Managerial Economics

Module-1

Topic of discussion:
Introduction to Economics

Aim of the Module:

The aim of these lessons is to provide students with background
information on the nature and conceptual evolution of economics and the
economic problem.

Learning Objectives:

At the end of the lessons, students should understand the following:

• The fundamental nature of economics - unlimited wants and scarce

resources and the need to make choices
• The three questions related to the economic problem and its
implications for an economy
• A definition of opportunity cost
• o Production possibility frontiers and their relevance to the concept
of opportunity cost

Prepared by

Makim Uddin
Adjunct Faculty, International Islamic University Chittagong
Dhaka Campus

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INTRODUCTION

Economics may appear to be the study of complicated tables and charts, statistics and
numbers, but, more specifically, it is the study of what constitutes rational human behavior
in the endeavor to fulfill needs and wants.

As an individual, for example, you face the problem of having only limited resources with
which to fulfill your wants and needs, as a result, you must make certain choices with your
money. You'll probably spend part of your money on rent, electricity and food. Then you
might use the rest to go to the movies and/or buy a new pair of jeans. Economists
are interested in the choices you make, and inquire into why, for instance, you might choose
to spend your money on a new DVD player instead of replacing your old TV. They would want
to know whether you would still buy a carton of cigarettes if prices increased by $2 per pack.
The underlying essence of economics is trying to understand how both individuals and nations
behave in response to certain material constraints.

We can say, therefore, that economics, often referred to as the "dismal science", is a study of
certain aspects of society. Adam Smith (1723 - 1790), the "father of modern economics" and
author of the famous book "An Inquiry into the Nature and Causes of the Wealth of Nations",
spawned the discipline of economics by trying to understand why some nations prospered
while others lagged behind in poverty. Others after him also explored how a nation's
allocation of resources affects its wealth.

To study these things, economics makes the assumption that human beings will aim to fulfill
their self-interests. It also assumes that individuals are rational in their efforts to fulfill their
unlimited wants and needs. Economics, therefore, is a social science, which examines people
behaving according to their self-interests. The definition set out at the turn of the twentieth
century by Alfred Marshall, author of "The Principles Of Economics" (1890), reflects the
complexity underlying economics: "Thus it is on one side the study of wealth; and on the
other, and more important side, a part of the study of man."

HISTORY OF ECONOMICS

The first writings on the subject of economics occurred in early Greek times as Plato, in The
Republic, and Aristotle wrote on the topic. Later such Romans as Cicero and Virgil also wrote
about economics.

In medieval times the system of feudalism dominated. With feudalism, there was a strict
class system consisting of nobles, clergy and the peasants. In the system, the king owned
almost all the land and under him were a series of nobles that had land holdings of various
sizes. On these landholdings were series of manors. These were akin to large farming tracts in
which the peasants or serfs worked the land in exchange for protection by the nobles.

Later the system of mercantilism predominated. It was an economic system of the major
trading nations during the 16th, 17th, and 18th cent., based on the idea that national wealth
and power were best served by increasing exports and collecting precious metals in return.
Manufacturing and commerce became more important in this system.

In the mid eighteenth century, the Industrial Revolution ushered in an era in which machines
rather than tools were used in the factory system. More workers were employed in factories
in urban areas rather than on farms. The Industrial Revolution was fueled by great gains in
technology and invention. This also made farms more efficient, although fewer people were
working the farms. During this time the idea of "laissez faire" became popular. This means

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that economies work best without lots of rules and regulations from the government. This
philosophy of economics is a strong factor in capitalism, which favors private ownership.

In the nineteenth century, there was reaction to the "laissez-faire" thinking of the eighteenth
century due to the writings of Thomas Malthus. He felt that population would always advance
faster than the science and technology needed to support such population growth. David
Ricardo later stated that wages tend to settle at a poor or subsistence level for most
workers. John Stuart Mill provided the backdrop for socialism with his theories that supported
farm cooperatives and labor unions, less competition. These theories were brought to a high
point by Karl Marx who attacked the capitalistic, "laissez-faire" theories of competition and
instead favored socialisms, marked more government control and state rather than private
ownership of property.

Another important idea at this time was the change in how items are valued. While formerly
and item's value stayed the same according to what the item was, now worth of an item is
determined by how many people want the item and how great the supply of the item was.
This was the beginning of the laws of supply and demand.

