1. The Market System and the Circular Flow of Income.
2. Microeconomic Basics - how markets work through Supply and Demand
3. Microeconomics of Trade - how different markets for the same goods interact.
4. Microeconomics of Quality - an elaboration of Demand
5. Microeconomics of Production - an elaboration of Supply
6. The logic of General Equilibrium: in search of harmony.
7. Macroeconomic Basics - the Circular Flow of Income (CFoI), with Government and Fiscal Policy
8. Money, Interest and Discounting

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1.    The Market System and the Circular Flow of Income.

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The general picture of interacting markets - the circular flow of income:

• Households own the factors of production (land - including raw materials, labour, management and physical capital).
• Note - capital here means physical capital - plant, equipment, buildings and machinery etc. (c.f. financial and money markets below)
• Households rent these factors to firms, in return for income:  land rents; capital interest and dividend payments, and equity appreciation (capital gains); wages and salaries.
• Factor ownership provides income which fuels consumption and demand in the goods and services markets
• Firms rent the factors of production from households according to their demands for these factors, which is derived from the demands for the final goods and services
• Factor markets operate so as to encourage the owners of land, labour, manaement and capital to rent out the services of the factors to the highest bidder
• Firms add value to their own purchases of inputs and raw materials. They earn gross margins (total revenues minus cash input costs [fuel, power, packaging etc.] which is the value added to these inputs.  The Gross margin, or added value, or gross product (each term means essentially the same thing for our purposes) is the income available to the fixed factors - land, labour, management and capital.
• In equilibrium, these returns will be normal profits - each firm earning sufficient to cover the opportunity costs of the factors of production which they employ.

[Note:  profits in the everyday sense are, typically, just the returns to capital - the earnings of the firms which are left after all other legitimate costs (including labour and management costs) have been deducted.  For self-employed family businesses, taxable profits will include the returns to the owners own labour and management, as well as returns to the owners land and capital, less allowable expenses in servicing mortgages, loans and debts.]

The UK food chain illustrates the outcome of this circular flow of income.
Agricultural and Food Chain, UK, 2000
Farms produce £15.3 bn. of output, of which £8.7bn. is spent on purchased inputs, leaving £6.6bn. as the gross product (gross margin) or returns to the factors of production (land, labour, management and capital).

• The farm sector generates incomes to all those with a direct interest in farming - the labour, owners of the capital (including the banks and their shareholders), the owners of the land, and the managers and farmers themselves.
• Likewise, the input supply industries also process their own inputs, using their own factors of production, producing their outputs (purchased by the farm sector) and generating their own incomes to land (including natural resources), labour, management and capital.
• Farm Output, in turn, is further processed by the Processing, Distribution and Retailing (PDR) sectors to generate both incomes to their own factors, and also the final output purchased by the final consumers.
• Thus, the final consumption figure (£123 bn.) represents the cumulative total of all values added throughout the food chain, and hence represents the total cumulative income earned by all those engaged in this food chain.
• Note that imports generate incomes in other countries rather than the UK, while exports generate incomes in the UK.

 

 

Measurement Issues:

• Each of these flows (measured in £ bn.) represents a large collection of individual trades (prices times quantities): P x Q
• Flows change through time because both prices and quantities change: P1 x Q1 different from P2 x Q2
• Comparison between different years (periods) compares both price and quantity changes
• Prices represent that rates at which quantities of one good or service are exchanged for other goods and services - including the services of factors of production (land, labour, management and capital), whose prices are rents, wages and salaries, and rates of return to capital.
• With prices set at some given, fixed level:  quantities then represent real income and real output of goods and services - the actual quantities of factor services which can be traded for the purchase of actual quantities of goods and services - the purchasing power of each good or service in terms of all other goods and services.
• To measure these real quantities,  prices (wages, rents etc. as well as prices of goods and services) have to be fixed at some given level. - Pf. - constant prices
• Comparison of Pf x Q1 with Pf x Q2 then shows the changes in quantities between Q1 and Q2.
• Also, comparison between Pf x Q1 and P1 x Q1 shows the difference in prices between the fixed, constant, prices and those ruling in period 1.
• Notice - simply fixing the price of ONE good (say for fertiliser), allows the actual physical quantities of fertiliser used by farms between years to be measured, but does NOT allow the measurement of the purchasing power of this fertiliser - to measure the purchasing power, we need to fix all prices at some constant level.

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2.    MICROECONOMICS - THE BASICS:   HOW MARKETS WORK

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• Markets:  processes through which demands for things (goods, products, commodities, services) are matched with supplies of those things:  the economic world consists of firms (businesses) who supply or produce and consumers (households) who demand and buy goods and services.
• Demand:  the desire to possess or use something backed up with purchasing power
• expressed or exhibited by people as households or consumers in two major dimensions:
• as a willingness to pay for something - how much will you pay for this thing?  What Price is it worth paying for it?  This is the Demand Price
• as a quantity which they are willing to buy at this price, whatever it is - the Quantity Demanded.
[NOTE quality is also important in practice - for the present ignored for simplicity]
• purchasing power:  =
• income: annual (or time dependent) flow
• wealth  (= stored income; a stock of income)
• or borrowings (credit), which as debts to lenders, requires servicing (repayments, including interest payments - see below)
• Final Demand is expressed or exhibited by households - the final consumers. In addition to purchasing power (income, wealth and thus credit worthiness), final demand will depend on,
• Tastes and Preferences of consumers (predispostions, attitudes, perceptions, personalities etc.)
• family conditions, social circumstances, occupational characters etc.
• demonstration effects (seeing other people using them) and habits
• and very likely a host of other things, too, dealt with by Marketing Courses.
• and on the cost of this good relative to the prices of other goods and services - the opportunities forgone by buying this good rather than another (possibly similar, or of a different quality)
• Intermediate Demand is expressed by firms and businesses for the inputs they require for their production processes, and is derived from the demand expressed for their final products - so is also called Derived Demand, depending on
• the conditions of final demand for the product
• the conditions facing the producer - the supply conditions.
• Supply:  the willingness to produce, market and sell something
• expressed or exhibited by people as firms or businesses
• as a willingness to provide something - how much money do you need to be willing to provide this thing?  What price will you accept in return for providing it?  This is the Supply Price.
• And as the quantity they willing to supply at this price - the Quantity Supplied
• These will depend on, especially:
• the costs of providing the thing (the costs of the inputs needed)
• what else the person or business might do instead of providing this thing - the opportunity cost as the value of the best alternative which is given up in order to provide this thing
• Market Supplies and Market Demands are the aggregates (sums of) individual firms supply and individuals (housholds) demand.  But:  people (as consumers or households) have different Demand Prices and are willing to pay for different quantities.  Likewise, people (as firms or businesses) have different supply prices and willing to provide different quantities.  And each of these decisions depends on a host of other things - really complicated!
• SO, SIMPLIFY:  hold all these other conditions and circumstances (things) constant - consider them as being fixed at some particular level or value - ceteris paribus - all other things considered equal (unchanging or invariable) -> the MARKET DIAGRAM.

