User's blog

Tag: understand economics

  • How price of anything is set?

    The answer to this complex question is simpler than you might think.

    Do you think a business can charge whatever price it wants, to get the highest possible profit? But consumers who demand those products would like to buy them at the cheapest price, so how do they come to a consensus? In markets that are highly competitive (see footnote)*, meaning there are many producers and consumers of a specific good or service, the price of that product or service gets determined by the interaction of supply and demand forces. These forces work together in the same manner as the blades of the scissors cutting the paper.

    Wait, but what are these supply and demand forces?

    First, let’s understand them individually, and later we will see how they interact to set the “right” price.

    Demand

    In economics, we assume that people buy more of something when its price is lower. This negative or inverse relationship between price and quantity demanded is called the law of demand. This means the higher the price, the lower the demand is, and the lower the price, the higher the demand is for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    Let me explain this with a simple example of the demand for bread. The prices are shown on the Y-axis and the quantity that people are demanding is on the X-axis. You can see this inverse relationship in the graph below that slopes downward.

    If the price of one loaf of bread is $10 there is going to be very less demand for it, let’s say only 10 loaves of bread will be demanded. Once the price is lowered to $6, a few more people will be willing to buy it, so the quantity demanded increases to 20. And if the price is further lowered to $2, more people would be willing to buy it, as more can afford it, so the quantity demanded now is 40.

    Supply

    Now let’s look at the supply pattern. For a producer, if he gets a higher price for bread, he will be willing to make more bread and supply more of it. A higher price or reward encourages producers to supply more, and you can see this positive relation in the graph below as an upward-sloping supply curve. So, the law of supply states that there is a positive relationship between the price of a good and quantity supplied. This means the higher the price, the more businesses or producers are willing to supply, and the lower the price, the less they would like to supply. In the graph below, we can see at $2, producers are only willing to supply 10 loaves of bread, at $4, 20 loaves, and at $10, 40 loaves of bread will be supplied.

    Now when we plot both of them together in one graph, we will see there is one price, where both these curves meet. In economics, we call it an equilibrium point, where the price is just right for the producer/seller and the consumers. In the graph below, this happens at point A, where demand and supply meet or cross each other. The price is set at $4 and the quantity demanded and supplied is 25 loaves of bread. Thus, we saw no one individually impacted the price, but producers’ supply and consumers’ demand worked together to set the price that makes everybody happy.

    You understood how prices can influence how much people want to buy and produce. Now, let’s understand also, how it works the other way round, meaning how much people demand and businesses supply can influence the prices as well.

    If there’s more demand than supply for something (such as point B above), this will send a signal to the producers to increase the price from $2 to $6, because they understand that people are prepared to pay more to receive that good or service. In this case, there is an incentive for the producers to increase the price. If the price goes up to $6, some consumers will drop out as they won’t be able to afford bread at price $6.

    On the other hand, if there is more supply than demand (shown as point C above), this is a signal to the producers to lower the price from $6 to $2, because the price at $6 was too high and there is a very limited number of people who are willing to buy it. Now some producers, might drop out and can’t lower the price to $2, because they can’t cover their cost of production.

    Over time the price will keep moving upwards or downwards until it reaches a point where demand is equal to the supply, at point A ($4).

    Today, you learned two fundamental concepts in economics: the law of demand and the law of supply.

    If you are wondering about whether it is possible to plot these demand and supply curves in real life, the answer is, yes? In economics, a graph is just a simple representation of economic principles or behavior observed. Economists survey people and collect data and plot that data using easy-to-understand graphs. In the demand and supply curves we looked at today, the slope could be steeper or flatter. In order to learn what decides how steep or flat (demand or supply) curve will be, we will have to look into another important principle in economics called elasticity. More on that will be in my future posts. For now, if you just want to know why economists use models and graphs to solve real-world economic problems, please read my post here.