In the first half of the twentieth century, John Maynard Keynes wrote about business cycles -
when the economy is doing well and when it is in a slump. His theories led to governments
seeking to put more controls on the economy to prevent wide swings.

After World War II, emphasis was placed on the analysis of economic growth and
development using more sophisticated technological tools.

In recent years, economic theory has been broadly separated into two major fields:
macroeconomics, which studies entire economic systems; and microeconomics, which
observes the workings of the market on an individual or group within an economic system. In
the later twentieth century such ideas as supply side economics which states that a healthy
economy is very necessary for the health of the nation and Milton Friedman's ideas that the
money supply is the most important influence on the economy.

In the twenty-first century, the rapid changes and growth in technology have spawned the
term "Information Age" in which knowledge and information have become important
commodities.

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WHAT IS ECONOMICS?

Economics is the science that deals with the production, distribution, and consumption of
goods and services and with the theory and management of economies or economic systems.

CLASSICAL AND NEO CLASSICAL ECONOMICS

Classical economics

Classical economics refers to work done by a group of economists in the eighteenth and
nineteenth centuries. They developed theories about the way markets and market economies
work. The study was primarily concerned with the dynamics of economic growth. It stressed
economic freedom and promoted ideas such as laissez-faire and free competition.

Famous economists of this school of thought included Adam Smith, David Ricardo, Thomas
Malthus and John Stuart Mill.

Neo classical economics

An approach to economics that relates supply and demand to an individual's rationality and
his or her ability to maximize utility or profit. Neoclassical economics also increased the use
of mathematical equations in the study of various aspects of the economy. This approach was
developed in the late-nineteenth century, based on books by William Stanley Jevons, Carl
Menger and Leon Walras.

Since its inception, neoclassical economics has grown to become the primary take on
modern-day economics. Although it is now the most widely taught form of economics, this
school of thought still has its detractors. Most criticism points out that neoclassical
economics makes many unfounded and unrealistic assumptions that do not represent real
situations. For example, the assumption that all parties will behave rationally overlooks the
fact that human nature is vulnerable to other forces, which cause people to make irrational
choices. Therefore, many critics believe that this approach cannot be used to describe actual
economies.

Neoclassical economics is also sometimes blamed for inequalities in global debt and trade
relations because the theory holds that such matters as labor rights will improve naturally, as
a result of economic conditions.

IMPORTANCE OF STUDYING ECONOMICS

Economics is an insightful study of how people behave and organizations operate under
constraints of resources. It provides powerful tools to understand and analyze many aspects
of our lives and help us to be an informed, perceptive decision-maker. Decision-making is an
integral part of business or governmental organizations. The economics department at
Georgia State University offers a modern curriculum to prepare you for future endeavors and
to meet unforeseen challenges successfully. There are many good reasons to study
economics:

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(1) To be a knowledgeable worker, consumer, investor, and citizen: Economics training
helps develop methodical ways of thinking and problem solving which can be used in our lives
as effective members of the workforce, responsible and knowledgeable citizens, informed
consumers, savers, and investors, and perceptive participants in the global economy.

(2) To acquire a set of important skills for career-building: A key element for getting a job
and succeeding in a career is your set of desirable skills. Economics training offers
individuals a terrific set of marketable skills. They include written communication and
presentation skills, quantitative communication skills, and analytical problem-solving skills.
Learning to communicate your ideas in writing and presentation to a broad range of
audiences is a key component of our economic curriculum. Economics majors are also
trained to understand numerical data and recognize their importance, use a variety of data
analysis and computing tools, and communicate quantitative information to others.
Moreover, there is no better major to acquire analytical problem-solving skills than
economics. Economic principles can be applied to identify the core elements of many
problems confronting business and government and to formulate effective decisions to tackle
those problems.

(3) To seek employment that interests you: Finding employment that interests you can be
crucial for a successful and fulfilling career. Studying economics is exciting and fun, and it
opens a wide variety of career opportunities for individuals. Economics graduates have gone
on to rewarding professional careers in industry, trade, banking and finance, law, consulting,
government, research, and education. The career flexibility is coupled with the fact that
economists often receive high salaries.