• As price is reduced, more (whatever it is) will be demanded - more people will be willing to buy more of the thing at lower prices than at higher prices (it is cheaper and it will be used or abused and wasted more as a result).
• the Demand Curve slopes downwards, and shows the relationship between the price people are willing to pay and the quantity they are willing to buy, all other things which might affect this decision being held constant.
• As price is increased, more will be supplied - more people (firms) will be willing to provide more at higher prices than at lower prices:
• the Supply Curve slopes upwards and shows the relationship between the price suppliers are willing to accept and the quantity they are willing to supply, all other things which might affect this decision being held constant.

• The Market will Balance - be in equilibrium - when the quantity demanded is equal to the quantity supplied (Qe = quantity supplied = quantity demanded)
• at any quantity less than Qe (closer to the origin), the demand price (shown by the demand curve) is higher than the supply price (shown by the supply curve) - so suppliers would make money and more of them would be willing to provide more, while consumers would be willing to buy more if they could (at a lower price).
• at any quantity greater than Qe (further away from the origin), the demand price is less than the supply price - so suppliers would find that they could not sell what they had produced - stocks of unsold goods would pile up - and would be obliged to cut back on production.
• At this Market Equilibrium (Qe) the Supply Price equals the Demand Price (both at Pe)
• at any price higher than Pe, the quantity supplied is greater than the quantity demanded - there is excess supply - unsold supplies building up as stocks or inventories - so price will tend to fall back towards Pe
• at any price lower than Pe, quantity demanded is greater than quantity supplied - there is excess demand - queues of willing buyers at this price - so price will tend to rise towards Pe.
• At Market Equilibrium: Pe x Qe = total expenditure by consumers = total revenues to producers.

• You should now check your understanding of this concept by thinking of which way (to the right or to the left) each curve (Demand and Supply) will shift as the other things change.

• Extent of the Price and Quantity changes when Demand or Supply Curves SHIFT depend on how steep or flat the other curve is - try it for yourself!
• But, how steep or flat each curve is depends on the units we use to measure price and quantity.
• So, we measure the ELASTICITY of supply and demand curves - how responsive each curve is to changes in price (or SHIFTS in the other curve):
• Elasticity of demand (or supply)

= % change in Quantity Demanded (or Supplied) per % change in Price (which removes the problem of what units we use to measure either price or quantity)

• equals minus infinity at the vertical axis (top left hand end), where P is a postive number, and Q is zero)
• equals minus zero at the horizontal axis (bottom right hand end), where P is zero.
• equals minus 1 half way down the curve (where P/Q = change in P/change in Q, so (change in Q/change in P) times P/Q = -1).

The Elasticity of the straight line supply curve passing through the origin (Qs = 0 if Price = 0) is ALWAYS +1, regardless of the slope of the supply curve:  P/Q = change in P/change in Q, so (change in Q/change in P) times P/Q = +1, since supply curves slope upwards.)

[Notice: although these notes use linear (straight line) supply and demand curves - this is only an analytic convenience - in practice we seldom know exactly what any particular demand or supply curve looks like, so we approximate them with their linear equivalents at the observed quantities supplied and demanded and the prices observed in the market.]

You should now be able to define and explain other elasticities: (how are they defined and what do their sizes and signs mean?)

• Cross price elasticities of demand and supply - the demand response (change in quantity demanded) to a change in the price of another good - which will be positive for substitute goods and negative for complementary goods;  the supply response (change in quantity supplied) to a change in the price of another good.
• Income elasticity of demand - the demand response (change in quantity demanded) to a change in income.
• Note:  The Expenditure Elasticity:  % change in the spending on a good (or service) per % change in income - this may not be the same as the Income elasticity (which measures the response of quantities purchased to income changes), because as people get richer, they may well prefer to buy better quality (or be prepared to pay premium prices for less trouble and effort in buying or using the good or service).  The difference between the Expenditure and Income elasticities thus measures the extent to which higher incomes lead to an increase in the demand for quality (as approximated by the unit price paid tfor the good or service)
  

3.    Microeconomics of Trade - how different markets for the same goods interact.

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• Imports reduce the price of the good in the importing country (or region or locality) and increase the quantity which is purchased.
• Exports raise the price in the exporting region or location and reduce the quantity consumed (purchased)

Trade will be in equilibrium when it no longer pays to buy cheap and sell dear - in the limit, when the prices in the two markets are the SAME (apart from transport and marketing costs between the two locations).  The process of trade can be represented through:

• Excess Demand (XD):  equivalent to the Demand for Imports - the difference between the quantity demanded and the quantity supplied in the local market at each and every price - which equals zero at the local equilibrium price (Pe in the diagram above), and increases as price is reduced below Pe - so is Downward sloping.
• Excess Supply (XS): equivalent to the Supply of Exports - the difference between the quantity supplied and the quantity demanded in the local market at each and every price - which is zero at the local equilibrium price (Pu above), and increases as price is increased above this level - so is Upward sloping.

• In practice, there are costs of moving goods between different markets (especially over international borders), so prices of the same goods are not the same in different markets - they will generally be higher in importing markets and lower in exporting markets.
• The Importing price is often referred to in the statistics and trade press as the "cif" price - meaning that the cost of the good, insurance and freight charges are all included in the price.
• The Exporting price is often referred to as the "fob" price - meaning the price of the good free on board the exporting ship, having been paid for, but not yet moved.
• The difference between these two prices therefore reflects the costs of moving the good (more generally, moving and marketing it)
• Although this illustration is in terms of international markets, EXACTLY THE SAME PRINCIPLES APPLY to separated regional or local markets.

4.    Microeconomics of Quality - an elaboration of Demand

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• Differentiated Goods - different qualities of beer and drinking environments (students union versus a city (or other) pub of club) are characterised by different demands and supplies - their "qualities" are different.
• So, the Markets for Differentiated Goods are segmented - they are somewhat different markets, each selling beers (and other things) - beer is a differentiated product, and beer markets are segmented - customers and suppliers have different tastes and requirements.
• Such markets can be represented as follows:  Du and Su for the Students Union Beer, Dt and St for the city (town) beer.  The Right Hand Side diagram is simply the SUM of the two different segments in terms of number of pints (the quantity axis).