    *In non-competitive markets, like monopolies, where one company controls the market, it gets more control in setting the price. The demand and supply forces don’t work very well here. Producers want to get the maximum profits by setting the price higher and can do that as well. In the absence of other competing businesses, consumers who want to buy their product or use their service, don’t get other options. Hence, they end up paying a higher price than they would have paid if more companies were in the market for that product or service. Usually, to prevent businesses from exploiting consumers, some government intervention is required so these monopolies don’t create artificial barriers to entry.  

    It is worth noting that, some monopolies can happen naturally and not all monopolies are bad. We will look at this more in detail with real-world examples in another post.

  • What are our real earnings when we deposit money in our savings accounts?

    If I asked, “What’s the interest on your savings account?” many of you will tell me the interest rate that the bank is stating. However, you need to understand the difference between nominal and real interest rates.

    In this post, you will learn about the true return you get by saving your money in a bank.

    What is a nominal interest rate?

    When you deposit money in your savings account at the bank, you get something called nominal interest. So, if your savings account has a 2.5% interest rate, that is actually a nominal interest rate.

    A nominal interest rate is the interest rate banks and financial institutions give to you. It is the actual rate they will pay on your savings balance. This interest rate is not adjusted for inflation.

    Before we dig into real interest rates, we need to understand what inflation is and how it impacts the real return on savings.

    What is Inflation and how does it affect your actual return?

    Inflation is the general increase in the prices of everyday goods and services we use. It is important to note that the price of one item can go up and down, but the increase in any single item won’t qualify for inflation. Inflation happens when price rise for a majority of goods and services we use. In other words, inflation only happens when the average price level is going up. For example, when the prices of food, housing, gas, and other items we use, all rise for a while. I have written a detailed post on inflation in another post if you are interested.

    Real interest rate – the one that actually matters!

    If there is any inflation in an economy, money loses its value or purchasing power. So, the interest you earn from the bank won’t buy the same amount of things it could before the price rise. Thus, we need to calculate the real interest rate. This is the rate we get after subtracting the inflation rate from the nominal interest rate your bank quoted to you. So, the real interest rate r is

     r = nominal interest rate- Inflation rate

    This is called Fisher’s equation in economics, named after American economist Irving Fisher. He explained the difference between true or real interest from nominal interest.

    Thus, we will only earn interest income on our savings, when the real rate of interest is positive. If this number is positive, we haven’t lost money and actually gained some by keeping it in bank.

    Let’s learn this by an example. Think of a big balloon with some air. Here air is the money you deposited in your savings account (balloon). Now, let’s think of the “nominal interest” you earn on your savings as the rate you are blowing air in the balloon to make it bigger. But let’s suppose there is a hole in the balloon, which is making the air come out of it as well. This air coming out of the hole is representing inflation in an economy.

    If you’re blowing faster than the air that is coming out of the hole, your balloon will become bigger. And if your balloon is getting bigger, then purchasing power of your money in a savings account will grow over time. This is when you are earning interest in a real sense, and you will be able to buy more things.

    But if the hole is bigger, the air will come out faster than the air going in. This will cause your balloon size to decrease, which means your purchasing power will go down.

    So even if you are getting a nominal interest on your savings account from the bank, because of inflation, you will only be able to buy fewer things with that money in the future.

    So, the real interest rate could be positive, zero, or negative depending on whether the inflation rate is less, equal, or more than the nominal interest rate.

    If the real interest rate is zero or positive, then saving your money in a bank is still better than keeping it with you.

    When you keep money in your house, it certainly will depreciate by the rate of inflation. The only time keeping money in the house will help is when there is a deflation, which means the general price level is going down.

    In the chart below, you can see how inflation affects your true savings return.

    Does anyone benefit from stable inflation?

    Savers, borrowers, and lenders all benefit when the inflation level is stable and low (around 2%). For borrowers, it helps them pay off their loans because they are paying a little bit less in real terms.

    Banks know the target rate of inflation, so they keep their nominal lending rate of interest higher than that. This helps them get some real return on lending money.

    Similarly, for depositors, if inflation is stable, they get the real return as the excess of nominal return over the inflation rate.

    However, if inflation is more than the normal 2%, then both lenders and depositors will lose money.

