Inflation

Economists use the term “inflation” to denote an ongoing rise in the general level of prices quoted in units of money. The magnitude of inflation—the inflation rate—is usually reported as the annualized percentage growth of some broad index of money prices. With U.S. dollar prices rising, a one-dollar bill buys less each year. Inflation thus means an ongoing fall in the overall purchasing power of the monetary unit.

There are several variations on inflation:

• Deflation is when the general level of prices is falling. This is the opposite of inflation.

• Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!

• Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.

Causes of Inflation

Economists wake up in the morning hoping for a chance to debate the causes of inflation. There is no one cause that's universally agreed upon, but at least two theories are generally accepted:

Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.

Costs of Inflation

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different people in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

• Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.

• Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.

• People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.

• The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus and more have to be updated.

• If the inflation rate is greater than that of other countries, domestic products become less competitive.

People like to complain about prices going up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad - it depends on the overall economy as well as your personal situation

UNIT 3

ELASTICITY

Elasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how supply and demand respond to various factors, including price as well as other stochastic principles. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity, which calculates the elasticity over a range of values, in contrast with point elasticity, which uses differential calculus to determine the elasticity at a specific point). It is a measure of relative changes.

Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

Elasticity corresponds to the slope of the line and is often expressed as a percentage. In other words, the units of measure (such as gallons vs. quarts, say for the response of quantity demanded of milk to a change in price) do not matter, only the slope. Since supply and demand can be curves as well as simple lines the slope, and hence the elasticity, can be different at different points on the line.

Elasticity is calculated as the percentage change in quantity over the associated percentage change in price. For example, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve. At all price levels, more luxury cars would be demanded.

Another elasticity sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0.

In a perfect economy, any market should be able to move to the equilibrium position instantly without travelling along the curve. Any change in market conditions would cause a jump from one equilibrium position to another at once. So the perfect economy is actually analogous to the quantum economy. Unfortunately in real economic systems, markets don't behave in this way, and both producers and consumers spend some time travelling along the curve before they reach equilibrium position. This is due to asymmetric, or at least imperfect, information, where no one economic agent could ever be expected to know every relevant condition in every market.

Other market forms

The supply and demand model is used to explain the behavior of perfectly competitive markets, but its usefulness as a standard of performance extends to other types of markets. In such markets, there may be no supply curve, such as above, except by analogy. Rather, the supplier or suppliers are modeled as interacting with demand to determine price and quantity. In particular, the decisions of the buyers and sellers are interdependent in a way different from a perfectly competitive market.

A monopoly is the case of a single supplier that can adjust the supply or price of a good at will. The profit-maximizing monopolist is modeled as adjusting the price so that its profit is maximized given the amount that is demanded at that price. This price will be higher than in a competitive market. A similar analysis can be applied when a good has a single buyer, a monopsony, but many sellers. Oligopoly is a market with so few suppliers that they must take account of their actions on the market price or each other. Game theory may be used to analyze such a market.

The supply curve does not have to be linear. However, if the supply is from a profit-maximizing firm, it can be proven that downward sloping supply curves (i.e., a price decrease increasing the quantity supplied) are inconsistent with perfect competition in equilibrium. Then supply curves from profit-maximizing firms can be vertical, horizontal or upward sloping.

Similarly, the demand curve is rarely linear. A great empirical example of this is given in this article on computer software pricing where the vendor deliberately varied the price and measured the resulting demand. It produced a very non linear demand curve.

Empirical estimation

Demand and supply relations in a market can be statistically estimated from price, quantity, and other data with sufficient information in the model. This can be done with simultaneous-equation methods of estimation in econometrics. Such methods allow solving for the model-relevant "structural coefficients," the estimated algebraic counterparts of the theory. The Parameter identification problem is a common issue in "structural estimation." Typically, data on exogenous variables (that is, variables other than price and quantity, both of which are endogenous variables) are needed to perform such an estimation. An alternative to "structural estimation" is reduced-form estimation, which regresses each of the endogenous variables on the respective exogenous variables.