• ST is the horizontal sum of St (town supply) and Su (Union supply).  At each and every price, the total quantity supplied in Newcastle is equal to the quantity supplied in the Union plus the quantity supplied in the town at that price.  At price Pa, QT, the total quantity supplied is equal to the supply in the Union market (Us) at this price (Pa) plus the supply in the town market (Ts) at this price (Pa).  The same logic is used to construct every other point on the ST curve.
• DT is the horizontal sum of Dt, the town demand and Du, the Union demand - so total demand (QT) at price Pa is equal to the demand in the Union market (Ud) at price Pa plus the demand in the Town market (Td) at this price Pa.  The same logic is used to construct every other point on the DT curve.
• Pa (the average price of beer in Newcastle) is a fictitious price.  Neither of our "real" markets shows this price Pa.  The Union segment has settled down at price Pu, and the town at price Pt.
• The average market price (Pa) = the total revenues from the sale of beer  (equal to the total expenditure on beer in Newcastle (Pu*Qu + Pt*Qt) divided by the total quantity of beer sold (Qu + Qt = QT).  The average price (sometimes called the "unit value") is a weighted average price - the weights being the quantities sold at each price making up the average price.
• Consumer spending on beer equal the Revenues for the publicans (Suppliers).
• Analysis of the Newcastle (or UK) beer market can frequently be done using the RHS diagram WITHOUT WORRYING ABOUT THE DETAILS of the segmentation.  Changing incomes, tastes and preferences for beer, population sizes etc. will tend to affect all market segments, almost regardless of quality.
• On the other hand, sometimes consideration of the specific Segmentation is necessary, in which case, it is IMPORTANT to remember that shifts in demand specific to one segment will imply  offsetting shifts in the other segments.  If tastes and preferences for one segment increase, then they are very likely to imply an offsetting fall in other segments.
• Importance of Quality in a market can be indicated by the relationship between the income elasticity and the expenditure elasticity for a product:
• Income elasticity (Ey) = % change in Quantity demanded per % change in Income
• Expenditure elasticity (Ee) = % change in Expenditure on product per % change in Income

The assumption is that better (higher) quality products (ceteris paribus) cost more per unit than lower quality products.  As incomes increase, we expect people to shift towards better quality products, if they are available.  If so, then Ee will be greater than Ey.  (More spent, but not on so much of an increae in quantity).
• Quality Elasticity (with respect to Income) = Ee - Ey.  If positive and larger than zero, quality matters.

5.    Microeconomics of Production - an elaboration of Supply

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• Fixed Costs - sometimes considered to be equivalent to the costs of the factors of production:  land, labour, management and capital plant and equipment etc. - the resources needed to be in production at all.
• Variable Costs - sometimes considered to be equivalent to the costs of the purchased inputs (fuel, raw materials, packaging materials etc.)
• However, the distinction between fixed and variable costs depends critically on the particular and specifc conditions and circumstances of the firm in question.  The precise details of these specific (and highly differentiated) conditions do not need to concern us here.  The general principles still apply, whatever the precise fixed or variable classification of particular costs.  The specific classification of costs is not fundamentally important.

• Average Total Costs (total costs ÷ quantity produced) is shown by the slope of a line from the origin to the total cost curve.  ATC is therefore "U" shaped, with a minimum where the origin line is tangential to the total cost curve.
• Average Variable Cost (AVC) is defined in exactly the same way (as total variable costs ÷ quantity produced), and exhibits the same "U" shape.
• Marginal cost (the cost of an extra or additional unit of output) is the slope of the total cost curve itself
• MC is at a minimum where the total cost curve is flattest, where its slope is least.
• For the quantity at which average cost is at a minimum, average cost is equal to marginal cost.  The marginal cost curve cuts the average cost curve from below, at the average cost curve's minimum point.  This has to be true by definition.  Average cost at its minimum is the slope of the tangent from the origin to the total cost cost curve.  The tangent to the total cost curve has the same slope at that point as the slope of the total cost curve, which is the marginal cost at that point.
• These diagrams assume that the manager(s) of the firm are as efficient as they can be in making and implimenting the decisions to change output levels.  They are effective in keeping costs as low as possible consistent with health, safety and product integrity.  In short, they assume effective business managment and operation.

Maximising Profits - stylised illustration of the firms cost curves:

To maximise profits ( = total revenues minus total costs): produce at that output level at which marginal cost equals marginal revenue. So long as the MC curve is rising, this will mean that all previous units of output cost less to produce than they earn in revenue, and any greater level of output will cost more to produce than it earns in revenue.
In a competitive industry (many other competing firms) the price is set by the market  - firms in a competitive market are Price Takers: there is no sense in charging less than the other firms, because this firm cannot produce enough to satisfy the whole market, and if it trys to charge more, it loses sales to other competing firms.
In this competitive case, Price = Marginal Revenue (MR) (the addition to total revenue consequent on the sale of one extra unit).  Hence, profit maximisation involves producing at the quantity for which MC = MR = Price.  If the market price is P, then the profit maximising output level is Q*, at which point MC = MR.
At this point, Average cost = C*, so that total cost = C* x Q*, while total revenues = P x Q*.  So, Profit = total revenues minus total costs = (P - C*)x Q* = the shaded area.
This profit is Pure (Economic) Profit - since the total costs include all opportunity costs, the excess of revenues over total costs is pure or economic profit over and above the returns necessary to cover all costs.  NOTICE - this Price = MC rule is the logical outcome of a firm's competitive behaviour, NOT a prescription for the effective management of the firm.

If this firm is making pure profit, then other firms will be attracted into this industry to produce this product.  As they do, so total market supply will increase, and the market price will fall.  When will this competitive market be in equilibrium?

When Price = MC = Min ATC  (at Ce in this diagram) with no pure profits to encourage firms to expand or enter the industry, and enough to cover all costs, including opportunity costs.  Each of the firms make just enough of a return to be willing to stay in the business rather than doing something else.  The return that is just enough is the return which covers all of the costs, cash costs and opportunity costs.  The opportunity costs measure how much each firm could earn if it moved its land, labour, capital and management into some other business or occupation.  So long as each earns at least this return, each will be content to stay in this business indefinitely.  If prices fall below this level, firms will leave the industry as the opportunity arises, and supplies will fall, and prices will start to rise again back to the equilibrium level.

Industry Supply - depends on:

1. each firms individual response to price changes
2. the change in the number of firms in the industry (product producing sector)
3. whether the situation is supposed to be Long or Short Run
• Long Run: all factors of production and all production inputs considered to be Variable - can be changed by the firms in response to changes in their economic environment.
• Short Run: - at least some factors of production and inputs are considered to be fixed at their current levels - cannot be changed in response to changing signals.
Clearly, there will be greater scope for responses in the Long run (when everything can be changed) than in the Short run, when only some things can be changed.

• represented by the firm's marginal cost curve.  For a firm in a competitive industry or sector, profit maximising means producing where price = marginal cost.  Hence, as price changes, so firm output will change according to the MC curve.
• Long Run Marginal Cost curves will generally be flatter - more elastic - than Short Run marginal cost curves.
• For firms in a competitive industry (many competing firms), any one single firm's changes in output, and hence changes in demands for inputs and resources, will NOT significantly affect the costs per unit of each of these inputs and resources.  Hence, marginal cost (and all other cost curves) for the firm assume that the cost per unit of inputs and resources is fixed and given.  Marginal cost curves slope upwards because each extra unit of output requires more physical units of input and resource to produce - not because the prices of these inputs increases.  NOTE - if this is not the case, then the firms were not operating efficiently in the first place - they could have produced more and earned more than they were doing.