    To learn about what measures the Fed takes to keep inflation stable at around 2%, please click here.

  • We hear this word so much in news, but what exactly is an economy?

    Has it ever happened to you while listening to the news that there is some big scary vague thing called the economy that’s just out there? You might think you have no control over it, as most of it is based on business and government decisions. You are wrong here!

    You are also a very important player in the economic game. The economy is just all of us together, acting in our own individual best interests, deciding how to use the limited resources we have, to get the maximum happiness. By pursuing our selfish interests, we indirectly contribute to the growth of society, by the magic of some invisible hand.

    We all are in the economy as everyday people, who are going about everyday tasks and decisions. The main point is that we’re all actors in the economy rather than spectators. So, we are not passively looking at this thing called economy but taking an active part in the economy all the time.

    In other words, an economy is a large set of interconnected production, consumption, and trade of goods and services that help in determining how scarce resources are allocated. I know in economics some fancy words are often used, such as “scarce”. By scarce we mean limited, something that we don’t have an infinite amount of.

    It is true that in the news, macroeconomic indicators are discussed more often, like inflation, GDP, unemployment, etc.  But believe it or not, a lot of times, the decision-makers behind these big indicators are millions of small entities like you and me. In microeconomics, we look at how people can make the best decision they can to make their lives better by making good choices.

    We apply an essential economic tool called “thinking on the margin” in our daily lives. It essentially means evaluating the benefit of one extra unit of something vs. the cost of one extra unit of the same thing.

    For example, should I spend one more hour studying? Should I eat one more pizza slice? Small decisions like that are also economic decisions. Households, businesses, and governments all think about tradeoffs and marginal cost vs marginal benefit analysis while taking many decisions in life.

    For an individual, it is a personal decision like should I spend a few additional minutes reading this article or should I switch to some other activity that may give me more marginal benefit? Similarly, firms must decide whether to hire additional labor to increase production and by how much? Will the extra revenue generated from hiring that extra labor to be enough to cover his cost of wages?

    Lastly, on a macro (aggregate) level, governments make the monetary and fiscal policies to make more significant decisions by doing the same marginal analysis. Should they build an extra park or use the money on healthcare? We need to remember that the principles of economics can provide guidance across all sectors, be it at the micro-level or macro level.

  • Global economy will slow down in 2022 and 2023. What policy measures the governments should take to get back to growth trajectory?

    IMF projects lower global GDP growth of 3.6% for the next two years

    IMF’s World Economic Outlook report published on April 19, 2022 has predicted a drop in the GDP growth of the world economies in the years 2022 and 2023 to 3.6%. This downward revision is from their previous estimate of 6.1%, largely because of the war in Ukraine. IMF publishes this report twice every year.

    Below is the chart from IMF showing these growth projections by region. These projections are for real GDP growth and not nominal GDP growth. As changes in real GDP are the most popular indicator of a country’s overall economic condition. If you want to know more about the US GDP and its components, please click here.

    Countries, like the United States, the EU, Japan, the UK, Canada, and other advanced countries are projected to grow on an average of 3.3% in 2022 and only 2.4% in 2023.

    The emerging market and developing countries such as India are projected to grow at 8.2% in 2022 and 6.9% in 2023. Whereas because of the lockdown in Shanghai, China, the projected growth is slightly lower at 4.4% in 2022 and it is expected to be 5.1% in 2023, as the lockdowns are eased.

    As expected, there is a severe double-digit drop (-35%) in GDP projection for Ukraine in 2022. They also project a contraction for Russia due to sanctions and European countries’ decisions to reduce energy imports. The war has also severely impacted emerging and developing Europe, which shares proximity to the war area with an expected fall of 2.9% in their real GDP in 2022. There is a hope of some recovery in 2023 with GDP growth returning to 1.3%. Russia will see a GDP growth of -8.5% in 2022 and -2.3% in 2023.

    The two charts below show the GDP growth comparison in some major countries of the world after the start of the global pandemic. The first chart shows the performance in the years 2020 and 21.

