the government pays on loans they use to finance the national debt. The government borrows by issuing government bonds. All such bonds hae fixed nominal amount and a given maturity date. The government promises to pay exactly the nominal amount, to the holder at the maturity date. Some bonds also promise regular coupon payments at regular intervals.

Relationship between the interest rate and bond price

Note that the interest rate depends on the issue price. Higher the issue price, lower will be the interest rate. If the price of a government bond increases, interest rate falls and vice versa. The price of a bond is usually determined by supply and demand which means you can understand movements in the interest rates by analyzing the market. For e.g. if the government needs to borrow more money, supply increases, bond prices fall and interest rates increase.

Yield curve

The yield curve is the graph of interest rates of different maturity (recalculated to yearly rates)at a particular point in time. If the market expects higher interest rates, then slope of the yield curve will increase. The slope of the curve will turn negative if the market expects the interest rates to fall more than the premium on the longer interest rates.

Other interest rates

Lets discuss the other interest rates that’s available in the market. For e.g. You will earn money when you deposit money in a bank account, and you will pay interest when you borrow money. These interest rates depends on the specifics of the deposits and the perceived risk when you borrow money.

Overnight interest rates

Overnight interest rates are rates for loans over a single night. These are shortest of all interest rates. During the day, banks normally have access to interest free loans from the central bank. At the end of the day, all such loans must be cleared with the central bank. For this reason, there is a market for loans overnight between banks and the overnight interest rate is determined by supply and demand in this market.

Central bank overnight interest rates

The overnight interest rate is an important interest rate for a central bank and it has methods of influencing this rate. In United States, this rate is federal funds rate. If the overnight rate steers away from the federal funds rate, the Federal reserve will take desired action to steer it back towards the federal funds rate.In addition to signaling a desired overnight interest rate, most central banks have standing facilities for overnight loans. The ECB has a deposit facility and a marginal lending facility that member banks use for deposits and for lending overnight. The overnight interest rates must therefore be in between the deposit rate and marginal lending rate.

Origin of money and its concepts

                              

In traditional societies, not the actual money but its proxy was used in all transactions. There were many forms of money, commodity money, credit money as well as representative money. Let’s understand the concepts below.

Commodity money:

In ancient age old times, barter system existed in societies. People exchanged commodities for commodities through a common agreement between two parties. The net gain from sharing of commodities was assumed to be equal.Such transactions were practiced for a long time in developing countries but there were a no of limitations.

Some commodities weren’t perfectly divisible.

There was lack of a common value in multi commodities trade. It was difficult to determine value of one commodity when exchange for
another.

Perishable commodities couldn’t be exchanged or substituted for other commodities.

Due to these limitations, commodity money usage declined and almost disappeared.

Representative money

After decline of commodity money, there came a phase, when representative money came into existence. Representative money is any type of money that has face value greater than its value as a material, such as precious stones, and metals like gold and silver. Such representative money was used in commodity transactions. Mostly, representative money was overvalued while the other commodities were undervalued. Also, they were limited availability of quantity of representative money and couldn’t be used for common transactions.

Credit money

Most of the commodities were exchanged based on credit basis. Other assets such as land, houses, factories were used in exchange of commodities. But such commodities were not liquid and available for masses. Therefore, credit money had severe limitations as well. In order to overcome all limitations of commodity, money is used as a medium of exchange. Now, today, almost all transactions take place in terms of money.

Money and its definition

Money is defined as any object that is accepted as a method of payment for goods and services. It’s a medium of exchange. Money is defined as store of value.

Characteristics of money are as follows

·        Acceptability-money is universally acceptable. The coins are supplied by the government. The currency notes are supplied by the reserve bank. Therefore, money is acceptable to people despite its unique shape, size and colour for every country.

·        Durability-money is durable and cannot be easily destroyed. Even though its exchanged and circulated in the economy, money remains durable and usable for long periods of time.

·        Divisibility- Money is perfectly divisible. It can be easily converted into different forms of notes. A five hundred rupee note can be easily exchanged for fifty ten rupee notes. Such divisibility facilitates commerce and trade. Its an important feature of money.

·        Uniformity- money is uniform, it is has consistent shape, colour and size.

·        Recognizability- people can recognize and identify money and use it when needed.

·        Scarcity- money is scarce and not easily available. In order to get money, a person has to take on a debt, borrow or work for it.

·        Stability-Money provides stability for individuals as well as economies.

Inflation

Inflation is defined as an increase in the overall price level. The overall general upward price movement of goods and services in an economy (often caused by an increase in the supply of money), usually as measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of goods and services increase, the value of a dollar is going to fall because a person won't be able to purchase as much with that dollar as he/she previously could.

Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products. When the economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services. It has its worst impact on consumers. High prices of day-to-day goods make it difficult for consumers to afford even the basic commodities in life. This leaves them with no choice but to ask for higher incomes. Hence the government tries to keep inflation under control.

Contrary to its negative effects, a moderate level of inflation characterizes a good economy. An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more and borrow more, because during times of lower inflation, the level of interest rate also remains low. Hence the government as well as the central bank always strives to achieve a limited level of inflation.