• In the Short Run - the industry supply curve can be thought of as the sum of all the individual firms marginal cost curves.
• BUT, there is one important caveat to this notion:
• If all firms increase their outputs up their marginal cost curves, they are all demanding more inputs to produce the extra output.
• This increased demand for inputs (shifting input demand curves to the right) will tend to increase the price (unit cost) of the inputs.
• This increase in the cost of inputs will shift the marginal cost curves upwards.
• Hence, the Short Run Industry Supply Curve (SRS) will tend to be Steeper (more inelastic) than the individual firms marginal cost curves, because their collective demand for inputs will tend to change the prices of these inputs.
• In the Long Run - increased demand for the industry products will tend to increase the price, thus increasing the profits earned by each firm in the industry.  More firms will be attracted into the sector, shifting the SRS to the right, increasing industry output and reducing prices again.
• The outcome is illustrated in the following diagram.  Start at an equilibrium position of Pe, with firms producing qe, all making normal profits (that is, covering all their costs including their opportunity costs) and with the sum total indistry output at Qe.
• Now suppose that demand shifts right to D1.  Initially, each existing firm increases output up its own MC curve, and makes pure profits.  New firms are attracted into the industry, increasing industry output and damping down the initial price increase. Increasing output increases the costs of inputs which shifts cost curves upwards to MC1 and ATC1.  The new long run equilibrium results when firms are once again only making normal profit (price Pe* = ATC1 = MC1), just covering all costs at their new level.
• The Industry long run supply curve (LRS) traces out the increase in output resulting from the shift in demand.
• Key Factors affecting the elasticity of supply
• It will always take time for the full supply response to a demand change to materialise - long run elasticities more elastic than short run. Over and above this general condition:
• Flexibility of production systems and processes - the more flexible, the more elastic supply;
• The more permanent the shift in demand is expected to be, the more likely it is that firms will take long run decisions and that new firms will become established - so the more elastic the supply response will be.
• The more industry or sector specific are the inputs and resources used, and the more limited they are in supply, the greater will be the cost increase associated with industry expansion, and the less elastic will be the industry supply response;  (e.g. - agriculture, with the requirement for land, which is limited in total supply).

• perfect competitors are Price Takers - cannot set or affect the market price on their own;
• imperfect competitors are Price Setters - they can set their own prices, and their sales levels affect the prices they can charge.
• Imperfect competitors face downward sloping demand curves, rather than the perfectly elastic (horizontal) demand curves which facce each FIRM in perfect competition.
• So, for imperfect competition, Price DOES NOT equal Marginal Revenue (MR) - the additional revenue earned by imperfect competitors from the sale of an extra unit of production requires that the price charged for all sales has also to be reduced - the Marginal Revenue curve is therefore steeper (more inelastic) than the demand curve.
• For a linear demand curve, the MR curve will be twice as steep as the demand curve (beginning at the same price on the vertical axis as the demand curve, but intersecting the horizontal (quantity) axis at half the quantity of the demand curve

• Profit Maximising means produce at quantity for which MR = MC.
• Set price for this quantity (Q0) according to consumers willingness to pay (the demand curve price for this quantity - P0
• Cost of producing this quantity (Q0) is AC0 per unit, so profit = (p0 - AC0) x Q0;  the shaded area.
• So, more firms will try and enter this industry
• with the effect that the demand curve and MR curve for this firm will SHIFT to the left as new entrants take market share
• Equilibrium in this Monopolistic Competition sector will occur when there are no pure profits left to attract new entrants
• No Pure Profits when, and only when, the Demand Curve shifts far enough to the left to lie at a TANGENT to the AC curve - then Price is set so as to equal AC.
• At this production (sales) point, MC will also equal MR - profit maximising with no pure profits.

Pure Monopoly:

1. Natural Monopoly:  production and supply conditions such that there is only room for one supplier from the whole market - costs are such that one firm can supply the total market more efficiently (lower costs) than a collection of firms (e.g. gas, electricity, railways etc.)
2. Patent rights over technologies - giving single firm temporary advantage
3. Monopoly Property Rights over necessary raw materials
4. Predatory business practices and artificial barriers to entry of other potential competitors

• Market is not large enough to allow monopolist to exploit cost advantage - railways in early days.
• Market shrinks because of substitutes (e.g. road and air for rail) - note: existence of close substitutes will make demand facing monopolist more elastic - bringing demand and MR curves closer together and reducing scope for pure profits.
• Costs increase (cost curves rise) because:
• suppliers and labour force also have more market power against a single user
• management performance falls through lack of competitive spur to do better

• Control over monoplists costs - how to ensure efficient production and operation?
• Setting socially acceptable prices - how to set prices to users so as to cover legitimate costs but not result in over-supply (costs higher than willingness to pay)?

6.    The logic of General Equilibrium: in search of harmony.

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Se, we are economical.  We concentrate on a very simple economy: one with only two factors of production (land and labour), which is only interested in producing and consuming two goods (food (+fibre); clothes (+ shelter)).  These two goods, which can be thought of composites as indicated, comprise all the necessities of life, and are all this simple economy produces, or, for the present, wants to produce.  It is self contained and self-sufficient as a whole. Our economy is a self-contained collection of producers and consumers - everyone is either one or both.

Notice - we are talking of an economy here - which might be a country, or a region, or a community or locality or village, or whatever. In the limit, such an economy could be as small as a self-sufficient, single and subsistence household.  It doesn't matter how big or small it is.  All that matters - for the moment - is that it is self-contained.  We will come to what can happen when two such economies meet and trade with each other below.  For the present, we just consider the logic of this single and simple economy as separate and self contained entity.

What options does our economy have?

• to produce food (and fibre), or clothes, or (more likely) a mixture of the two.
• to consume (use) food and fibre or clothes, or almost certainly a mixture of the two.

How might we do that?  Answer: look at the production possibilities (the supply side) and the consumption preferences (the demand side) for the two goods (which makes up the totality of our simple economy).

The diagram we will use relates production and consumption of one good (food (and fibre)) to the production and consumption of the other (clothes (and shelter)).  So we measure (illustrate) quantities of each good on the two axes:  quantity of clothes on the vertical axis and food on the horizontal axis - though it could just as easily be the other way round, it doesn't matter.  Get a bit of paper and draw this diagram for yourselves now.  Then read the following and trace the argument (logic) out on your diagram as you follow it through.

The supply side:

Consider the production or supply side first.  What options does our economy have?  To use all available production factors (land and labour) to produce food;  or to use all its factors to produce clothes; or to produce some combination of the two goods. And, because our citizens are sensible, they will organise themselves to produce as much as possible of each good.  What?  What about leisure and living?  Don't they take time and effort?  Yes, so our production possibility set will represent the quantities of the two goods our citizens are prepared to, are willing to produce, given that any production involves use of scarce (limited) time and effort, for which there are competing leisure (consumption) and recuperation (investment - see below) demands

So, there is some upper limit to the amount (quantity) of each good our citizens are prepared to produce in this economy.  We can mark these two upper limits (F* and C*) on each of the axes of our diagram of the economy.  Producing F* means that will not produce any C at all, so quantity of C is zero when Food production is at F*, and vice versa. OK?

