Variety of Micro- and Macroeconomic Theories - Essay Example

? Principles of Economics Introduction The essay shows the various policies public and private s adopt to successfully exist in the industry. The essay covers a wide variety of macroeconomic and macroeconomic theories. In the first context, it analyses about the different approaches introduced in price and output determination in the economy by Keynesian and Monetarist school of economics. The essay emphasizes in the role undertaken by government and monetary authorities in the economy to maximize social welfare. It also throws light on the recent strategic tools of business adopted by the entrepreneurs in the market. Part I Keynesian Theory John Maynard Keynes was a British economist, his theories and ideas have fundamentally influenced modern macroeconomics. The policies undertaken by governments in different economies are highly influenced by his theories even today. The theories introduced by Keynes mainly concentrate in the nature of total spending in the economy. The theories also analyze the influence of aggregate demand in economies inflation and output level. According to Keynes the aggregate demand created in the economy is often not equal to the productive capacity of the economy. Keynesian theories were introduced during Great Depression in the economy. Keynesian theory supports a mixed economic system, where the main sectors of the economy are headed by private business entities but are guided under the rules and regulations of the government at times of recession (Keynes, 1979). New Classical Theories of Economics New Classical theories of economics are consisted with the economic views of the modern contemporary economists. The theories mainly concentrate in the price, output and determination of income distribution in the economic system. The conjectures focus on the free forces of market demand and supply in the economy. These theories explain the idea of rational economic behaviour. Maximization of consumer utility subject to budget constraints or maximization of producers profit subject to cost constrains are theories of neo classical economics. It assumes that economic entities in the world undertake their economic decisions after getting equipped with the underlying relevant information. Neo Classical theories of economics dominate the Keynesian views economics (Arnold, 2008). Aggregate Supply Curve The aggregate supply curve (AS) shows the different levels of Gross Domestic Product (GDP) in real terms, generated at changed levels of prices in a particular period of time. The curve shows the relation between price and real GDP, assuming all other factors affecting real GDP constant (Ceteris Paribus assumption). The Keynesian and Neo Classical views regarding the shape of the AS curve are contrasting. Keynesian AS curve Keynesian theory was introduced during the Great Depression when the economy was under strict recession. Due to recessionary trends in the market most of the resources were ideal and insensitive in the economy. Thus Keynesian theory firmly believed in the rigidity of price and wage rates in the economy. Keynesian theory is consistent with a horizontal AS curve where any changes in the real GDP are caused simply due to changes in the aggregate demand (AD) in the economy. It was analyzed by Keynes theory that only changes in the aggregate demand, could improve the state of a depressed economy. Figure 1 - Keynesian Horizontal AS curve CPI AD p AS q Real GDP (Source: Author’s Creation) The graph above illustrates the AD and AS curve in Keynes views. The consumer price index (CPI) is the average price level of all the goods and services produced in the economy. AD is inversely proportional to CPI as per the law of demand. The market equilibrium price (p) and equilibrium quantity (q) of real GDP generated in the economy are determined from the point of intersection between the AD and AS curves. Rise in Government Spending Impact In order to improve the aggregate income level in the economy the government undertakes expansionary fiscal policies. These policies involve in government spending in the economy. It can be in the form of tax deductions or rise in the infrastructural expenses in the economy. A rise in the level of unilateral transfers is also a different of fiscal policy undertaken by the government. According to Keynesian macroeconomic view, a rise in government spending would augment the level of aggregate demand in the economy. The aggregate supply level will remain unchanged. As a result, the price level will be constant with a higher level of real GDP. Figure 2 - Rise in Government Spending (Source: Tucker, 2010) As explained in the above analysis, due to a rise in government spending the AD curve shifts rightward from AD1 to AD2. The AS curve remains unchanged, as a result the CPI level retains the value of 200. The level of real GDP increases from $ 12 trillion to $ 16 trillion per Year. The point of equilibrium shifts from E1 to E2. The rise in government spending creates a crowding-out effect in the private sector investments. A rise in both public and private sector investment helps to increase the production level in the economy. Employment opportunities in the economy rise due to the rise in manufacturing activities. Finally the rises in employment opportunities result in rise of purchasing power of the consumers, making them create a higher demand for goods and services in the economy. Keynes introduced the theories during recessionary traces in the economy. The impact of trade unions or supplier bargains was mostly ineffective during recessionary period in the economy. For this reason, Keynes highly believed in rigidity of prices and wage rates in the economy. Thus under Keynesian view the aggregate supply curve is horizontal. New Classical AS curve The neo classical economic theories were introduced before the Great Depression. The economists who invented the Neo classical theories were known