(4) To gain a solid foundation for other advanced fields of study: Because of vigorous and
comprehensive training, economics majors are sought by not only employers but also
graduate schools. Graduate study in law, business, politics, or public policy commonly
demands logical thinking abilities and strong investigative and quantitative skills. Indeed,
economics is one of the most highly respected academic disciplines

(5) Flexible: With the major changes that have taken place in the world of work, the rapid
changes in technology and globalization, it is not uncommon for individuals to make several
career changes during their lives. Today's hot specialized degree has often become
tomorrow's target for downsizing. Companies that were relatively unchallenged in the
domestic market have suffered as a result of global competition. As a result, experts in
career development recommend that one seriously consider a flexible degree such as
economics.

(6) Rewarding: Majors in economics receive average starting salaries that are in the upper
range of salary offers made to majors with other business degrees and significantly above
most majors in other areas of the liberal arts.

(7) Challenging: Economics is a discipline in which you learn a unique way of thinking. This
unique way of thinking is a primary reason that economics is also a flexible degree. Economic
concepts have been applied to a number of different areas that would, at first, seem totally
unrelated to economics. However, the concepts of economics are critical to finding solutions
to problems in a wide variety of areas.

(8) Rich in Skills

(a) Analytical/Critical Thinking Skills - There is no better major for learning
analytical problem solving than economics. You have learned how to take a problem,
and break it down into its separate elements (ceteris paribus). You have learned that
economics has a core set of tools that can be applied in a wide variety of settings (the

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 same tools apply to both consumer and firm behavior, for example). All of business is
problem solving, and this is the expertise you have learned from the logical constructs
in economics.

(b) Quantitative Skills (Mathematical and Statistical Techniques) - This means the
ability to understand numbers and their importance, and the ability to communicate
quantitative information to others. All the graphs in economics represent quantitative
concepts, and as an economics major you will certainly have no fear of graphs.
Further, many classes use explicit numerical problem solving. You also have the
opportunity to explicitly learn a wide range of statistical and computing tools, in
Statistics, and Econometrics. You have the opportunity to explicitly learn a broad
range of mathematical tools in Mathematical Economics, Game Theory, Experimental
Economics and a wide variety of other courses.

(c) Communication Skills (Written and Oral) - This means communicating with a
variety of audiences in a variety of formats. In economics, you will learn to
communicate your ideas in writing- through essay exams, papers, and homework. In
addition, the small class sizes in the upper level classes allows you the opportunity to
speak in class. All of these tools improve your interpersonal communication skills.
Some classes also present the opportunity to work with other students explicitly.

MICROECONOMICS AND MICROECONOMICS

What Does Microeconomics Mean?

The branch of economics that analyzes the market behavior of individual consumers and firms
in an attempt to understand the decision-making process of firms and households. It is
concerned with the interaction between individual buyers and sellers and the factors that
influence the choices made by buyers and sellers. In particular, microeconomics focuses
on patterns of supply and demand and the determination of price and output in individual
markets (e.g. coffee industry).

What Does Macroeconomics Mean?

The branch of economics that studies the behavior of the aggregate economy.
Macroeconomics examines economy-wide phenomena such as changes in unemployment,
national income, rate of growth, gross domestic product, inflation and price levels.

WHAT'S THE DIFFERENCE BETWEEN MACROECONOMICS AND MICROECONOMICS?

What are the differences between Microeconomics versus Macroeconomics?

The subject is broadly divided into two main branches: microeconomics, which deals with
individual agents, such as households and businesses, and macroeconomics, which
considers the economy as a whole, in which case it considers aggregate supply and demand
for money, capital and commodities. Aspects receiving particular attention in economics are
resource allocation, production, distribution, trade, and competition. Economics may in principle
be (and increasingly is) applied to any problem that involves choice under scarcity or
determining economic value.

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Mainstream economics focuses on how prices reflect supply and demand, and uses equations
to create economic models in order to predict the consequences of decisions or events, and to
measure real changes in production. Models can also analyze the behavior of whole societies.

1. Microeconomics deals the allocation of resources, production of commodities,

determinations of price, etc, are affected by the independent decisions of the consumers,
producers and other economic agents.

Macroeconomics deals with aggregate variables facing an economy. Gross National

Product (GDP), aggregate employment level, the general price level, the growth rate of the
economy, etc.

2. Macroeconomics shows how the equilibrium levels of income and consumption of the
economy are determined.

Whereas Microeconomics determines the utility maximizing levels of commodities of a

consumer.

3. Microeconomics discusses the determination of relative prices of the commodities and

services.