But neither of these extremes is likely to be a sensible choice for our people - they are much more likely to choose a combination of the two goods.  What are the production possibilities for mixtures of the two goods?  Suppose we start with the economy producing all food and no clothes (at point F*), and now ask ourselves how much clothing this economy could produce if it diverted some of its resources from food to clothes production.  How much food production would have to be given up to produce the first few units of clothes?  Probably not very much, since some factors of production (land and labour) is not very good for food production and would be better at producing clothes.  Furthermore, some of our people would prefer to make clothes than produce food, so are likely to be better at producing clothes than food.

So, to begin with, moving from F* upwards and to the left to produce more clothes and less food, our economy could gain quite a lot of clothes without having to give up much food production.  Eventually, though, as we progressively cut back on food production in order to produce more clothes, we will find that we are having to give up more and more food for each extra unit of clothing production - as the extra resources we need to produce clothes are progressively better at producing food than clothes.  Eventually, we would wind up producing all clothes and no food - at point C*.

So, our production possibility relationship will be curved between F* and C*.  Make sure you follow this logic and the representation of it as the production possibility frontier (PPF) on the diagram .  This should be what you got on your own diagram as you followed the argument through.  If you didn't, why not?  Notice, it is frontier because this curve represents the maximum possible combinations of food and clothes that our citizens are willing to produce, given the land, skills, technologies and work preferences they have.

Notice, too, what this PPF means.  Suppose we start at point C* and then ask how many clothes we have to give up to produce some food.  Move along the PPF, and watch how much extra food we get as we give up limited quantities of clothes. At first, we only have to give up a little clothes for a lot of food - the slope of the PPF is quite flat.  In other words, the supply price (cost) of more food in terms of clothes given up (the opportunity cost, which here is the total cost of food production) is low.

But, as we progress down the PPF, the real cost of food  (its cost relative to everything else in the economy, which in our case is clothes) increases - the slope of the PPF gets steeper.  The cost of food production increases the more food we try and produce - the real supply curve for food slopes upwards.

Repeat this argument (logic) for the price of clothes in terms of food - you will get the same answer - the real supply curve of clothes also slopes upwards: the more we want to produce, the higher the cost in terms of foregone food production - the higher the real (relative) cost of clothes.

PPF Conclusions:

• The PPF shows the full employment capacity of the economy: inside it means unemployment; outside it is impossible (unless, that is, we add to the capacity of the economy - see below)
• So, it also shows the maximum real income our economy can generate, in terms of food and clothes mixtures.  Our producers are here not producing these things just for fun, they are producing them because they and their neighbours want them - the products are their income, their return for the work they do.
• The slope of the PPF measures the real supply price (the real cost) of producing both goods.
• The supply curves for both products slope upwards - greater quantities supplied cost more per unit.

• By "investing in human capital" - improving the skills and productivity of our people - the labour, (and the consumers), or simply having more people.
• By investing in land to make it more productive (draining it etc.)
• By improving the effectiveness of our production systems - getting more out for the same level of land and labour input - improving efficiency, which means one or both of better management (ideally less management, since management by itself produces nothing), and better technologies.
• By investing in capital (tools, plant and equipment) which labour can use with the land to produce the goods.
• By combining these things so that work (production) becomes more fun and more respectable, so that people are more willing to work than before (a point seldom, if ever recognised in the textbooks)

What about the consumption or demand side?  Now we have to think about how to represent consumer choices about how much of each (food and clothes) they would like to have and enjoy.  Go back to your paper diagram.  Start with some mix of the two which represents one particular (and observable) choice (F1 of food and C1 of clothes) - a point (x) which will be in the middle of our diagram somewhere - it doesn't really matter exactly where. But, if you are drawing this on the diagram with the PPF on it (which you should now have labelled), you had better put your x somewhere on this frontier, hadn't you?   Why?

Otherwise you will be trying to consume mixes of the two goods you cannot possibly produce (x lies outside the PPF).  Or you will be wasting resources - x lies inside the PPF, which means leaving people and land unemployed when they could be working, and working at something they would like to do, and earning a living, and producing something we want, and thus earning respect.

So, put your x on the PPF - anywhere else is daft, (or, as economists say, inefficient), so we would not expect people to choose it, unless they are so stupid as not to be human.  This point x represents the one the people in our simple economy choose for themselves - it is the one we would observe them at, if we could find this simple economy to look at.

Now ask yourself how the consumers in the economy might judge other combinations or mixes of the two goods that they might have chosen instead of x (F1 and C1)?  How might they compare other possible points on this diagram with x?

Within reason, more of each good would typically be considered preferable to less of each of the two goods, especially as we have included capital in each, - right?  So we can identify the north east quadrant (all points above and to the right of point x) as a preferred set or zone of possible consumption mixes or 'baskets' of goods.  Draw this zone on your diagram now.  And the south west quadrant (all points or good combinations consisting of less and F1 food and C1 clothes) will be considered inferior choices or combinations for our consumer population.  Otherwise they would have chosen one of the points in this zone, and they did not.  Shade in this inferior zone in now.

So, somewhere in the top left (north west) and bottom right (south east) quadrants will lie a boundary which separates the preferred set of consumption mixes from the inferior set, compared with our initial combination x.  There will be a separation between mixes which are preferred and mixes of goods which are considered inferior - a separation zone or boundary along which our citizens cannot make up their minds about which mix is better and which worse - they are, in effect, indifferent between any of the mixes defined by this boundary or indiference zone.

This boundary will (has to) slope downwards and to the right, passing through our reference point, x.  So, draw such a boundary on your diagram.

You have just drawn what economists call an indifference curve (or boundary) (let's label it I2) which indicates all those combinations of food and clothes which the consumers cannot judge to either worse or better than the one they chose initially (x) - they are indifferent between any of the combinations which lie on this boundary or curve.  So, you can now extend the shading of both the preferred zone and the inferior zone up to this boundary. Got that?  If not, go back and re-read the logic and re-draw your own diagram.

You should have got (most of) this diagram.  But you didn't get three curves, you only got I2.  So what are the other curves?  Well, what we are drawing here is a map of consumer preferences.  The further north east we go this map, the more preferable the bundles of goods become - bundles to the north east of x have a higher value to the consumers than bundles to the south west.  The indifference curve we have drawn is a contour line on this preference "hill" - a line joining together all those points (bundles of the two goods) which are considered of equal value by the consumers, the citizens of our economy.  So there are as many other contour lines as we care to draw on this preference map.  I have just drawn in two others, of lower value than I2, so I have labeled them I1 and Io respectively.

Now go back to point x.  Ask yourself how much food our citizens would be willing to give up in exchange for a little more clothes - move upwards and to the left of point x along the indifference curve, I2.

Why along the curve?  Because, if we move upwards and to the right of this curve, we are assuming that our consumers consider themselves to have suddenly become richer.  How come?  Because they can get to a preferred mix of both goods anywhere above and to the right of I2 - (I2 marks the boundary between the preferred set of goods and the set considered inferior.)  They choose x - because they could not get any mix of goods above and to the right (outside) I2.  If they could have, they would have, and x would be in a different place than we supposed. [This sort of analysis is known, in the textbooks as revealed preference theory for this reason - the choices people actually make reveal their preferences for what they want, and about how much effort they are prepared to put in to get it]

Indifference Curve Conclusions:

An indifference curve also shows a constant real income level for our economy, where income is now defined as command over consumption (and investment) mixes ("demand income"), rather than as the returns from production.  Note, again, that this is not a distinction that the textbooks identify.  Why not?  The answer takes us into some even deeper conceptual water than we are already in, and I don't think is necessary here.

