Demand and supply are underpinned by the basic economic problem and how we choose to solve that problem. Discuss
Economics is one of the most important and influential disciplines practised by individuals, companies and countries all over the world due to its volume of knowledge and extensive theories that enable considerable insight into how markets are formed, sustained and managed (Baumol & Blinder 2008). Demand and supply are a common phenomenon in human existence: people have always, and will always, create demand for goods and services, and businesses will always exist to satisfy that demand, as they are exposed to varying factors that affect the availability and allocation of scarce resources.
The basic economic problem is that available resources are presently inadequate relative to what they can be used for. Consequently, choices pertaining to how to use these limited resources have to be made with care. This is why the basic problem of economics is often referred to as one of scarcity and choice (Baumol & Blinder 2008).
Resources can be defined as anything that can be used to support our well-being and existence on the planet. Resources may mean physical materials such as oil, minerals and fisheries or human resources, namely people and the skills they can bring on board. Due to the fact that human beings have unlimited wants which can expand on a daily basis, these wants and desires cannot be fulfilled by the number of resources available. There are only so many resources on the Earth and, consequently, people have to make tough choices, compromise and manage whatever resources are available to them.
The Concept of Scarcity
Scarce resources refer to capital, land, labour and enterprise. Land incorporates all natural resources; Labour includes any energy, mental and physical resources directed at getting a job done; Capital incorporates machinery, gadgets and equipment used for the production of goods and services; Enterprise on the other hand, is the skill needed to combine the resources mentioned above in a way that is cost-effective and efficient.
Scarcity can thus be further referred to as the result of lacking in necessary resources, the insatiability of people’s wants and a combination of the two. Because of the limited resources available, organizations, business and even countries have to apply economic principles to conserve existing resources and make use of whatever they have to survive.
Economists make a distinction between wants and needs. Needs are what people need in order to survive such as food, water, shelter, while wants are what we can do – i.e. survive – without. Opinions may collide regarding whether something (e.g. a computer or TV) is a want or a need, and perception may vary between countries and cultures. The want is actually the demand in this context. Whenever one choice is made over another in the midst of scarce resources, we arrive at what is known as opportunity cost (Mankiw, 2008). Opportunity cost can be described as the item that is given up in place of another. It is referred to as the next best alternative.
How to Solve the Basic Economic Problem
A free market economy can be described as one of the ways of solving the basic economic problem. It is a type of market that is free of government regulation and economic intervention except law enforcement in places where applicable (Babb & Carruthers 1999). In free markets, there are no regulations, subsidizations and governmental monopolies where government regulates the market. This is in contrast to a controlled economy (Babb & Carruthers 1999). The free market addresses the problem of scarce resource because it ensures that producers can supply whatever amounts they want thereby, attempting to satisfy the needs of the people. It also attempts to bring about an equal distribution of resources across the country in which it is practised. However, there is arguably no such thing as a free market: even in the USA, there are very many regulations and government subsidies; for example, every passenger on American railways is apparently subsidised by the State to the tune of over $20 – a genuine free market would actually mean no trains in America, as well as no public (i.e. state funded) schools, no subsidised Medicare public healthcare etc.
A mixed economy is one in which there exists a component of public control and government interference and involvement. One facet involves a degree of private economic freedom that is practiced without government plans and regulations. This type of market is better in developing countries because less privileged people will not be subject to market forces but protected by the government who negotiates the market price.
A planned economy, also known as a directed economy is a system where state workers are in charge of managing the economy. In this type of system, the central government makes all the necessary decisions on the production and sales of goods and services (Babb & Carruthers 1999). Examples such as The Soviet Union or North Korea would suggest that this method does not work, and China’s present boom resulted in abandoning this failed system.
- The law of demand and utility theory make important assumptions about how consumers behave. Discuss
Consumer demand can be defined as the quantity of a product that consumers are willing to buy at various prices, assuming all other factors of demand are kept constant. A change in price leads to a change in quantity demanded. The factors that must be kept constant in most scenarios include population size, income distribution, prices, substitute goods and other significant factors (Hazlitt 1988). All these factors have a considerable effect on the level of demand.