Macroeconomic uses of demand and supply

Demand and supply have also been generalized to explain macroeconomic variables in a market economy, including the quantity of total output and the general price level. The Aggregate Demand-Aggregate Supply model may be the most direct application of supply and demand to macroeconomics, but other macroeconomic models also use supply and demand. Compared to microeconomic uses of demand and supply, different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. Demand and supply may also be used in macroeconomic theory to relate money supply to demand and interest rates.

Demand shortfalls

A demand shortfall results from the actual demand for a given product being lower than the projected, or estimated, demand for that product. Demand shortfalls are caused by demand overestimation in the planning of new products. Demand overestimation is caused by optimism bias and/or strategic misrepresentation.

History

The power of supply and demand was understood to some extent by several early Muslim economists, such as Ibn Taymiyyah who illustrates:

"If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down.

The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into the Principles of Political Economy, published in 1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations, and David Ricardo titled one chapter of his 1817 work Principles of Political Economy and Taxation "On the Influence of Demand and Supply on Price"

In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its "merit" (value) would decrease as its "scarcity" increased, in effect what was later called the law of demand. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches on the Mathematical Principles of the Theory of Wealth.

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price.

In his 1870 essay "On the Graphical Representation of Supply and Demand", Fleeming Jenkin drew for the first time the popular graphic of supply and demand which, through Marshall, eventually would turn into the most famous graphic in economics.

The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics. Along with Léon Walras, Marshall looked at the equilibrium point where the two curves crossed. They also began looking at the effect of markets on each other.

UNIT 4

SUPPLEMENTARY READING

Price in economics and business is the result of an exchange and from that trade we assign a numerical monetary value to a good, service or asset. If Alice trades Bob 4 apples for an orange, the price of an orange is 4 apples. Inversely, the price of an apple is 1/4 oranges.

Price is only part of the information we get from observing an exchange. The other part is the volume of the goods traded per unit time, called the rate of purchase or sale. From this additional information we understand the extent of the market and the elasticity of the demand and supply.

The concept of price is central to microeconomics where it is one of the most important variables in resource allocation theory (also called price theory). Price is also central to marketing where it is one of the four variables in the marketing mix that business people use to develop a marketing plan.

In general terms price is the result of an exchange or transaction that takes place between two parties and refers to what must be given up by one party (i.e., buyer) in order to obtain something offered by another party (i.e., seller).

Yet this view of price provides a somewhat limited explanation of what price means to participants in the transaction. In fact, price means different things to different participants in an exchange:

Example - Price is commonly confused with the notion of cost as in “I paid a high cost for buying my new plasma television”. Technically, though, these are different concepts. Price is what a buyer pays to acquire products from a seller. Cost concerns the seller’s investment (e.g., manufacturing expense) in the product being exchanged with a buyer. For marketing organizations seeking to make a profit the hope is that price will exceed cost so the organization can see financial gain from the transaction. Finally, while product pricing is a main topic for discussion when a company is examining its overall profitability, pricing decisions are not limited to for-profit companies. Not-for-profit organizations, such as charities, educational institutions and industry trade groups, also set prices, though it is often not as apparent. For instance, charities seeking to raise money may set different “target” levels for donations that reward donors with increases in status (e.g., name in newsletter), gifts or other benefits. While a charitable organization may not call it a price in their promotional material, in reality these donations are equivalent to price setting since donors are required to give a contribution in order to obtain something of value

A market is any one of a variety of different systems, institutions, procedures, social relations and infrastructures whereby person’s trade, and goods and services are exchanged, forming part of the economy. It is an arrangement that allows buyers and sellers to exchange things. Markets vary in size, range, geographic scale, location, types and variety of human communities, as well as the types of goods and services traded. Some examples include local farmers’ markets held in town squares or parking lots, shopping centers and shopping malls, international currency and commodity markets, legally created markets such as for pollution permits, and illegal markets such as the market for illicit drugs.

In mainstream economics, the concept of a market is any structure that allows buyers and sellers to exchange any type of goods, services and information. The exchange of goods or services for money is a transaction. Market participants consist of all the buyers and sellers of a good who influence its price. This influence is a major study of economics and has given rise to several theories and models concerning the basic market forces of supply and demand. There are two roles in markets, buyers and sellers. The market facilitates trade and enables the distribution and allocation of resources in a society. Markets allow any tradable item to be evaluated and priced. A market emerges more or less spontaneously or is constructed deliberately by human interaction in order to enable the exchange of rights (cf. ownership) of services and goods.