as the laissez-faire economists. Adam Smith was the founder of the Classical theories. The scarcity of resources in the economy was not predominant during this period of time. Thus it was believed that the economy would likely operate at its full capacity. Thus under the New Classical economic theory the economy always operates at the full employment level, all the resources are fully and efficiently utilised. Thus AS curve under the Neo Classical theory is Vertical. The Neo Classical theories assume flexible prices and wage rates in the economy. In order to keep the output at the full employment level, prices of the goods and services and the production costs change in the same percentage according to these theories. The shape of the AD curve is same in the Neo Classical and Keynesian approaches. Figure 3- New Classical Vertical AS curve CPI AS p AD q Real GDP (Source: Author’s Creation) The above graph shows the vertical AS curve under Neo Classical approach. The equilibrium level of average price (p) and real GDP (q) are determined at the point of intersection of the AS and AD curves. Implication of Rise in Government Spending The rise in government spending would impact in a rise in the aggregate demand in the economy for the same factors as defined in the above context. The New Classical economic theories stand with the consensus of economy always operating to its full capacity. Thus a rise in the aggregate demand will result in scarcity of goods and services in the economy, output level cannot be increased as all the resources are assumed to be utilized. In order to maintain the full employment level of output, prices of the goods and services in the economy would increase under the Neo Classical regime. Figure 4 - Rise in Government Spending CPI AS P2 AD2 P1 AD1 Q1 Real GDP (Source: Author’s Creation) The above graph explains the case of rise in government spending in Neo Classical regime. The aggregate demand increases from AD1 to AD2. As the economy already operates at the full employment level Q1, the rise in aggregate demand causes scarcity in the economy. The scarcity in the economy causes price rise from P1 to P2. Thus a rise in aggregate demand causes a rise in price level with constant quantity demanded under Neo Classical theory. Prior and After Great Depression Thus considering the economic conditions before and after Great Depression, the AS curve includes both Keynesian and Neo Classical views. Figure 5- Actual AS curve CPI AS P AD1 AD2 AD3 q Real GDP (Source: Author’s Creation) The suppliers in the economy can flexibly increase their output level till a threshold level of full employment q output. The CPI would be fixed till p, after which any further rise in aggregate demand would increase the average price level in the economy. AD1, AD2, AD3 shows the different aggregate demand curves at different periods of time. Any rise in aggregate demand beyond AD2 would result in rise of price level, as all the resources would already be utilised by that level. Part II Monetary Policy Committee Monetary policies are the policies undertaken by the administrative authorities in an economy only regarding the monetary affairs affecting the economic system (Mihov, 2002). In the current economic snare, controlling inflation in the economy is a matter of deep concern for the administrative authorities. It is believed by the economists that an independent and autonomous monetary policy committee would help to efficiently control the level of inflation in the economy. This committee helps in stabilizing the monetary affairs in the economy. The monetary policy committee in United Kingdom (U.K.) arranges a meeting for about three days every month to set the official rate of interest in U.K. The committee also decides the monetary policies that would rule the actions of the state in the economy. The committee comprises of eight members, which even includes the Governor of the Bank of England. The committee also decides on the appropriate value of CPI and desires to control the rate of inflation of the economy as targeted by the government. In 2013 the committee also aimed to facilitate employment and growth in the economy (Select Committee on Economic Affairs, 2004). Example The European economy faced credit crunch at around 2008. The Monetary Policy Committee has adopted the tool of Quantitative Easing as a tool to increase the supply of money in the economy. The process involves in creating money electronically, by issuing non liquid assets like government bonds and securities. In this process, the central bank offer loans at only 1% interest rate to the commercial banks. The loans are offered against credible government bonds and securities from the commercial banks. The rise in available credit in the economy is likely to be beneficial for the commercial banks as they would be able to offer loans to many potential investors in the economy (Pettinger, 2012). On the other hand, an increase in the demand for government bonds would increase the bond prices. In the long run, the rise in government bonds would help lowering the interest rates of the economy. Finally the tools would increase the level of economic activities and reduce the credit crunch in the economy (Economicshelp, 2013a). Macroeconomic and Microeconomic Significance The state of monetary affairs in the economy is often influenced negatively by the wrong decisions imposed by opportunistic administrative political authorities. Autonomous and independent Monetary Policy Committee has large macroeconomic and microeconomic influence. The interest rates in the economy are tackled this committee. U.K. economy still operates at a floating exchange rate regime. The changes in the rate of interests affect the demand and supply of foreign currencies and hence the exchange rates. Rather the interest rates set by the Monetary Policy Committee controls the macroeconomic variables in the economy like GDP, employment and inflation. At a micro level tools