The law of demand states that a decrease in price leads to an increase in the quantity of a product that is demanded. Conversely, an increase in the price of a product causes the demand for that product to reduce. In conclusion, we can say that price and quantity demanded move in opposite directions along the demand curve. For example, customers would demand for more cars if the price were to fall. This is the same for almost every type of commodity.
The Utility Theory asserts that a customer will not spend more money on an extra item unless its utility is more than or equal to that of another item (Hazlitt 1988). The theory attempts to explain the behaviour of consumers as being determined by the perceived utility derived from a particular product. Utility in this context refers to the relative satisfaction derived from the consumption of various goods and services. This theory can be used to explain customer behaviour in various contexts.
- Explain why the price elasticity of demand for foreign holidays is likely to be elastic. What would be the consequences of an appreciation of the UK exchange rate (price increase) on UK firms that supply these foreign holidays?
Price Elasticity of demand can be defined as the change associated with quantity demand relative to a price change. In mathematical terms, it is the percentage change in quantity demanded relative to the percentage change in price of that commodity (Mankiw, 2008).
To explain further, the demand for an item can be said to be inelastic if customers would pay any amount of money for the product, for example, important commodities like drinking water. Demand is however elastic when customers will pay only a certain amount or stick to a defined price range for a product.
The price elasticity of demand for luxury goods such as foreign holidays is likely to be elastic because customers are prepared to pay only a certain, limited amount of money for a holiday and the level of this depends largely on their income. If the price tag associated with these holidays increases, customers can always explore substitute holiday locations. They may decide to arrange local holiday trips which are cheaper – as people did in the past before foreign holidays were common – and also look for substitute deals to other locations. Also, if the amount charged for the foreign holiday trip is a large percentage of the average income, people may well reduce their demand. This is mainly because ‘Foreign Holidays’ fall under the category of wants and luxurious goods, but not needs.
An appreciation of the UK exchange rate would cause an increase in the price of foreign holidays which may lead to a decline in the request for foreign holiday trips by people. Also, if Sterling appreciates, the foreign holiday providers would be able to increase the value obtained from each trip thereby shifting the supply curve to the right and reducing the equilibrium price.
- Using the concept of cross price elasticity of demand, why would firms be concerned about changes in the supply and demand conditions in the coffee market.
In normal market situations, a change in the price of one item causes a change in the demand for another item. For a firm that manufactures products like coffee, it would be concerned about other firms that produce substitute products in the markets such as Cappuccino, Teeccino, Rooibos tea and so on. An increase in the price of coffee would cause a higher demand for substitute products which can offer customers the same level of satisfaction. The coffee market is full of multifarious alternatives to coffee. Consequently, a decrease in supply of coffee or an increase in its price would cause customers to switch to these similar products.
Using the coffee market scenario, if the price of coffee falls, the market demand for coffee would increase and reduce the demand for substitute products which have remained at a certain price level or increased for one reason or the other. Producers of substitute drinks would consequently experience a decrease in the demand for their own products since the price of coffee is less.
Cross price elasticity is one of the most efficient methods of measuring the degree to which a product can be substituted for another. Goods that are unrelated to each other are deemed to have zero cross elasticity (Mankiw, 2008). Substitute goods on the other hand, would have a positive relationship between the change in the price of one to the quantity demanded of another.
Babb, S. L., & Carruthers, B. G. (1999). Economy/Society: Markets, Meanings, and Social Structure (Sociology for a New Century Series). Thousand Oaks, California: Pine Forge Press.
Baumol, W. J., & Blinder, A. S. (2008). Economics: Principles and Policy. Mason, OH: South-Western College Pub.
Hazlitt, H. (1988). Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics. new york: Three Rivers Press.
Mankiw, N. G. (2008). Principles of Economics. Mason, OH: South-Western College Pub.