Economic systems

ECONOMIC SYSTEMS 1. Definitions An economic system is the system of production, distribution and consumption of goods and services of an economy. Alternatively, it is the set of principles and techniques by which problems of economics are addressed, such as the economic problem of scarcity through allocation of finite productive resources The econonic system is composed of people and institutions, including their relationships to productive resources, such as through the convention of property. Examples of contemporary economic systems include capitalist systems, socialist systems, and mixed economies. "Economic systems" is the economics category that includes the study of respective systems. Currently capitalist system is the world's most dominant form of economic system. An economic system can be defined as a "set of methods and standards by which a society decides and organizes the allocation of limited economic resources to satisfy unlimited human wants. At one extreme, production is carried in a private-enterprise system such that all resources are privately owned. It was described by Adam Smith as frequently promoting a social interest, although only a private interest was intended. At the other extreme, following Karl Marx and Vladimir Lenin is what is commonly called a pure-communist system, such that all resources are publicly owned with intent of minimizing inequalities of wealth among other social objectives". 2. Type of Economic System Three types of economic systems exist, each with their own drawbacks and benefits; the Market Economy, the Planned Economy and the Mixed Economy. An economic system is loosely defined as country’s plan for its services, goods produced, and the exact way in which its economic plan is carried out. In general, there are three major types of economic systems prevailing around the world. 2.1 Market Economy In a market economy, national and state governments play a minor role. Instead, consumers and their buying decisions drive the economy. In this type of economic system, the assumptions of the market play a major role in deciding the right path for a country’s economic development. Market economies aim to reduce or eliminate entirely subsidies for a particular industry, the pre-determination of prices for different commodities, and the amount of regulation controlling different industrial sectors. The absence of central planning is one of the major features of this economic system. Market decisions are mainly dominated by supply and demand. The role of the government in a market economy is to simply make sure that the market is stable enough to carry out its economic activities 2.2 Planned Economy A planned economy is also sometimes called a command economy. The most important aspect of this type of economy is that all major decisions related to the production, distribution, commodity and service prices, are all made by the government. The planned economy is government directed, and market forces have very little say in such an economy. This type of economy lacks the kind of flexibility that is present a market economy, and because of this, the planned economy reacts slower to changes in consumer needs and fluctuating patterns of supply and demand. On the other hand, a planned economy aims at using all available resources for developing production instead of allotting the resources for advertising or marketing. 2.3 Mixed Economy A mixed economy combines elements of both the planned and the market economies in one cohesive system. This means that certain features from both market and planned economic systems are taken to form this type of economy. This system prevails in many countries where neither the government nor the business entities control the economic activities of that country - both sectors play an important role in the economic decision-making of the country. In a mixed economy there is flexibility in some areas and government control in others. Mixed economies include both capitalist and socialist economic policies and often arise in societies that seek to balance a wide range of political and economic views. SUPPLY AND DEMAND Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity. Supply is the amount of product that a producer is willing and able to sell at a specified price, while demand is the amount of product that a buyer is willing and able to buy at a specified price. Thus, the supply and demand model shows the relationships between a product’s accessibility and the interest shown in it. Unlike with general equilibrium models, however, this model does not define the attributes that are responsible for supply schedules Supply Supply is The quatity of a good sellers wish to sell at each convervable price. Supply is not a particular quantity but a complet description of the quatity that sellers wouls like to sell at each and every possible price. Law of Supply As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes: Input prices - As the prices of inputs such as labour, raw materials, and capital increase, production tends to be less profitable, and less will be produced. This leads to a decrease in supply. Technology - Technology relates to methods of transforming inputs into outputs. Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply. Expectations - If firms expect prices to rise in the future, may try to product less now and more later. Supply Curves and Schedules The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift. Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves, such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply. When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems. Demand Demand is the quantity of a good buyers wish to purchase at each conceivable price. Thus demand is not a particular quantity, such as six bars of chocolates, but rather a full description of the quantity of chocolate the buyer would purchase at each and every price which might be charged. Law of Demand The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include: Income - Generally, as income increases, we are able to buy more of most goods. When demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good. Price of related products - Related goods come in two types, the first of which are "substitutes". Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar. Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run. Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption. Law of Supply and Demand In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and demand, since actions of buyers and sellers tend to match prices back toward their equilibrium levels. While the economy is becoming more global, some factions in developing countries are against the merging of markets. This has lead to violence in some parts of the world. Ambassadors and other officials traveling to foreign nations are normally supplied with body armor and a convoy for protection against hostile groups. 2.3 Disting wish “want” and “need” A need is something you have to have, something you can't do without. A good example is food. If you don't eat, you won't survive for long. Many people have gone days without eating, but they eventually ate a lot of food. You might not need a whole lot of food, but you do need to eat. A want is something you would like to have. It is not absolutely necessary, but it would be a good thing to have. A good example is music. Now, some people might argue that music is a need because they think they can't do without it. But you don't need music to survive. You do need to eat. These are general categories, of course. Some categories have both needs and wants. For instance, food could be a need or a want, depending on the type of food. You need to eat protein, vitamins, and minerals. How you get them is up to you (and your family). You can eat meat, nuts, or soy products to get protein. You can get fruits and vegetables to get vitamins and minerals. You can eat yogurt or cheese to get other vitamins and minerals. You can eat bread to get still more vitamins and minerals. These basic kinds of foods are needs. Ice cream is a want. You don't really need to eat ice cream to survive. You can eat it to get some vitamins and minerals, but other foods like cheese and yogurt give you more of those same vitamins and minerals without giving you the fat that ice cream does. Still, ice cream tastes good to many people. They like to eat it. They want it, but they don't need it. They like it, but they don't have to have it to survive. INGLATION 3.1 Definition In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. 3.2 Types of InflationThere are four main types of inflation. The various types of inflation are briefed below. Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the supply of the same. When the supply is less, the prices of these goods and services would rise, leading to a situation called as demand-pull inflation. This type of inflation affects the market economy adversely during the wartime. Cost-push Inflation: As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished goods and services. For instance, a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in prices for the related end product. This type of inflation may or may not occur in conjunction with demand-pull inflation.  Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins. A point noteworthy is pricing power inflation does not occur at the time of financial crises and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of pricing their goods and services.  Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even though it had originated in one basic sector. If this situation occurs when there is a recession in the economy, there would be layoffs and it would adversely affect the work force and the economy in turn.Other Types of Inflation Fiscal Inflation occurs when there is excess government spending. This occurs when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the presidentship of George W. Bush due to excess spending in the defense sector.  Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a country’s monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322 percent per month with October being the month of highest inflation. 3.3 Consequences of inflation The impact of inflation on individuals and businesses depends in part on whether inflation is anticipated or unanticipated: Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members. Households may also be able to switch savings into deposit accounts offering a higher nominal rate of interest or into other financial assets such as housing or equities where capital gains over a period of time might outstrip general price inflation. In this way, people can help to protect the real value of their financial wealth. Companies can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, most of the major airlines buy their aviation fuel several months in advance in the forward market, partly as a protection against fluctuations in world oil prices. Unanticipated inflation: When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another. Money Illusion: It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses The Main Costs of Inflation What are the main costs of inflation? Why is the control of inflation given such a high priority in macroeconomic policy-making? Supporters of tough inflation control would support the arguments made in this quote in a speech delivered in 2002 from Mervyn King. The case for maintaining price stability‘It is clear that very high inflation – in extreme cases hyperinflation – can lead to a breakdown of the economy. There is now a considerable body of evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’ Source: Mervyn King, Governor of the Bank of England In explaining and assessing the costs of inflation, we must be careful to distinguish between different degrees of inflation, since low and stable inflation is perceived to have less of a damaging effect than hyper-inflation where prices are out of control. Another important part of your evaluation is to be aware that inflation will have differing effects both on individuals and also the performance of the economy as a whole. Impact of Inflation on Savers: Inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%. Inflation Expectations and Wage Demands Inflation can get out of control because price increases lead to higher wage demands as people try to maintain their real living standards.  Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a ‘wage-price spiral’. Rising inflation leads to a build-up of inflation expectations that can worsen the trade-off between unemployment and inflation. Arbitrary Re-Distributions of Income Inflation tends to hurt those employees in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers. Business Planning and Investment More generally, inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economy’s long run growth potential Competitiveness and Unemployment Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. The UK government believes that monetary stability (i.e. low inflation) is a precondition for sustained economic expansion.  As the chart below demonstrates, the UK has made progress in reducing the volatility of its inflation rate in the last decade. The era of high and volatile inflation may have come to an end.