like quantitative easing helps in the availability of credit. Thus increases the per capita income levels o the economy. The increase in income levels help individuals to improve their quality and standard of life. Natural Rate of Unemployment Milton Friedman and Edmund Phelps were the two economists who first invented the concept of natural rate of unemployment in the early 1960’s. It is the approximate level of hypothetical rate of unemployment persisting in the economy (OECD, 1991). The natural rate of unemployment is consisted with the aggregate level of output manufactured in an economy. The idea omits the temporary frictions like the incomplete adjustments of price in the markets of goods or labour. It is the usual unemployment rate prevailing in the economy according to the Classical view. The natural rate of unemployment is mainly determined by the supply side factors of the economy. Thus the production possibilities in the economy determine the natural rate of unemployment. The natural rate of unemployment often includes involuntary unemployment level persisting in the economy. The Keynesian view explains that some factors of the aggregate demand also influence the level of natural rate of unemployment. Disturbances in the economy make the actual rate of unemployment deviate from the natural rate of unemployment. Figure 6- Natural Rate of Unemployment (Source: Economicshelp, 2013b) The above graph shows the natural rate of unemployment with a red line, in the labour market equilibrium. The aggregate demand for labour (ADL) is able to mitigate a portion of the full labour force in the economy (N). Thus actual rate of employment remains at ASL. Example The graph below shows the trend of natural rate of unemployment persisting in the economy of U.K. from 1980 to 2012. Figure 7- U.K. Unemployment Rate (Source: Economicshelp, 2013b) It is empirically analyzed that the level of natural rate of unemployment in U.K. has been declining since 1980s. Although the economy had a high growth but still the strength of unemployment was as high as 2 million. It was observed that the average unemployment rate fell in 1990s. The underlying cause was the flexibility of labour unions in the economy, making the labour market flexible. Privatization in the economy has lead to growth of industries leading to a rise in the level of employment opportunities. The people in the economy undertake better education and training for the purpose of getting a job. The graph shows the trend of rise in natural rate of unemployment from 2004 onwards. One cause for this impact may be a rise in the level of under employment in the economy. Macroeconomic and Microeconomic Significance An economy that exhibits a large gap between actual and natural level of unemployment always result in having big gaps in income inequalities. An economy persisting high natural level of unemployment is likely to exhibit low Gross National Product. The state and monetary authorities of such an economy must undertake expansionary policies to augment the level of employment in the economy. In microeconomic view high natural rate of unemployment involves in low average per capita income levels. Low per capita income levels result in poor standard of living of people in an economy. Strategic Barriers to Entry The characteristic features of market structure for most of the firms in the economy are monopolistic or oligopolistic. The firm’s exhibit cut throat competition among themselves. Strategic barriers to entry are the different strategies adopted by the firms to artificially discourage the potential competitors from entering the business environment Taylor, and (Weerapana, 2008). There are various strategic barriers that a firm may adopt. A business firm often produce excess capacity of an output son that they can minimize their average costs. Such an action discourages new entrants as the new entrants exhibit high average start-up production costs. Figure 8 - Capacity produced by a firm in the long run (Source: Taylor and Weerapana, 2008) The graph above shows excess capacity produced by a firm in the long run where it operates at the breakeven point. The red perpendicular on the X axis shows the large quantity produced by the firm in the presence of low average cost of production. Another tool adopted by the firms is Limit pricing. A monopoly seller may enjoy supernormal profit in the industry. This profit level may encourage other firms to enter in the market in order to share the surplus. The monopoly seller may introduce Limit pricing strategy to discourage entrants in the market. The monopolist produces a high quantity of output at a lower price level and enjoys lower profit. This discourages the other sellers from entering in the market. Figure 9- Limit Pricing (Source: Hall, 2008) The graph above explains the case of limit prising. Any potential entrant in the market finds its entry cost equal to the Limit price. Thus only if they can cover up their cost of production at this pricing level, they would easily be able to inter in business. Doomsday device is also another strategy adopted by the firms to introduce strategic barriers for entrances. The firms artificially increase the cost of exit, so that firms who get tempted to enter in the industry often get discouraged in fear of competition in the new market. The firms often adopt the policy of predatory pricing where they set their prices initially below their short run marginal cost curves and discourage rivals to enter the business (Huber, 2010). Example The company of eBay dominates the online business market. The company enjoys high reputation in the industry. The company enjoys high experience in terms of the characteristic features of the market online. The cost of entrance in online business is extremely high. Moreover online sales require high customer trust on the brand of the company. Thus potential rivals find it a big challenge to attract the consumers over internet services in presence