In macroeconomics, there are three distinct yet important questions:
To start, we need a little micro economic background. We start first with the idea of scarcity. Resources in an economy can be used to produce goods and bads. Goods are things people are willing to trade for like cars and dental services. Bads are things that people do no want such as litter or smog. Bads will become important again in another essay. For now it is enough to know they exist. Resources do not have to be just materials like copper, water, or bananas. Resources can be things like available labor, or aggregate ambition. There are not an infinite number of resources to be had in any economy. Therefore, competition will arise for use of the scarce resources that are available. However, not all resources are made equal, some are worth more than others, so some rationing device is normally used for distribution of said resources.
Resources are also not perfectly adaptable. This means that shifting from production of apples to oranges will not yield exactly one less apple and one more orange. There are diminishing returns for resource reallocation. These diminishing returns bring us to the idea of a Production Possibilities Frontier model in a simple two good economy.
Imagine an economy where the two goods produced are televisions and food. A general case for a Production Possibilities Frontier (PPF) would look something like a quarter circle drawn onto a graph with the x axis labeled as the output of televisions for the economy and the y axis labeled as the output for food (example). The quarter circle curve represents the maximum output of all resources in the economy. Any level of production that lies on or inside the curve is possible and any point outside the curve is not possible to produce at because such a level of production would require more resources than are currently available.
If we take a look at the example, points A, B, and C are possible and point D is not. Point A is an inefficient level of production because not all resources are being utilized. Point A represents inefficiency in microeconomics and unemployment in macroeconomics. Points B and C are efficient because all available resources in the economy are being used. To an economist, point C is not necessarily better than point B or vice versa. Economists draw the distinction between points B and C in terms of advantages and opportunity costs. The advantage of producing at point B rather than point C is the extra amount of televisions produced (calculated by TVB - TVC). The opportunity cost of producing at point B instead of point C is the amount of food that is forgone (calculated as Food C – Food B). The advantage of producing at point C rather than point B is the extra amount of food produced (calculated by Food C – Food B). The opportunity cost of producing at point C instead of point B is the amount of televisions that are forgone (calculated as TVB – TVC). Also from the example we can see that it becomes more and more expensive in terms of food when trying to increase production of televisions and vice versa. This phenomenon is due to resources being specialized and not perfectly adaptable. For example, it is more difficult to make televisions with the foregone fertilizer from less food production than it is from a shift in the labor force.
The only way to produce at point D is to have economic growth that provides more resources. This growth can take the form of having more children to increase the labor pool, acquiring more land to grow more food, or acquiring more mineral mines to increase the quantity of inputs of production for televisions.
From the idea of scarcity, we move on to the idea of microeconomic supply and demand. In this model there are a large enough number of producers and consumers of a given good that no one entity has the ability to affect price in any meaningful manner. The model only represents the supply and/or demand for a particular good or type of goods in a specific time period. First, we will consider demand. In almost every case, as the price of good increases, the quantity demanded decreases. It happens often enough that economists call it the law of demand. This phenomenon can be explained through what is known as the substitution effect. The substitution effect is the idea that people substitute relatively lower priced goods for relatively higher priced goods. An example of this would be the cereal market. If the price for name brand cereals rises, people will look for lower priced substitutes of those cereals. We expect that at least some people will be able to find an acceptable substitute. Therefore, we expect the quantity of name brand cereals purchased to decrease when the price for those cereals rises. From this we can gather that a simple demand curve would look something like a downward sloping line. As price increases, quantity demanded decreases as in this example.
(Those of you who are math oriented, may notice that for some reason economists placed the independent variable on the vertical axis and the dependant variable on the horizontal axis. I have no idea why economists do this, but it does not change the slope, direction of the curves, or how they interact with each other, so I will stick with convention)
It is important to note that a change in the price of a good changes only changes the quantity demanded. To be put another way, the price of a good affects the quantity demanded for that good but does not change the number of people willing to buy at that price.
Conversely, as the price of a good increases, the quantity supplied also increases. Higher prices are an incentive to suppliers to produce more of a good. This incentive takes the form of higher profits.
Realistically, supply and demand curves would not be straight lines but would be varied and nuanced. At prices that approached certain psychological barriers (under $10, under $1 per unit, etc.), there may be little movement in the quantity demanded until that threshold is crossed and then a sudden change in the quantity demanded occurs. Supply may have a similar shape but has its psychological barriers at different points that represent certain profit percentages (10% margin, 25% margin, etc.). However, the exact shape of the curves does not change their overall behavior or how they interact with each other, just where the exact equilibrium price and quantity are. So for our general understanding purposes, simple sloped lines will suffice.
If the quantity of a good supplied in a market is greater than the quantity demanded, then a surplus or excess supply exists. If the quantity demanded is greater than the quantity supplied, then a shortage or excess demand exists.
In the case of a surplus, the additional supply is a signal for the price to drop in order to increase the number of trades or sales. In reality, this would look like hundreds of basketballs sitting on retail shelves selling for $150. Since the basketballs are not selling at this price point and the available stock is very large, there is an indication that the price should be lowered in order to affect more sales. As the price decreases there will be more basketballs demanded and fewer supplied. This movement along the supply and demand curves continues until the surplus is eliminated.
In the case of a shortage, the pressure on the price is the opposite. The additional demand, or lack of supply, is a signal for the price to increase. People will respond to the shortage by offering to buy or sell at a higher price. Like in the case of the surplus, this produces movement on both the supply and demand curves until the shortage disappears.
Once there is no longer a shortage or a surplus, we say that the market has reached equilibrium. Equilibrium occurs when the quantity supplied equals the quantity demanded. There is only one equilibrium for a given time period. Since there is neither a surplus nor a shortage, there are no signals for the price to change in either direction.
Equilibriums exist for a particular time period and do not last indefinitely. This happens because market forces move the equilibrium point. In the case of demand, there are six major factors that can shift the demand curve: income, preferences, prices of substitutes, prices of complements, number of buyers, and price expectations. These factors create a different quantity demanded for every price point. So instead of moving along the demand curve, the entire curve shifts. If the income of buyers increases, buyers are more willing to buy the good at higher prices. Alternatively, if the income of buyers decreases, all buyers are less willing to buy at the current price and demand for market decreases. Prices of substitutes affect the demand curve in a similar manner. Substitutes are goods that can be substituted for one another without a large loss in quality. Many people will use Coca-Cola and Pepsi as an example of substitute goods; earlier we considered name brand cereal and off brand cereal. Still, a better example would be two equal but separate brands of strawberry jelly. If the price of one of Brand A increases for some reason, there will be an increase in the demand for Brand B as people shift towards using the cheaper substitute. Complementary goods are those that are consumed together. Examples of this include tennis rackets and tennis balls, bread and peanut butter, and milk and cereal. If there is a rise in the price of good then demand for the complement decreases and vice versa. For instance, in increase (decrease) in the price of tennis rackets will cause a decrease (increase) in the demand for tennis balls. The number of buyers affects the entire demand curve by adding more or removing people willing to buy a good at every price point. Finally, expectations of future prices for a good shift the demand curve for a it by compelling people to by the good sooner if the expectation is that prices will be higher and compelling people to buy the good later if the expectation is that prices will be lower.
For supply, there are seven major factors that can cause a shift in supply: prices of relevant resources, technology, number of sellers, sellers price expectations, taxes, subsidies, and government restrictions. These factors create a different quantity of a good that sellers are willing and able to supply at every price point.