So, if we want to know how much food our consumers will be prepared to give up (pay) for an additional quantity of clothes, we had better hold their demand incomes constant - otherwise we will confuse ourselves about why they are willing to pay more or less for more clothes.  So we move up the indifference curve I2.  As we do so, what do we see?  That our consumers are willing to give up progressively less and less food for more and more clothes.  The indifference curve gets steeper.  The more clothes they want, the less food they are prepared to trade (pay) for them, the demand curve for clothes is downward sloping.

Alternatively, move down the indifference curve from point x.  The consumers are willing to give up less and less clothes for more and more food.  The indifference curve gets flatter.  The more food they want the lower the price in terms of clothes (the real price) they are prepared to pay.  The demand curve for food is downward sloping.

The slope of the Indifference Curve shows the real demand prices (the prices consumers are willing to pay) for the two goods. These are indeed real prices - each is priced relative to the other (which is all there is in this economy).

We have already seen the partial answer to this question - the intersection of supply and demand curves in a single-good market. As the markets (the possible trade-offs) for each of the two goods settle down to their equilibrium positions, each will settle on a particular quantity and a particular price - at which the supply cost equals the demand price (where the supply curve and demand curve intersect).  Where will this equilibrium quantity mix (of food and clothes) be on our production possibility frontier (PPF) and consumer preference map (indifference curve map) diagram?  What combinations (quantities) of the two goods would you expect this single economy to choose?  Think, before you read on.

Answer: first, it has to be a mix that our citizens are willing to produce - so the combination has to lie somewhere on the PPF.  But where? Where the consumers think they are getting the best value from their consumption - i.e. as high up the preference map as possible  - on the highest possible indifference contour or curve.  Which is a single unique point (X) as a combination of C1 clothes and F1 food.  This economy, or community, cannot do better than this on its own.

We should expect a sensible, coherent and communicative, and cooperative community to come up with this, given time and no interference from anywhere else.  This is how we would expect people to learn to behave, if left to themselves.  What?  No, you wouldn't expect this?  They will fight and bicker?  They will steal and thieve?  They will behave like children, then?  They won't grow up and be sensible and wise?  Why not, if we leave them alone, wouldn't we expect them to grow up and learn from their mistakes and work out how to do things better?  Isn't this what humans do, if we leave them alone?  If they don't, they will wipe each other out.  These people, in case you hadn't noticed, are our ancestors - so they didn't wipe themselves out.

OK, so I have altered the shape of the PPF here - the reason will become obvious in a minute.  For the present, just notice that this different shape reflects the capacity of the community, and its willingness to work at these particular activities - this one is better at producing clothes than food compared to the previous one.  Why?  because it has more labour and less land, perhaps, and clothing (and shelter) production is more labour intensive and less land intensive than food and fibre production.

At this unique point, this single optimum combination of food and clothes, the indifference curve and the PPF will be tangential to each other - they will have the same slopes.  In other words, at this point, the rate at which consumers are willing to give up one good in terms of the other (the slope of the indifference curve), which is the consumer demand price for each good, will equal the rate at which it is possible to supply one good in terms of the other - the supply cost of each good - the slope of the PPF.  At this point, and this point alone, the production value of the two goods will equal the consumption value.

What are these rates?  They are the real (relative) prices of each good in terms of the other.  The supply prices are equal to the demand prices at this general equilibrium in our two markets.  And the price ratio of one good in terms of the other is the slope of the tangent - the ratio of C0 to F0 in the diagram opposite -  the supply price ratio of the slope of the PPF equals the demand price ratio of the indifference curve.  So, this country's markets will settle down at a general equilibrium of producing and consuming at point X, = C1 of clothes and F1 of food.

General Equilibrium Conclusion:
Markets can achieve the best of all possible worlds, in the real world in which we live. This is a fact of logic not just an assertion or an assumption.  It is true in principle.  And we, as humans, are uniquely capable of turning our principles into practice - that is what we do that makes us different from the animals.  If the real world does not live up to this principle in its practice, then we will work to understand why, and then work to fix it.  This is science and reason.  Anything else is idle speculation or fantasy.  Simple, isn't it?  Tough, isn't it?  Is this why people don't like economics?

Implication:
The market system rewards the owners of the factors of production - those who have the most land, the most capital and the labour skills best fitted, most well matched to the wants of society (the consumer) will earn the most production income, and thus get to exercise the most money votes about what is produced.   If you (land, labour, capital, or management) are useless, you won't get paid in this system, and you won't get the chance to exercise your consumption income. To him that hath shall be given - from those who are most able, but not (necessarily) to those who are considered most deserving.

So we would also expect our sensible human community to show some humanity and seek to soften the harsh realities of natural selection (since that is what this system really is).  Our community will also develop governance and redistribution (care) systems alongside its market systems.  Why? Because, some form of government is an essential complement to this trading system - the long arm of the law is necessarily attached to Adam Smith's invisible hand of the market - to outlaw theft, enforce contracts and protect property rights (whether these are common rights or private rights).  Once in place, such governments will also become responsible for managing the natural selection of the market - including acting as judge to redistribute losses and gains, and protect or support the less well off.  The humane economy will naturally develop gifts from those who have to those who have not, which will be outside the system of exchange portrayed here. But not independent of it, since the capacity to give depends on the resources one can accumulate and incomes one can generate.

We have not concentrated on either the sociology or the politics of our economy, our community, here - because this is an economics course.  But it is nonsense to pretend that these aspects of humanity do not exist, or that economics is fundamentally different and separated from them.  They have to fit, and the way they fit is through the governance (or management, if you prefer) of the market system.

Finally - the benefits of Trade.
Now, at last, we are in a position to look at the benefits from trade.  Suppose, now, we have another community (or country, if you prefer).  This second country - country 2 - is practically identical to country 1 except that it has more land and less labour.  Otherwise the mix of skills and preferences are identical.  The PPF for country 2 shows that the country is better at food production and not so good at clothing production as country 1.  But the preference maps are identical for the two countries.  On its own, then, country 2 would choose to produce and consume C2 clothes and F2 food, at a real price ratio of C3/F3.

Now suppose you are a trader. You have an opportunity to do business between these two countries.  What are you going to do?  Buy clothes where they are cheap and sell them where they are expensive, and the same thing for food.  And where is food cheap?  In country 2 - you don't have to pay a much in clothes in country 2 as you do in country 1.  And clothes are cheap in country 1.  So there is money to be made shipping food from country 2 to 1 and clothes from 1 to 2 - right?  Just think about the meaning of the slopes of the "price lines" in each country - they show the price of one good in terms of the other.