Historically, markets originated in physical marketplaces which would often develop into — or from — small communities, towns and cities.

UNIT5

WHAT ARE INFERIOR GOODS?

An Inferior Good is a good for which demand decreases as our income increases. Inferior goods are often of lower quality -- things that we would not yearn for if we could afford a better alternative. So, when we happen upon a higher income, our desire for these inferior goods decreases. For example, as our income goes up, we tend to buy less lower quality fast food and more nutritious imported gourmet food, because we can now afford the higher-quality preferable good.

Inferior goods differ from normal goods. Normal goods are goods for which an increased income leads to increased demand for the good. Examples of normal goods are the "nutrituious imported gourmet food" mentioned above and luxury cars. (The demand for luxury cars increases as income increases.)

Example of an Inferior Good

John is a poor college student, with his only source of income coming from his campus job leading tours at Case Western Reserve University. He gets paid $10 an hour, but he only gives two 1 hr. tours a week. With an inadequate college meal plan, John feels his money would be best spent on more (cheap) food -- mainly "budget" goods, such as instant macaroni-and-cheese and MacRonald's fast food burgers. He rarely treats himself to a meal from the ChocoCake Factory. With his current $20 a week, he typically decides to use his money to buy six packets of macaroni-and-cheese (at $2 a pack) and one meal at the ChocoCake Factory (at $8 a meal).

(Right now, John is spending $12 a week on mac-and-cheese and $8 a week on meals at the ChocoCake Factory)

When John graduates and finds a high paying job, his lifestyle changes and he is now a consumer of more normal goods. He now works as Assistant to the Professor of Microeconomics at CWRU, and earns a stunning $40 a week -- double what he was making as a lowly freshman tour guide. On a regular basis he now consumes 4 meals a week at the ChocoCake Factory and only buys four packets of macaroni-and-cheese.

(John is now spending $8 a week on mac-and-cheese and $32 a week on meals at the ChocoCake Factory)

From his new consumption pattern post-graduation, we can conclude that cheap macaroni-and-cheese is an inferior good; even though John's income increased, he chose to consume less macaroni-and-cheese.

Understanding how to set prices is a key element to your pricing strategy. To set a price for your product or service you need to know your market and your competition, know what the demand, and understand the price elasticity of demand for your product or service.

Setting prices is also affected by how unique or differentiated your product is; in other words, is it a commodity item or a specialty or niche item? And then, most importantly, do your customers value the differentiation?

Price Sensitivity

Part of your strategy in building price must be to consider price sensitivity. This is particularly important when you are introducing new products or services to the market – and, when you are changing price (that is, increasing or decreasing price).

The market is less sensitive when the product is unique or differentiated and has high value; price increases in this scenario do not affect demand.

The market is more sensitive when the product or service is easily substituted for a more economically priced alternative; price increases in this scenario would affect demand negatively.

The market is less sensitive when products have quite different qualities and are therefore hard to compare to each other; price increases in this scenario often do not affect demand.

The market is less sensitive, and relatively inelastic, when the cost of switching from one product to another involves significant cost (penalties for moving to another supplier - such as breaking a lease).

The market is less sensitive to price when the product is a necessity, as compared to a discretionary item.

Price Elasticity of Demand

The elasticity of demand formula calculates the impact of a change in price for a given product on demand:

The percentage change in demand divided by the percentage change in price.

For example, the demand for hotel rooms decreased by 10% when hotel room taxes increased by 8%: 10% divided by 8% = 1.25 (demand is elastic in this example – it is affected by an increase in price) Note: While the result is a negative, economists typically don't show it that way in the formula.

Demand Elasticity Values

If Price Elasticity of Demand = 0, then demand is perfectly inelastic. This means that demand is not affected by price changes (the demand curve in this instance is vertical).

If Price Elasticity of Demand = between 0 and 1, then demand is inelastic. This means that the demand change will be proportionately smaller than the price change.