Macroeconomics discusses the determination of general price level in the economy.

4. Microeconomics assumes prices of other commodities and services to remain fixed when it
explains the determination of price of one commodity.

Macroeconomics assumes that the relative prices have already been determined when it
explains the determination of the general price level.

5. Values of Macroeconomic variable are not equal to sums of values of microeconomic

variables. The two types of variables are quite distinct. Consider, for example, the case of
transfer payments to a person, who wins a lottery award of forty lake taka. There is no
doubt that the income of the person has increased, but national income has not increased
due to the increment in personal income. In other words, national income does not reflect
the increment in personal income in this case.

The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy
while macroeconomics takes a top-down approach. Regardless, both micro- and
macroeconomics provide fundamental tools for any finance professional and should be studied
together in order to fully understand how companies operate and earn revenues and thus, how
an entire economy is managed and sustained.

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MANAGERIAL ECONOMICS

Managerial economics (sometimes referred to as business economics), is a branch of

economics that applies microeconomic analysis to decision methods of businesses or other
management units. As such, it bridges economic theory and economics in practice. It draws
heavily from quantitative techniques such as regression analysis and correlation, Lagrangian
calculus (linear). If there is a unifying theme that runs through most of managerial economics
it is the attempt to optimize business decisions given the firm's objectives and given
constraints imposed by scarcity, for example through the use of operations research and
programming.

Almost any business decision can be analyzed with managerial economics techniques, but it is
most commonly applied to:

• Risk analysis - various models are used to quantify risk and asymmetric information
and to employ them in decision rules to manage risk.

• Production analysis - microeconomic techniques are used to analyze production

efficiency, optimum factor allocation, costs, economies of scale and to estimate the
firm's cost function.

• Pricing analysis - microeconomic techniques are used to analyze various pricing

decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and choosing the optimum pricing method.

• Capital budgeting - Investment theory is used to examine a firm's capital purchasing

decisions.

At universities, the subject is taught primarily to advanced undergrads. It is approached as an

integration subject. That is, it integrates many concepts from a wide variety of prerequisite
courses. In many countries it is possible to read for a degree in Business Economics which
often covers managerial economics, financial economics, game theory, business forecasting
and industrial economics.

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SCARCITY

Scarcity is the problem of infinite human needs and wants, in a world of finite resources.
Society has insufficient productive resources to fulfill those wants and needs. Alternatively,
scarcity implies that not all of society's goals can be pursued at the same time; trade-offs are
made of one good against others. In an influential 1932 essay, Lionel Robbins defined
economics as "the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses."

Goods (including services) that are scarce are called economic goods (or simply 'goods' if
their scarcity is presumed). Other goods are called free goods if they are desired but in such
abundance that they are not scarce, such as air and seawater. Too much of something freely
available can informally be referred to as a 'bad', but then its absence can classified as a
good, thus, a mown lawn, clean air, etc.

For example, fruits such as strawberries are scarce on occasion because they grow only at
certain times of the year. When the supply of strawberries is lower, they are scarce, or not
always available. If enough people want strawberries when none are available, then the
demand increases. And this demand is high not because the price is low but because the
supply is low.

POSITIVE AND NORMATIVE ECONOMICS

Both macro- and micro-economics involve facts, theories, and policies. Each contains
elements of positive economics and normative economics.

Positive economics deals with what the economy is actually like. Such factually based
analysis is critical to good policy analysis. All sciences and fields of learning try to be positive
and deal with facts and models based on facts. Try to be positive i.e. scientific in your
statements, especially when writing essays and in the exam room!

In contrast, normative economics involves value judgments about what the economy should
be like or what particular policy actions should be recommended to get it to be that way. It
underlies expressions of support for particular economic policies.

Positive Statements

Positive statements are objective statements dealing with matters of fact or they question
about how things actually are. Positive statements are made without obvious value-
judgments and emotions. They may suggest an economic relationship that can be tested by
recourse to the available evidence.

Positive economics can be described as “what is, what was, and what probably will be”
economics. Statements are based on economic theory rather than raw emotion. Often these
statements will be expressed in the form of a hypothesis that can be analysed and
evaluated.

