Problem Solving in Economics

The following sections are included:

• Dedication
• Preface
• About the Author
• Contents

The conventional economic model of the consumer postulates a self-seeking individual who does the best she can, subject to affordability. When faced with a choice of how much of each good to buy, the consumer chooses the “best” bundle of goods that is affordable. We start by focusing on a precise meaning of affordability leaving a description of what is meant by the “best” till later.

In this chapter, we use the concepts developed in Chapter 1 to analyse the consumer’s optimum choice bundle. Specifically, we will address the question of how the consumer’s optimum bundle is characterised and whether the characterisation depends on the nature of preferences (utility function). We illustrate different possibilities in the examples. We also create examples to illustrate how the optimum changes as prices or money income change.

In the analysis of consumer choice, we focused a lot on the tangency solution. Our analysis was restricted to the two good cases, and the “derivation” of the tangency condition was essentially geometric intuition. Furthermore, in all the examples so far, the constraint was essentially linear. Before looking at further applications and extensions, it would be helpful to sketch a general solution method which works with more than two variables and also can encompass nonlinear constraints. The treatment of this important problem is heuristic rather than rigorous. We focus on how to use the method…

In this chapter, we begin our analysis of the behaviour of another major player: the business firm.

In Chapter 3, we saw how to derive an individual’s demand curve for a commodity starting from their preferences, their income and the market price. Holding all else constant, the demand curve for a price-taking utility maximising individual shows the quantity demanded by the individual at every conceivable market price. The inverse demand curve expresses the same relationship with price as the dependent variable and quantity as the independent variable. Similarly, in Chapter 4, we saw how to derive an individual firm’s supply curve for a commodity starting from their technology, factor prices and the market price of the commodity. Holding all else constant, the supply curve for a price-taking firm relates the quantity supplied by the profit-maximising firm at every conceivable market price. The inverse supply curve expresses the same relationship with price as the dependent variable and quantity as the independent variable. In this chapter, we use these ideas to discuss the configurations that arise when we consider many price-taking consumers and many price-taking firms to arrive at market demand and supply. We will study the market equilibrium and how it changes in both the short and the long run.

In the previous chapter, we analysed equilibrium price–quantity configurations in a competitive market. The essence of such a market is that each agent — firm and consumer — takes market price as given and reacts to it by choosing a quantity to sell or buy. In effect, this means no agent has any market power to influence the price. In this chapter, we look at situations where at least one agent has market power and can directly influence the price. We will focus on firms as the agents possessing market power. Examples of consumer market power (through consumer associations, etc.) are rare. There are many different ways in which economists have conceived the market power of firms. We shall look at the most common forms in this chapter.

In the previous chapters, we assumed that decision-making never involved commodities beyond a single period, i.e., today. However, there are very important decisions which by their nature are spread over time. Examples include how to balance present with future consumption. One strategy is to save (consume less than current income) today and invest the savings to generate income for future consumption. We start by assuming that the decisions to save and invest are carried out by the same agent. We further imagine that there are only two periods of time which we call the “current” or “today” (period 0) and the “future” or “tomorrow” (period 1). In reality, the future consists of many periods but nothing conceptually important is lost by the simplicity of the two-period model. We assume there is only one good called corn which can be consumed today or tomorrow.

In all economies, there are many economic agents taking decisions simultaneously. Consumers are deciding what to buy, how much to save, etc. Firms are deciding what and how much to produce and sell, how much to invest, how many workers and machines to hire, etc. In this chapter, we study the issue of how such myriad decision-making is coordinated. Do we get order or chaos? We will analyse the role played by markets and a planner in coordination…

Macroeconomics is concerned with the analysis of aggregate variables which affect human well-being. In particular, we will focus on the determinants of the level and growth of national income, the price index and inflation, employment and unemployment, and the balance of our economic relationships with other countries. The role of government in policymaking intended to improve macroeconomic outcomes is a central part of the analysis. In all economies, there are many economic agents taking decisions simultaneously. Consumers/workers are deciding what to buy, how much to save, how much to work, etc. Firms (including banks) are deciding what and how much to produce and sell, how much to invest, how many workers and machines to hire, etc. Government seeks to influence these decisions by changing the environment in which the private sector (consumers/workers and firms) operates.