If Price Elasticity of Demand = 1, then demand is unit elastic. This means that the increase in price would result in the same decrease percentage in demand.

If Price Elasticity of Demand > 1, then demand is elastic and it is more than proportionately affected by a change in price.

What is the demand elasticity of your product in your market? Understand that price elasticity of demand is closely tied to the amount, direction (up or down), and frequency of price change.

The Relationship Between Price Elasticity and Pricing Strategy

If possible, try to test pricing through surveys, or focus groups, or by talking to your customers. Define the product or service in the test, set various levels of price for that product (going up in specific increments), and ask at what level of price does your customer consider the price to be 'fair'; at what level of price would your customer consider an alternative; and, finally, at what level of price would your customer would stop buying.

The relationship between rising price and falling demand is the price elasticity of demand.

Using a spreadsheet analysis, you can develop demand curves that show you at what price point demand will start falling. As you might expect, the higher the price, the lower the demand; unless you are selling luxury or prestige products or services. This is important data when determining pricing method and techniques.

For example, a customer expects to pay a high price for a Lamborghini or for a yacht (it’s part of the prestige) and demand in those product categories is not affect by price but by brand identity. For those types of products or services, the demand curve would be considered to be abnorm

Why is Price Elasticity of Demand Important?

Because you can use elasticity of demand data to predict the potential impact of a price change on your total sales revenues. Pricing helps drive sales revenues; it is not a cost center (unlike other marketing mix elements such as product, promotion, packaging and place/distribution)!

UNIT 6

SUPPLEMENTARY READING

The Meaning of Markets

When people talk about markets, they may be referring to a number of different meanings of the word, from very concrete to very abstract. In the language of economics there are at least three different uses of the word "market," and the appropriate meaning must be judged from the context in which it appears. We will start with the most concrete and move toward the more abstract definitions

The most concrete and commonsense definition of a market is the idea that a market is a location—that is, a place where people go to buy and sell things. This is historically appropriate: Markets such as the Grand Bazaar in Istanbul or African village produce stands have flourished for ages as meeting places for people who wish to make exchange transactions. The same criterion applies today, even when the “market” has become a shopping center or mall, with many retail stores sharing one huge building, or a stock or commodity exchange, where brokers stand on a crowded floor and wave signals to each other. A market, as suggested by these examples, can be defined as a physical place where there is a reasonable expectation of finding both buyers and sellers for the same product or service.

However not all markets are physical places where buyers and sellers interact. We can think of markets in more general terms as institutions that bring buyers and sellers together.

Institutions are ways of structuring the interactions between individuals and groups. Like markets, institutions can also be thought of in concrete or abstract terms. A hospital can be considered an institution that structures the interactions between doctors and patients. A university is an institution that structures the interactions between professors and students. But institutions can also be embodied in the customs and laws of a society. For example, marriage is an institution that places some structure on family relationships. Laws, courts, and police forces are institutions that structure the acceptable and unacceptable ways that individuals and groups interact.

When we think of markets as institutions, we see that a market does not need to be a physical location. Internet auctions, such as eBay, are market institutions that bring buyers and sellers together. The New York Stock Exchange can be considered both a physical location—a building on Wall St. where brokers buy and sell stocks—and an institution where investors all over the world interact indirectly according to a set of established rules and structures.

Thinking of markets as institutions, rather than concrete places, leads to various ways of discussing particular markets. Many economists spend much of their time investigating one or more such specific institutional markets. They may track the trades made at various prices over time for a specific good, like heating oil or AT&T bonds, try to forecast what might happen in the future, or advise on the specifics of market structures. When such an economist speaks of a market, he or she most often means the institutional market for such a specific good.

Public goods. Some goods cannot, or would not, be well-provided by private individuals or organizations acting alone. A public good (or service) is one where the use of it by one person does not diminish the ability of another person to benefit from it (“nondiminishable”), and where it would be difficult to keep any individuals from enjoying its benefit (“nonexcludable”).

