How can I become a master of economics?
You wake up early in the morning to go to work. The first customer walks in, declares that he’s hungry, and buys a slice. When he’s done, he buys another… and another! After three slices, though, he’s through. The utility - the enjoyment - he received from the third slice of pizza is far less than that of the first slice, and the law of diminishing utility can accurately predict that the fourth slice of pizza is certainly not worth his money.
From across the room, you spot a potential customer looking at the menu, finally deciding that $10 for a pie of pizza is just too much. The customer at the counter, though? He’s famished. He’d pay $15. You don’t know exactly what each customer is willing to pay, but you’ll try to price the pizza in order to maximize profits, while taking into account the public’s general demand for pizza.
A couple of days later, you realize that the price is too high, as you have too few customers. You lower the price, and voila! More people come. Eventually, you settle at a price which ensures that you’re making as much as you can, and that price is now in equilibrium.
The owner of the neighboring pizza parlor, meanwhile, is wondering why nobody seems to be coming ’round anymore. He stops by at your place, and notices that your pizzas sell for $8, while his go for $9. Reluctantly, he lowers his price and takes the loss. Ah, well - that’s competition for you.
A couple of days later, he knocks at your door and asks to speak with you privately. This competition isn’t good for profits, says he. What if we both raise our prices? The customers won’t walk far in order to buy a pizza elsewhere! You think about it for a moment, then decline. While this price fixing can certainly help you out in the short term, in the long term customers will plan to circumvent both of your stores, so this oligopoly of two stores which own all of the pizzas in the area won’t last long.
Are you sure? He asks. I’m sure you’ve heard of Jessica, who bought out every single pizza parlor around her area and now enjoys monopoly status. She’s making a killing! Not only is she enjoying economies of scale, which means that’s she’s able to buy pizza supplies in bulk and enjoy lower variable costs, she’s also managed to replace many workers with an automated line, making her labor far more efficient! She’s able to supply far more pizza at a lower price! Maybe we can cut some kind of deal which would work to our benefit. Maybe we could expand and build something bigger together.
True, you mull. Interest rates are particularly low, so it wouldn’t be so bad to take out a loan and invest in the business. The way you see it, the internal rate of return - how much you stand to gain by choosing to expand the business - is far better than just leaving your money in a bank. Let’s do it, you say.
The government, meanwhile, is quite happy with your decision - they want people to expand their businesses, that’s their monetary policy. They changed the interest rates using all sorts of macroeconomic tools, and are now hoping that their decision is the correct one.
After a good day’s work, you’re about to close up shop. But wait! There seems to be a crowd headed your way, encouraged by the local festival. You know that your pizza can complement the festival quite nicely and would stand to make a decent amount of money by keeping open for another hour, but you have promised your wife that you’d spend some quality time with her and the kids. You smile, and lock the store, accepting the opportunity cost - in this case, income forgone - that you’ve paid in order to make time for what you value more. Besides, your demand for family time is inelastic, even a higher price won’t make it change much - after all, if you don’t do as your wife says, you’ll be sleeping on the sofa tonight.
“Wait a minute.”, you’re probably thinking. “What if I don’t work in a pizza parlor, like you?”
Ah, but I’ve never worked in a pizza parlor. I just happened to visit one an hour ago, and that’s why I chose that particular example.
Economics, though? It’s everywhere.
And while the textbooks that you will (I hope) eventually be reading will explain in great detail what the words written above in bold mean, you can learn economics simply by opening your eyes to the world around you.
Best of luck, and enjoy!
Comments
I'd like to point out that the answer is meant to be relatively simplistic, and give the readers who haven't had as much exposure to economics a bit of an incentive to study, both by using textbook terminology and a real world example.
Obviously, economics is generally more complicated in the real world, as some people have pointed out, therefore a fuller explanation is required in some cases. If this interests you, by all means, keep reading!
First of all, as pointed out by Sung Kim, this answer assumes that pizza is an item which is the same in every single store. Therefore, if one store raises the price while the price at a different store remains the same, consumers will usually prefer the cheaper store, which will increase demand in the cheaper store and lower it in the more expensive one. However, pizza can come in many shapes and sizes, and with different toppings, appetizers, etc. Therefore, a store might raise its price without losing customers, for example, if the pizza there is better, the selection is wider, or the store is nicer. This kind of market is defined as monopolistic competition, as there are both elements of perfect competition (for which a good example would be the market for sea salt) and monopoly.
Equilibrium, per definition, is a state in which something (in most cases in economics including this one - price) reaches a point where it no longer wants to change. As Erik Madsen pointed out, this isn't the necessarily the same thing as a company (or a pizza parlor) settling on a profit-maximizing price. My original answer assumes that there aren't an obscene amount of pizza parlors nearby, therefore the stores decisions is directly influenced by the general demand for pizza and not as much from other stores. Of course, if there were many other pizza parlors nearby, they'd affect the pricing of all of the rest of the pizza parlors, change the equilibrium price, and take away from the original parlor's profits.
Erik is also right in saying that macroeconomics and macroeconomic decisions are far, far more complicated than implied in the question, and I encourage everyone to read his comment about the topic.
Krishnabh Medhi takes things one step further in his brilliantly written comment, and discusses what happens when the government gets heavily involved in the economics of the pizza parlor, most notably in the form of raising the minimum wage for the workers and subsidization of pizza. I highly recommend that you read it, although keep in mind that we're dealing with normative economics (i.e. discussion of what the economy ought to be like, and what economic decisions should be made) rather than positive economics(the way the economy works), meaning that some people may disagree with the point he's making: the government should almost never get involved and allow for free markets. Personally, I'm with Krishnabh on this one, but everyone's welcome to their views on this complex matter.
Tushar Khatri correctly points out that monetary policy is set by the Central Bank of a country and not directly by the government (as opposed to the governments fiscal policy, which deals with taxes and government spending). Still, it’s safe to say that the government is still heavily involved in the decisions made, so it isn’t completely incorrect to use the government for this particular example.
User-13712087709274714530 gives a superb example of comparative advantagein the comments, check it out!
Keep the constructive criticism coming, folks!
Post a Comment