    The second chart shows the projections by IMF for the years 2022 and 2023.

    Sadly, the war just doesn’t affect the countries directly involved, its economic costs and implications are widespread. Through commodity markets, trade, and to some extent financial interlinkages of the countries, the war can indirectly affect so many more countries.

    Globally we are seeing rise in fuel and food prices since late 2021. The fear of War is aggravating high inflation problem even further. Unfortunately, the world’s poor population, particularly in low-income countries is getting the most impacted by this. To know more about inflation, please click here.

    Many leading economists propose mutual efforts by countries to respond to the war crisis and prevent further economic fragmentation. At the same time, it is important to manage the debt problem, tackle climate change and end the pandemic to bring back economic growth.

    Fighting inflation without slowing down the economy is the toughest challenge many central banks are facing currently. To know more about monetary policy and the role of a central bank, in controlling inflation, please click here.

  • What is economics and why should I learn it?

    A lot of people think economics is all about money, banks, complicated graphs, and mathematical modeling, but truly speaking it is much more interesting than that.

    So, what exactly is Economics?

    Economics is a study of human behavior, understanding the choices people make with their limited resources. By resources, we mean the tools needed to produce goods and services for humans consumption for a comfortable life. These resources are usually classified into 1)land, 2)labor, 3)capital such as tools and machinery, 4)human capital or entrepreneurship, and 5)our precious time.

    We don’t usually have an infinite amount of these resources, so how do we allocate the limited resources to make us better off and happier? In short, Economics deals with our struggle to achieve happiness in a world full of constraints and limitations.

    The word Economics comes from the Greek word oikonomia, which means household management. It starts with an individual making a tradeoff, choosing the best option that satisfies their wants, and forgoing the other best alternative use of their resources. From individual households, it moves to businesses, deciding what and how much to produce and sell. And lastly, government and the central bank decide when and how to intervene to ensure maximum happiness for its citizens.

    We are making choices every single day. For example, if you are reading this, you have chosen to gain some knowledge vs. maybe, watching a TV Show or doing something else.

    While reading this, you think you are making the best use of your time. (or at least I hope you do 😉 In short, you apply economics every minute (even when you don’t know it).

    What does the field of Economics cover?

    As you learn Economics, you can find answers to some fascinating questions such as:

    • How the price of anything is set?
    • How do we measure a country’s prosperity?
    • Why are some countries rich, while others are still poor?
    • What is inflation?
    • How do we understand business cycles?
    • What tools do the central bank and government use when the economy is facing inflation or a recession?
    • Is international trade a good thing?
    • And is reading this article even worth my time?

    Trust me, the list is endless. There is a wide variety of areas that economics can cover. Economists try to solve many of these problems our world is facing today by simply understanding human behavior and the choices people make. I might have used the word choice a lot here, but hope you got the idea?

    You will understand our rapidly evolving complex economies and how the economic fundamentals can still explain the changes.

    You can apply Economics in your day-to-day life, such as while analyzing the cost and benefits of a particular decision you are going to make and managing your finances.

    Similarly, you will also understand how economic principles apply to the businesses around us from a small local donut shop to a big company like Apple.

    Understanding economics will enable you to evaluate the feasibility of promises made by politicians to get your vote.

    Believe it or not, Economics can also help us understand the best strategy to deal with environmental issues, such as global warming and pollution.

    Last but not least, since Economics is based on human behavior, there can be more than one view on any economic issue. It’s not an absolute science and many times economists differ on how a certain situation should be handled.

    When you study Economics, you can acquire the necessary skills to argue why a specific viewpoint makes more sense to you.

    Some key principles of economics are:

    • Everything has an opportunity cost and experiences diminishing returns.
    • People are rational (for the most part) and act in their self-interest (even charity is considered self-interest since it gives you some happiness).
    • Supply and demand interact through an invisible hand.
    • Comparative advantage fosters trade.
    • People think on the margin.

    I will explain the above points in detail in my other posts. We will also dig into the two main subdivisions of economics: macroeconomics and microeconomics. We are only getting started!