For example, if a local police force helps make a neighborhood safe, all the residents benefit. Public roads (at least those that are not congested and have no tolls) are also public goods, as is national defense. Education and quality childcare are public goods because everyone benefits from living with a more skilled and socially well-adjusted population. A system of laws and courts provides the basic legal infrastructure on which all business contracting depends. Environmental protection that makes for cleaner air benefits everyone.

Because it is difficult to exclude anyone from benefiting, public goods cannot generally be bought and sold on markets. Even if individual actors would be willing to pay if necessary, they have little incentive to pay because they can’t be excluded from the benefit. Economists call people who would like to enjoy a benefit without paying for it "free riders." Because of the problem of free riders, it often makes sense to provide public goods through government agencies, supported by taxes, so that the cost of the public benefit is also borne by the public at large.

Externalities. Other activities, while they may involve goods and services that are bought and sold in markets, create externalities. Externalities are side effects or unintended consequences of economic activities. They affect persons, or entities such as the environment, that are not among the economic actors directly involved in a particular economic activity. These effects can be positive or negative. Sometimes positive externalities are referred to as “external benefits” and negative externalities are referred to as “external costs.” Externalities are one of the primary ways in which the true social value of a good or service may differ from its market value.

Examples of negative externalities include a manufacturing firm dumping pollutants in a river, decreasing water quality downstream, or a bar that plays loud music that annoys its neighbors. Examples of positive externalities include the fact that parents who, out of love for their children, raise them to become decent people (rather than violent criminals) also create benefits for society at large, or the way in which one person getting vaccinated against a communicable disease to protect himself or herself also protects people around him or her from the disease’s spread. In both cases, there are social benefits from individual actions. Well-educated, productive citizens are an asset to the community as well as to their own families, and disease control reduces risks to everyone.

Some of the most important externalities have to do with the economic activity of resource maintenance: Relying on markets alone to coordinate economic activities allows many activities to happen that damage or deplete the natural environment, because the damage often does not carry a price tag and because people in future generations are not direct parties to the decision-making.

If economic activities affected only the actors directly involved in decision-making about them, we might be able to think about economic activity primarily in terms of individuals making decisions for their own benefit. But we live in a social and ecological world, in which actions, interactions, and consequences are generally both widespread and interknit. If decisions are left purely to individual self-interest, then from a societal point of view too many negative externalities will be created, and too few positive externalities; the streets might be strewn with industrial wastes, while children might be taught to be honest in dealings within their family, but not outside of it. Market values and human or social values do not always coincide.

Transaction costs. Transaction costs are the costs of arranging economic activities. In the basic neoclassical model, transaction costs are assumed to be zero. If a firm wants to hire a worker, for example, it is assumed in that model that the only cost involved is the wage paid. In the real world, however, the activity of getting to a hiring agreement may involve its own set of costs. The firm may need to pay costs related to searching, such as placing an ad or paying for the services of a recruiting company. The prospective worker may need to pay for preparation of a resume and transportation to an interview. One or both sides might hire lawyers to make sure that the contract terms reflect their interests. Because of the existence of such costs, some economic interactions that might be lead to greater efficiency, and that would occur in a transaction-cost-free, frictionless idealized world, may not happen in the real world.

Market power. In the basic neoclassical model, all markets are assumed to be “perfectly competitive,” such that no one buyer or seller has the power to influence the prices or other market conditions they face. In the real world, however, we see that many firms have market power. For example, when there is only one firm (a monopolist) or a few firms selling a good, they may be able to use their power to increase their prices and their profits, creating inefficient allocations of resources in the process. Workers may also be able to gain a degree of market power by joining together to negotiate as a labor union. A government, too, can have market power, for example when the Department of Defense is the sole purchaser of military equipment from private firms.

Businesses may also gain power by their sheer size—many corporations now function internationally, and have revenues in the tens of billions of dollars. The decisions of individual large corporations can have substantial effects on the employment levels, economic growth, living standards, and economic stability of regions and countries. Governments may need to factor in the responses of powerful business groups in making their macroeconomic decisions. National leaders may fear, for example, that raising business tax rates or the national minimum wage may cause companies to leave their country and go elsewhere. Corporations frequently also try to influence government policies directly, through lobbying, campaign contributions, and other methods.