of reputed and known firm like eBay (Forbes, 2013). Macroeconomic and Microeconomic Significance Barriers in the market in any good or a service is harmful in term of consumer welfare attainment. Success of a business firm in crating barriers monopolizes the industry. As a result the consumers are often deceived by the monopolists in the market. The monopolists often introduce policies of price discrimination among the buyers. The existing sellers in such an industry set high levels of price and create pressure in the budget of the consumers. A Quantity Discount In the competition in the markets the sellers try their level best to win a broad customer base. They try to achieve loyalty of the customers for its brand. In order to augment the level of their sales and turnover the seller often offer their manufactured commodities art a lower cost. A quantity discount is a discount or special cut in the price level for goods or services introduced by the sellers to tap over potential customers in the market. If the buyers demand for a bulk quantity of a commodity from a seller, the seller often gives quantity discounts to them. This is because by demanding a large quantity of a commodity, the buyer’s gives the sellers a chance to enjoy economies of scale in the manufacturing activities. On the other hand the buyers continuously try to maximize their utility subject to budget constraint. So with the help of quantity discounts the buyers are able to afford a wider basket of goods and services. As a result they enjoy a higher utility (Oxford University Press, 2013). Figure 10 - impact of a product discount Product ‘a’ U0 U1 A1 A0 Product ‘b’ B0 B1 (Source: Author’s Creation) The graph above shows the impact of a product discount in the Indifference curve and Budget curve. An indifference curve shows the various combinations of two commodities that a consumer may consume. Each curve explains a particular level of utility. The higher the distance from the origin, the greater is the level of utility in the indifference curve. The budget curve is a downward sloping curve as it depicts the various choices of expenditure consumer can incur at on any two goods. The optimal choice made is the point of tangency between the budget and the indifference curve. Let the two goods considered in the above example be ‘a’ and ‘b’. As shown in the graph, the slope of the budget curve is the ratio between the price of product b and a. When the sellers offer a quantity discount in the price of say commodity b, the slope of the budget curve flattens. With the benefit of discount, the consumers purchase more of both commodities. The purchase of commodity ‘b’ increases from B0 TO B1 and that of commodity ‘a’ increases from A0 to A1. As a result the consumers increase their utility level from U0 TO U1. Example Wal-Mart Stores, Inc. is a famous American retail corporation operating in many countries all over the world. The company is well known for providing variable types of quantity discounts in a wide range of commodities. The company leads the market as a discount store. The organization concentrates majorly in achieving a broad customer base and it seems that it provides less attention in segments like fashion and trend (Fishman, 2006). Macroeconomic and Microeconomic Significance Quantity discounts helps firms to grow. Investors get highly motivated to invest in the growing businesses. With rise in investment levels in the economy there would be a significant growth in National Income aggregates. At a microeconomic view quantity discounts helps to augment consumer utility subject to the budget constraints. Conclusion After analysing the different concepts of macro and micro economics it can be analysed that considering the current economic condition a mixed economic system is the best for the society. Existence of hostile private business enterprises often depletes the social welfare in the economy. Thus it is desirable that private enterprises enhance their business activities under the efficient rules and regulation of government. Welfare in the economy can be restored only by active state participation. The combined efforts of private and public sectors will lead to a stabilized and strong economic system in a country. Reference List Arnold, R. A., 2008. Macroeconomics. Connecticut: Cengage Learning. Economicshelp, 2013a. UK Monetary Policy. [online] Available at: < http://www.economicshelp.org/macroeconomics/monetary-policy/> [Accessed 14 August 2013]. Economicshelp, 2013b. The Natural Rate of Unemployment. [online] Available at: [Accessed 14 August 2013]. Fishman, C., 2006. The Wal-Mart Effect: How the World's Most Powerful Company Really Works-- and how It's Transforming the American Economy. London: Penguin Press. Forbes, 2013. Top Stories. [online] Available at: [Accessed 14 August 2013]. Hall, R. E., 2008. Potential Competition, Limit Pricing, and Price Elevation from Exclusionary Conduct. [pdf] Available at [Accessed 14 August 2013]. Huber, H., 2010. Strategy and Entry Barriers in European Aviation. Saarbrucken: VDM Publishing. Keynes, M., 1979. Essays on John Maynard Keynes. Cambridge: Cambridge University Press. Mihov, I., 2002. Credibility and Flexibility with Monetary Policy Committees. [online] Available at: [Accessed 14 August 2013]. OECD, 1991. OECD Economic Surveys Canada 1990-1991: Canada 1990-1991. Paris: OECD Publishing. Oxford University Press, 2013. Indifference Curve Analysis. [online] Available at: < http://global.oup.com/uk/orc/busecon/economics/gillespie_econ2e/01student/advanced/02indifference/ > [Accessed 14 August 2013]. Pettinger, T., 2012. Quantitative Easing Definition. [online] Available at: [Accessed 14 August 2013]. Select Committee on Economic Affairs, 2004. Monetary and Fiscal Policy: Present Successes. London: The Stationery Office. Taylor, J. B. and Weerapana, A., 2008. Economics. Connecticut: Cengage Learning. Tucker, I. B., 2010. Survey of Economics. Connecticut: Cengage Learning. Read More