When macroeconomists seek to analyse the economy, they construct a little miniature of the economy which embodies the key features of interest. Such an artificial construction is called a model. Typically, a model will consist of a set of equations that link the variables of interest. These equations are usually of two types. The first type is what is called an equilibrium condition. The concept of equilibrium is fundamental to a study of economics. An equilibrium is a situation in which there is no force for change — a situation which can be sustained. For example, in macroeconomics, a situation where planned expenditure equals national income is often described as an equilibrium. In later chapters, we will show how this can be justified. For now, we simply assume that planned expenditure equals national income represents a macroeconomic equilibrium. Denoting national income by Y, consumption by C and investment by I, then in a simple closed economy with no foreign trade, planned expenditure Z is simply the sum of consumption and investment. The equilibrium condition in this particularly simple economy is thus Z = C + I = Y or

This model of the labour market has enjoyed popularity for a considerable length of time. It is based on the idea of perfect competition which implies that all agents in the market are price takers. The price-taking assumption means that agents take the price as given and simply choose optimising quantities in the belief that any action they take cannot influence the price. At its simplest, the agents are of two opposite types. First, there are firms which use labour (together with other inputs) to produce output which is sold in the search for profits. This is the source of the demand for labour. On the other side are workers. They supply labour in return for remuneration which finances their consumption. Given relevant prices, firms only have to choose how much labour to hire while workers have to decide whether to work or not.

In the previous chapter, we showed how real wage flexibility determines both the level of employment and output. In this chapter, we extend the analysis to the other main macroeconomic variables, namely interest rates and the price level. The role of the money supply is emphasised particularly in the determination of the price level. We assume a closed economy in which there is no foreign trade. And in the spirit of the classical theory, we assume all relevant prices are fully flexible.

In the previous two chapters, we analysed the macroeconomy from the classical perspective which is based on the presumption of fully flexible real prices. In particular, we showed how real wage flexibility determines both the level of employment and output in the labour market. In this chapter, we explore another view — one associated with John Maynard Keynes and referred to as Keynesian macroeconomics. The essence of this view is that real and nominal prices are sticky, even rigid and do not adjust at least in the short run. Hence, output is not predetermined by the prior determination of employment in the labour market. On the contrary, it is output that determines employment.

In the previous chapter, we analysed the role of Fiscal Policy — government spending and tax — on the macroeconomy from the Keynesian perspective which is based on the presumption of fixed price level in the short run. We saw that changes in government spending and taxation or both can influence output and hence employment. The size of the impact — the multipliers — was dependent on how government spending was financed. In this chapter, we extend the ideas of the previous chapter to focus on monetary policy. Initially, we take monetary policy to mean a change in money supply M^s brought about by the Central Bank (CB). The CB does this by buying government bonds from or selling government bonds to the public. CB sale of bonds reduces money supply while CB purchase of bonds increases money supply. If the price level P is fixed, then every change in nominal money supply M^s produces a similar change in the real money supply M^r because M^r = M^s/P.

Up to now, the fact that most countries trade with each other has been ignored. In this chapter, we consider how international factors influence the macroeconomy and may constrain macroeconomic policy options. We consider the case of a small open economy, like the UK. The small open economy cannot influence the world economy but is influenced by events and policies in the world economy. For ease of exposition, we consider the macroeconomics of a domestic small open economy (the UK prototype) trading with the large “rest of the world economy” which we call ROW. The currency of the domestic economy is pounds (£) and that of ROW is dollars ($). They are linked by the concept of the exchange rate.

In our analysis of macroeconomics so far, we have distinguished between the short run and the long run. The short run is conceived as a period of time in which prices are fixed and cannot change. By contrast, the long run has been conceived of as a period of time in which prices can fully adjust. However, both in the short-run as well as in the long-run analyses, we have maintained the implicit assumption that the productive capacity of the economy is unchanged. The capital stock is assumed to be constant. Investment adds to aggregate demand but its impact on capital accumulation and hence capacity has been ignored. In this chapter, we analyse the role of capital accumulation in moving the economy forward. Investment is the source of additions to the capital stock or capital accumulation. This in turn leads to greater output which in turn leads to greater savings. If these savings are partly or wholly converted into investment, the process continues driving output upwards. This may be thought of as the economics of the very long run.

The following section is included:

• Index