Please note that inflation does not apply to the price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same. Inflation can also be defined as a decline in the real purchasing power of the applicable currency.

Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a year-on year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base.

Formula for calculating Inflation=

 (WPI in month of current year-WPI in same month of previous year)
-------------------------------------------------------------------------------------- X 100
WPI in same month of previous year

Consumer Price Index (CPI)

The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This data is used to compare the prices for a particular month with the prices from a different time period.

CPI Sources of Bias

The CPI is not a perfect measure of inflation. Sources of bias include:

·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price increases may reflect quality adjustments that are still counted entirely as inflation.

·New goods - new goods may be introduced that will be hard to compare to older substitutes.

·Substitution - if the price goes up for one good, consumers may substitute another good that provides similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting discount or outlet stores.

Gross Domestic Product (GDP)

Gross domestic product, or GDP, is the key economic indicator of a nation. It measures the total value of final goods and services produced within a given country's borders. It is the most popular method of measuring an economy's output and is therefore considered a measure of the size of an economy. When people say one economy is larger than another or that an economy is growing or shrinking, usually they're referring to GDP figures.

GDP is defined as all consumption by households, all investment by businesses, and all purchases by the government, plus purchases made by foreigners minus purchases of things made abroad.As an aggregate measure of total economic production for a country, GDP represents the market value of all goods and services produced by the economy during the period measured, including personal consumption, government purchases, private inventories, paid-in construction costs and the foreign trade balance (exports are added, imports are subtracted).

GDP is important because it gives a bird's-eye view of how an economy is doing. If GDP speeds up, it can be a sign that good things are happening or are about to happen in a number of areas — people getting more jobs or better pay, for example, or businesses feeling confident enough to invest more. It's not a complete picture of a national economy by any means, but it's a good start at a quick summary.

GDP = C[onsumption] + I[nvestment] + G[overnment purchases] + X [exports] - M [imports]

Alternative ways of calculating GDP

There are three approaches of calculating GDP

·        Expenditure approach- As above, calculates final spending on goods and services.

·        Product approach- Calculates the market value of goods and services produced.

·        Income approach- Sums the income received by all producers in the country.

GDP per capita

An approximation of the value of goods produced per person in the country, equal to the country's GDP divided by the total number of people in the country.

GDR

Global Depositary Receipt. A negotiable certificate held in the bank of one country representing a specific number of shares of a stock traded on an exchange of another country. American Depositary Receipts make it easier for individuals to invest in foreign companies, due to the widespread availability of price information, lower transaction costs, and timely dividend distributions also called European Depositary Receipt.

Difference between GDP and GNP

GDP measures all of the sales of final goods and services domestically — within the country’s borders — plus exports and minus imports. GNP counts, production by workers or owned enterprises wherever they are located, but excludes production by foreign people or foreign-owned enterprises even if they are located in the same country. In the United States, GNP was used until 1990s, when it changed to GDP in order to be consistent with other nations.

Difference between GDP and GDI

Conceptually, GDP (the value of everything produced) and gross domestic income (the value of everything earned by producing things) are identical. But in terms of the construction of statistical series, GDP is assembled by adding up spending on final goods and services while GDI measures aggregate income — wages and profits.

GDI = W[ages] + R[ental income] + I[nterest income] + P[rofits]

Nominal GDP vs Real GDP

Normally, GDP calculation gets distorted with inflation. This unadjusted GDP is called nominal GDP. In order to get real GDP, the nominal GDP is divided with a price deflator.

Note, in an inflationary environment, the nominal GDP is greater than real GDP. If price deflator is not known, an implicit price deflator is calculated by dividing nominal GDP by the real GDP.

GDP growth

GDP growth is very essential for the well-being of a nation.Note, growth in GDP does not result in increase in purchasing power if the growth is due to inflation or population increase. For purchasing power, it is the real, per capita GDP that’s important.

No one thinks GDP is perfect, and so many people/places have come up with their own ways to measure the economy, ranging from tweaks to full-on overhauls. Here are just a few of the many examples out there:

GDP Plus — Promoted by the Philadelphia Fed, GDPplus is a way of combining information from both GDP and GDI, creating a less-noisy series of growth estimates.

Green GDP — China introduced this measure in 2006 to measure its economic growth while accounting for environmental damage. The nation soon discontinued it, when the measure showed that growth in some areas was near-zero under the measure.

Genuine Progress Indicator — This indicator measures lots of the things that are not included in GDP but can profoundly affect people's lives, like volunteering, pollution, crime, and income distribution. The idea behind GPI isn't so much to measure the size of the economy, as GDP does, as it is to measure how people are experiencing life within an economy. Maryland and Vermont have both adopted this as one measure of well-being in their states, and other states are considering it as well.

Gross National Happiness — Bhutan famously measures how happy its citizens are, and has done so since the 1970s. The country measures well-being across several areas: education, psychological well-being, and good governance, for example. However, it appears GNH's importance may be waning. Bhutan's latest prime minister has signaled that he will focus more closely on GDP.