And what happens when we start to trade - exporting food from 2 to 1 and clothes from 1 to 2?  Remember the results of the last session?  The price of food will rise in country 2 (the food exporter), and thus the price of clothes will fall in 2.  Country 2's "price line" (C3 to F3) will get steeper.  The opposite will happen in country 1 - the line C0 - F0 will get flatter.

And what will limit this process of price changes as a consequence of trade between to two countries?  Again, from the previous session - the free trade or "world price" will be the same in each country - the slopes of the price lines will be the same, flatter than 1's and steeper than 2's.  The trading price line will lie between the price lines of the two countries, as in the figure below (Ce - Fe). I have omitted the previous no-trade price lines from these diagrams, to make them clearer.  But you should be able to re-draw these for yourselves.

So what? At this price ratio, country 1's optimum consumption point is now C1c of clothes and C1f of food.  This is where the trade price line touches the highest possible indifference curve. A higher indifference curve than it can possibly get to without trade - a higher consumer or demand income - so it is definitely better off with trade.

How does it manage to consume this amount of food (which is more than it could possibly produce itself in this diagram - C1f lies outside the PPF)?  Answer - it imports food, and pays for these imports with exports of clothes.

How much food and clothes would it pay country 1 to produce?  Where the trade price line is the same slope as (lies tangential to) the PPF - since the slope of the PPF shows the supply price ratio of the two goods - the price ratio which matches the opportunity costs of producing each of the goods.  So, country 1 produces P1c of clothes, and P1f of food, and trades (P1c - C1c) clothes for (C1f - P1f) food.

The exports [production minus consumption] of clothes pays for the imports (consumption minus production) of food, at the trading price ratio between the two products.  And country 1 is clearly better off with trade than without it, since it can now consume above (beyond) the limits of its production possibilities.  The same arguments apply to country 2.  Follow them through for country 2 for yourselves.

Conclusions from Trade:

• Country 1 is said to have a comparative advantage in clothing production - it can produce clothes relatively cheaply in terms of food, whereas country 2 has a comparative advantage in food production.  Notice, importantly, that one of these countries could be absolutely better at producing both goods - able to produce both more food and more clothes per person or per hectare.  But this would make absolutely no difference to its comparative advantage.  Unless both countries are absolutely identical (in which case their real prices would also be identical, and there would be no gain from trade, and thus no trade) , one must have a comparative advantage in one good and the other must have a comparative advantage in the other good - fact of logic; mathematical certainty; law of human nature - call it what you like.
• In particular - there is no way that one country can possibly have a comparative advantage in the production of both goods.  Having a comparative advantage in one good automatically means that the country has  comparative disadvantage in the other.  This result is perfectly general - it holds however many goods we might like to consider - any country will have a comparative advantage in something - something which it is relatively good at compared with all the other things it might be able to do.
• Trade allows these countries to exploit their comparative advantages, buying (importing) things which are relatively cheap from elsewhere and paying for these imports with exports of things which are relatively cheap in this country, and thus relatively expensive elsewhere.
• It will pay countries to specialise in the things which they are relatively good at - the things in which they have a comparative advantage.  Country 1 here specialises in clothes - producing more than it is willing to consume, and country 2 specialises in food (& fibre) production.
• Trade prices equalise between countries as trade occurs, which encourage the appropriate supply and demand responses to exploit these opportunities for specialisation
• The results of this logical analysis are unambiguous - trade pays and is of benefit to everyone.  There is no doubt about this - it is a fact of logic - it stands to reason.  Not believing this is exactly equivalent to not believing that the earth is round and goes round the sun - it is daft, nonsensical, illogical, without foundation.
• It is also, I argue, a fact of life as well as a fact of logic - because the principle of specialisation and trade according to comparative advantage is a basic principle of evolution and natural selection.  Rabbits don't try to be wolves - they get better at being rabbits, and working better with the resources and conditions in which they find themselves. This is how natural ecosystems work, as well as how markets work.  But this is another story.

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7.    Macroeconomic Basics - the Circular Flow of Income (CFoI) - also applies to regional economies.

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• Consumption (C) is spending on goods and services for final use (consumption) during this period.
• Investment  (I) - an injection into the CFoI - is the purchase of actual physical capital (equipment etc.), or the improvement of peoples skills and expertise - final spending on things which are intended to increase income levels in future periods rather than this one. [Please Note:  Firms are responsible for most of this investment, not governments, though some government spending is investment for future periods rather than spending on current (this year's) goods and services]
• Saving (S) is just and only income which is NOT spent on final goods and services. (= Yd - C) - a withdrawal from the CFoI. [Please Note:  Investment spending is matched with Savings through the financial and money markets (see below), which are separate from this Circular Flow of INCOME picture of the economy]
• Government Spending (G) is ONLY spending on final goods and services (wages and salaries, paper, power, building maintenance and improvement etc.) used up in this period or intended for use in future periods (includes any government investment) - an injection into the CFoI
• The other (major) part of total government expenditure is Transfer Payments:  social security, unemployment benefit, public (national) pension payments etc.  which simply add directly to the recipients incomes, and which are not paid in return for actual services.
• Taxes are the government reciepts - actually also raised on the spending loop (VAT, excise duties), as well as on income streams (income and corporation taxes)  - T is best thought of as total taxes minus transfer payments - a withdrawal from the CFoI
• Exports of goods and services provide income for firms, and also measure this part of total output of the economy - an injection into the CFoI
• Imports of goods and services leak income out of the national (domestic) flow of income - a withdrawal from the CFoI
• Total Expenditure equals Output (C + I + G + X - IM) equals Income (called Gross Domestic Product) (Y) which equals Disposable Income (Yd) plus Taxes.

Distinguish between

• trend growth (improvement in technology and productivity (outputs per unit inputs)) typically about 2.5 - 3.5% per year
• cyclical growth (or decline) round the trend growth - booms (strongly positive growth rates) and recessions (slower growth rates) or depressions (negative growth rates).

• Increasing Injections (G, I, X) and/or reductions in Withdrawals (T, S, IM) will increase the CFoI (increasing income and output (expenditures) and vice versa.
• Multiplier process - increasing an injection (for instance) increases income, which then leads to further increases in spending and resulting income
• until income levels have risen sufficiently that new levels of withdrawals equal the new level of injections (increasing incomes tend to lead to increased savings, taxes and imports).  Y (GDP) will not be in equilibrium until resulting Withdrawals balance Injections

• Government Fiscal Policy (the balance between G and T) can influence equilibrium Income levels
• Increase G (or reduce T) to counteract  a recession
• Reduce G (or increase T) to counteract an unsustainable boom (income growth exceeding full capacity of the economy, which leads to inflation - see below)

• Total Capacity of the economy to generate output and income depends on the quantities of land, labour, management and capital plant and equipment available
• When all of these factors of production are fully employed, the economy is operating at full capacity.  Otherwise, there is unemployment - the economy could produce more income and output.
• Capacity can be increased by:
• investment in capital plant and equipment - more capital for production and output;
• increase in the labour force participating in the economy - more employment -> more output & income;
• improvement in technology - more output & income from the same amounts of labour and capital through technological improvement - better quality and more productive capital;
• improved productivity of labour - better skilled and better organised labour increasing the amounts that can be produced and the income that can be earned;
• structural change- re-organisation of resources among different firms with lower costs, improving management.
• Fiscal Policy (G and T) can affect these capacity increasing processes - so should be used with care and caution.