Examples:
• A rise in interest rates will cause a rise in the exchange rate and an increase in the
demand for imported products
• Lower taxes may stimulate an increase in the active labour supply

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 • A national minimum wage is likely to cause a contraction in the demand for low-
skilled labour
• The UK economy now has lower unemployment than Germany
• The American stock market has boomed in recent years
• A rise in consumer incomes will lead to a rise in the demand for new cars
• A fall in the exchange rate will lead to an increase in exports overseas
• If the government raises the tax on beer, this will lead to a fall in profits of the
brewers
• A reduction in income tax will improve the incentives of the unemployed to search for
work
• A rise in average temperatures will increase the demand for chicken
• The level of poverty in the UK has increased because of the fast growth of executive
pay

Normative Statements

Normative statements are subjective - based on opinion only - often without a basis in fact
or theory. They are value-laden, emotional statements that focus on "what ought to be". It is
important to be able to distinguish between these types of statements - particularly when
heated arguments and debates are taking place. Most economists tend to adopt a positive
approach.

Examples:
• The decision to grant independence for the Bank of England is unwise and should be
reversed
• A national minimum wage is totally undesirable as it does not help the poor and
causes higher unemployment and inflation
• The national minimum wage should be increased to £6 as a method of reducing
poverty
• Protectionism is the only proper way to improve the living standards of workers whose
jobs are threatened by cheap imports
• The level of duty on petrol is too unfair and unfairly penalizes motorists
• Drivers of 4x4 vehicles should pay higher road tax and a higher congestion charge if
they drive into London
• The government should increase the national minimum wage to £6 per hour in order
to reduce relative poverty.
• The retirement age should be raised to 75 to combat the effects of our ageing
population
• The government ought to provide financial subsidies to companies manufacturing and
developing wind farm technology

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PRODUCTION POSSIBILITY FRONTIER (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF) represents the
point at which an economy is most efficiently producing its goods and services and,
therefore, allocating its resources in the best way possible. If the economy is not producing
the quantities indicated by the PPF, resources are being managed inefficiently and the
production of society will dwindle. The production possibility frontier shows there are limits
to production, so an economy, to achieve efficiency, must decide what combination of goods
and services can be produced.

Let's turn to the chart below. Imagine an economy that can produce only Computer and Gun.
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 levels of
resources.

As we can see, in order for this economy to produce more Computer, it must give up some
of the resources it uses to produce Gun (point A). If the economy starts producing more Gun
(represented by points B and C), it would have to divert resources from making Computer
and, consequently, it will produce less Computer than it is producing at point A. As the chart
shows, by moving production from point A to B, the economy must decrease Computer
production by a small amount in comparison to the increase in Gun output. However, if the
economy moves from point B to C, Computer output will be significantly reduced while the
increase in Gun will be quite small. Keep in mind that A, B, and C all 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 Computer is in demand, the cost of increasing its
output is proportional to the cost of decreasing Gun production.

Point X means that the country's resources are not being used efficiently or, more
specifically, that the country is not producing enough Gun or Computer 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 Gun 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.

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When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when
the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its
most efficient allocation of resources and optimal production capability. A shrinking economy
could be a result of a decrease in supplies or a deficiency in technology.

An economy can be producing on the PPF curve only in theory. In reality, economies
constantly struggle to reach an optimal production capacity. And because scarcity forces an
economy to forgo one choice for another, the slope of the PPF will always be negative; if
production of product A increases then production of product B will have to decrease
accordingly.

Opportunity Cost

Opportunity cost or economic opportunity loss is the value of the next best alternative
forgone as the result of making a decision. Opportunity cost analysis is an important part of a
company's decision-making processes but is not treated as an actual cost in any financial
statement. The next best thing that a person can engage in is referred to as the opportunity
cost of doing the best thing and ignoring the next best thing to be done.

Opportunity cost is a key concept in economics because it implies the choice between
desirable, yet mutually exclusive results. It is a calculating factor used in mixed markets
which favour social change in favour of purely individualistic economics. It has been
described as expressing "the basic relationship between scarcity and choice." The notion of
opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.
Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of
output forgone, lost time, swag, pleasure or any other benefit that provides utility should
also be considered opportunity costs.

This is important to the PPF because a country will decide how to best allocate its resources
according to its opportunity cost. Therefore, the previous Computer/Gun example shows that
if the country chooses to produce more Computer than Gun, the opportunity cost is
equivalent to the cost of giving up the required Gun production.