• National Income (GDP) = P x Y  (a grand sum of millions of price times quantity trades) - where Y is real income - in terms of purchasing power over all goods and services, and P is the general price level (an index of all prices in the economy)
• Money (M) is the medium through which these trades take place (notes, coins, and current accounts with banks)
• Money is a STOCK which is exchanged between different people and businesses as trades happen
• The FLOW of money round the CFoI is given by M x V, where V is the Velocity of Circulation - the number of times any one £ changes hands in the course of 1 year.
• MV = PY (the Quantity equation of exchange) always holds - it is the only way of defining and measuring V.
• If V is constant, then PY (nominal or current GDP, national income) can only increase if M increases.
• If Y is fixed by the Capacity Constraint - at Yf (full employment national income), then any increase in MV will lead to an increase in P - inflation.

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8.    Money, Interest and Discounting

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The Market for Money (Money market)

• Demand for money (current account bank balances) depends on:
• Income (especially for transactions or active balances)
• Price (the interest rate) especially for idle balances - the higher the interest rate, the greater the opportunity cost of holding wealth as money rather than as financial or physical assets.
• Money Supply is controlled by the Monetary Authority - the Bank of England (BoE).
• Monetary Policy is decided by the Monetary Policy Committe of the BoE, with the objectve of controlling inflation
• either through controlling the Supply of Money directly (which proves to be rather difficult)
• or by setting the base lending (interest) rate of the Bank of England to the commercial banking system - the current system of Monetary policy. (Setting the interest rate at a new level above r* will automatically result in a contraction of the supply of money to match the reduced demand - since the BoE, through its function as lender of last resort, implicitly sets the supply of money to match its ruling interest rate)

Capital Markets:  Balance between Savings and Investment (in new plant and equipment etc.)

Financial and Asset Markets - who owns what bits of existing capital.

The total stock of land is Qf. Whatever the price, this total stock cannot be changed (aside from minor changes like draining lakes etc.) The sellers are signalling a negative demand for the thing (land in this case) - the offer curve (Oc) - the higher the price, the greater the quantity we might expect present owners to be willing to sell. By the same token, all present owners who are not selling are exhibiting a positive demand for their stock given present prices. This positve demand is labelled the reservation demand (RD) in the above figure, which is the mirror image of the offer curve (Oc). What is not being offered for sale by present owners is being retained (held onto) - that is, it is being demanded.
The excess demand curve (XD) shows how much more land present owners and non owners want to own at each price - more is demanded over and above present holdings of land as the price falls.
The horizontal sum of the reservation demand (RD) and the excess demand (XD) is the total demand (TD) for land, or stock. It is the intersection of this total demand (TD)with the fixed supply (Sf) which determines the market price for land (Pe).

The trades we observe in a stock market are those between people who no longer want to own the stock, for whatever reason, shown by the offer curve (Oc) and those who want to own more than they presently have (which might be some or none at all) - shown by the demand for additional stock (excess demand) labelled XD above.  Offer and XD intersect at the trading price (Pe) and Qt of land (or stocks and shares) change hands between buyers and sellers.

When all these trades have been made,  the present owners are now willing to go on owning land at the present price, and are not willing to sell any.

Share Prices and Stock Market price movements.
So, what is a stock or share (or piece of land) worth?  The simple answer first - it is worth whatever someone else will pay for it.  The current market price of the share, or piece of land, or any other physical asset, is as good an estimate of what it is worth as you can get.  The current price reflects the total demand (reservation and excess demand) matched with the fixed available supply.  The price will change, as in all markets, only if demand shifts or supply shifts. For land and stock markets, the shifts in total supply are usually pretty trivial compared with the total stock.  So it is shifts in demand which are critical in determining prices in these stock markets.

What will shift the demand curve for land (or stocks and shares) and hence change their prices?

• expectations of future annual returns - if these expectations increase, then demand for the asset will increase - shift to the right, pushing up the asset price
• expectations of future selling price (market price) for the asset - it is expected to become more valuable in the future than it is now - which also pushes up the current market price

• The market price of an asset (P) is the present value of its expected future earnings stream, as anticipated by the people trading the asset in the stock market.
• This present value discounts future earnings because:
• we have to wait to get them - the risk-free rate or return or discount rate (r)
• we need to cover the expected inflation rate in the future (p)
• we need a premium to cover the uncertainty (risk) associated with this future stream (u)
• The discount rate (or interest rate) i can thus be thought of as being made up of three components: the real risk-free rate of return (r), the expected inflation rate (p) and the risk premium (u).
• For any perpetual asset - whose returns are expected to continue indefinitely at some fixed value (R) - the Present Value = R/i

• If the return is fixed (assumed to be known and given) at R, then an increase in the price of the asset implies a lower rate of return (as a % annual payment) - as asset prices increase, their internal rates of return fall (other things being equal)
• If returns are expected to increase, then we would expect the price of the asset to increase, given the discount rate as the opportunity cost of capital - the rate of return we can earn on other alternative assets.
• If the interest rate in the economy increases, then the opportunity cost of capital increases, and asset prices will fall.

Suppose we do not expect rents to remain constant in the future.  What might they do?  They might be expected to increase (or fall) by some average and constant amount each year (say plus or minus £A per year).  In this case, the relevant sum for the present value of this stream of future rents (annual returns) becomes:
 PV = R/i + A/i² , where R is the basic rent or annual return (expected this year) and A is the amount by which we expect this annual return to change each year in the future, and i is the discount rate (the opportunity cost of capital - what we could earn elsewhere, investing in something else).  So, if we expect returns to fall, the present value is reduced compared with the simple sum which assumes the return stays constant.  But, if we expect returns to increase, then the present value increases, too.

Or, we might expect a continual percentage change in the annual return, say plus or minus g% per year.  In this case, the PV sum becomes:
PV = R/(i - g), so that, if the expected growth rate (g) in the returns on this asset are higher than the opportunity cost of capital (i), the present value for this asset goes to infinity: there is no price it is not worth paying for such an asset - which is an explanation of why share prices shoot upwards for companies expected to do very well in the future.

Depreciating assets - ones that wear out.
So, how do we account for the fact that physical plant and equipment wears out and becomes obsolete?  By making an allowance for the depreciation of the asset - the continual re-investment necessary to maintain it in a non-depreciating state.  Suppose that this depreciation rate is d%.  The gross return we need to get from this asset needs to cover this depreciation rate, so the net return we need to get on any depreciating asset is the gross return minus the estimated depreciation rate.  So, the gross return we expect to get should be i = r + p + u + d on these assets.

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SEE HERE for the final steps in the story of the CIRCULAR FLOW OF INCOME - THE BALANCE BETWEEN IMPORTS & EXPORTS AND THE FOREIGN EXCHANGE (ForEx) MARKET, AND IMPLICATIONS FOR MACRO-ECONOMIC MANAGEMENT.