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BASIC PROBLEMS OF ECONOMIC ORGANIZATION AND THEIR SOLUTIONS

The fundamental economic problem in any society is to provide a set of rules for allocating
resources and/or consumption among individuals who can't satisfy their wants, given limited
resources. The rules that each economic system provides function within a framework of
formal institutions (e.g., laws) and informal institutions (e.g., customs).

In every nation, no matter what the form of government, what the type of economic system,
who controls the government, or how rich or poor the country is, three basic economic
questions must be answered. All 3 problems are more clearly explained using a ppf/ppc:

1) What to produce:

This problem is what should the economy produce in order to satisfy consumer wants (as seen
by demand curves) as best as possible using the limited resources available. If a country
produces goods in a way that maximizes consumer satisfaction then the economy is
allocatively efficient.

2) How to produce:

This problem is how to combine production inputs to produce the goods decided in problem 1
as most efficiently as possible. An economy achieves productive efficiency if it produces
goods using the least resources possible. A productively efficient economy is represented by
an economy that is able to produce a combination of goods on the actual curve of the PPF.

3) For whom to produce:

Should the economy produce goods targeted towards those who have high incomes or those
who have low incomes. What sort of demographic group should the goods in the economy
that are produced be targeted towards? If the economy is addresses this problem then it has
reached pareto efficiency or pareto optimality.

How to solve them in different economic system?

Countries have scarce resources. The economic systems of countries are designed to allocate
those resources, through a production system, to provide output for their citizens. The
fundamental questions that these systems answer are:
• What and how much will be produced?
• How will it be produced?
• For whom will it be produced?

If all three problems are addressed at any one time then the economy has achieved static
efficiency. If the economy achieves static efficiency over a period of time then it is
dynamically efficient.

All these problems are focused around the problem of unlimited wants and limited resources.
Where resources are the factors of production (such as labor, capital, technology, land)
which are used to produce the products that satisfy the wants.

In practice, all economies are actually mixed economies, incorporating some facets of both
market and command economies. The relative importance of the particular economic system
in the country is the determinant of the type of economic system that it is generally
considered to be.

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 ECONOMIC SYSTEM

There are four main types of economic system:

a) Traditional or Subsistence Economies

b) Command Economies
c) Mixed Economies
d) Market Economies

Traditional or Subsistence Economies

A traditional economy is an economic system in which resources are allocated by inheritance,

and which has a strong social network and is based on indigenous technology and methods.
Although this type of economy has been converted to mixed, command, or market
technologies in many societies that were once traditionally driven; over 400 million people
across the globe still practice this methodology, as researched by the World Bank.

Characteristics:

A subsistence economy is one where:

• There is little specialisation and trade within the economy and with other countries
• The productivity of workers tends to be low leading to low incomes and a poor
standard of living
• People tend to live in family groups, and grow most of their own food, make their own
houses, gather their own fuel and provide their own leisure activities i.e. to a great
extent they are self-sufficient
• Few goods and services are marketed and command a price or value - there is little
surplus production to export
• Traditional economies are found in rural, non-developed countries
• Technology is not used in traditional economies
• Men and women are given different economic roles and tasks
• Usually social behavior based on custom
• Individuals don’t make decisions on what they want, determined by elders

Some parts of Asia, Africa, South America and the Middle East have traditional economies

Advantages
• Everyone knows their role
• Little uncertainty of what and how to produce, for whom is usually themselves

Disadvantages
• Discourages new ideas/technology
• Punishes people that break rules
• Lower standard of living

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Command Economies

A command economy is one where all key economic decisions are made by the government
(or state). The government decides:
• What to produce,
• How it is to be produced and
• How it is to be allocated to consumers.

This involves a great deal of economy planning by the state. The price mechanism has no
active role in a pure command economy since market prices are rarely used. By state
planning, goods and services can be produced to satisfy the needs of all the citizens of a
country, not just those who have the money to pay for goods. Over the last decade, many
former planned economies have attempted to bring market forces into their economy.

Characteristics:

• The government or other central authority makes decisions and determines how
resources will be used
• There is little individual freedom
• There is no competition
• Businesses are not run to create a profit
• Consumers have few chooses in the market place
• Factories are concerned with quotas
• Shortages are common because of poorly run factories and farms
• The government dictates the job in which you work
• The government sets the prices of goods and services
Examples of command economies: Cuba, North Korea and the People's Republic of China

Advantages:

• Maximize consumers' welfare and demands

• Mostly affordable for the consumers
• Maximizes the continues utilization of resources.
• Distributes wealth equally among all people so there are no inequalities.
• Some education, health care, public services available at little or no cost

Disadvantages:

• No competition to motivate the workers

• Labor only try to maintain the standards
• Achieve the government's target but did not improving them
• Lack innovation.
• Can not detect consumer preferences accurately.
• Overstaffing problems, poor product quality, lack of efficiency.
• Sacrifice for the good of the state and benefit for future generations
• No incentive to work hard—just enough to fill quota
• Little flexibility—discourages change

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Mixed Economies

A mixed economy is a mixture of a pure free-enterprise market economy and a command

economy. There is a private sector and a public sector in the economy. Both these sectors
exist and function for achieving national objectives and make the economic system of the
country. In fact the mixed economy is the happy combination of private enterprise with
government enterprise on the one side there is freedom of enterprise, private ownership and
profit earning. On the other side there is government guidance and control so as to stop evil
economic, pressures. In order to remove the effects of the capitalistic economy, mixed
economy has been introduced. It prevails in most of the countries of the world.

Characteristics:

• Government and individuals share the decision making process

• Government guides and regulates production of goods and services offered
• Individuals own means of production
• Protects consumers and workers from unfair policies
• Most effective economy for providing goods and services

The United States and most Western European countries are mixed economies

Advantages

• The mixed economy is helpful in increasing national production in the country.

• Both public and private sectors work hard to bring about more production.
• The problems created by free enterprise and too much public control are solved
through mixed economy.
• It provides freedom of enterprise ownership and profit earning as well as social
welfare and political freedom.
• All the national recourses are utilized under mixed economy.

Disadvantages

• Mixed economy is half way house.

• It is not helpful in achieving optimal use of national resources.
• The mixed economy suffers from the drawbacks of both the capitalism and the
socialism.
• Mixed economy seldom achieved progress.
• It suffers from continues backwardness.
• Under mixed economy wastage of different types occurs in the economy.

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Market Economies
A market economy is one where economic decisions are made through the free market
mechanism. The forces of market demand and supply, without any government intervention,
determine how resources are allocated. This is known as the working of the price mechanism.

Characteristics:

• Resources are owned and controlled by individuals

• Economic decisions are made by individuals competing to earn profits
• Individual freedom is considered very important
• Economic decisions are made by the basic principles of supply and demand
• Profit is the motive for increasing work rather than quotas
• Also called capitalist economies
• There are many economic freedoms
• There is competition among businesses
• Competition determines price which increase the quality of the product
• People and firms act in their own best interests
• Allow buyers/sellers to come together to exchange goods & services

Ex: US, Japan, Germany

Advantages

• Over time can adjust to change

• Individual freedom
• Little government interference
• Decentralized decision making
• Variety of goods/services
• High consumer satisfaction

Disadvantages

• Doesn’t provide for basic needs of ALL members

• Doesn’t provide enough services people highly value
o Ex: education, health care
• High degree of uncertainty for workers & businesses
• Can fail if 3 conditions are not met
o Reasonably competitive markets
o Resources able to move from one activity to another
o Consumer access to information to make wise choices
o Government helps to ensure these

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International Trade, Comparative Advantage and Absolute Advantage

International Trade

The economic system of exchanging good and services, conducted between individuals
and businesses in multiple countries.

Comparative Advantage

In economics, the law of comparative advantage refers to the ability of a party (an
individual, a firm, or a country) to produce a particular good or service at a lower marginal
cost and opportunity cost than another party. It is the ability to produce a product most
efficiently given all the other products that could be produced.[1][2] It can be contrasted with
absolute advantage which refers to the ability of a party to produce a particular good at a
lower absolute cost than another.

Comparative advantage explains how trade can create value for both parties even when one
can produce all goods with fewer resources than the other. The net benefits of such an
outcome are called gains from trade.

Absolute Advantage

In economics, absolute advantage refers to the ability of a party (an individual, firm, or
country) to produce more of a good or service than competitors, using the same amount of
resources. If a party has an absolute advantage when using the same input as another party,
it can produce a greater output.[7][8] Since absolute advantage is determined by a simple
comparison of labor productivities, it is possible for a party to have no absolute advantage in
anything.[9] It can be contrasted with the concept of comparative advantage which refers to
the ability to produce a particular good at a lower opportunity cost.

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