Imperfect competition

In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied. It is a market structure that does not meet the conditions of perfect competition. ^[1]

Forms of imperfect competition include:

• Monopoly, in which there is only one seller of a good.
• Oligopoly, in which there is a small number of sellers.
• Monopolistic competition, in which there are many sellers producing highly differentiated goods.
• Monopsony, in which there is only one buyer of a good.
• Oligopsony, in which there is a small number of buyers.

There may also be imperfect competition in markets due to buyers or sellers lacking information about prices and the goods being traded.

There may also be imperfect competition due to a time lag in a market. An example is the “jobless recovery”. There are many growth opportunities available after a recession, but it takes time for employers to react, leading to high unemployment. High unemployment decreases wages, which makes hiring more attractive, but it takes time for new jobs to be created.

perfect competetion

perfect cometition:-

In neoclassical economics and microeconomics, perfect competition describes a market in which there are many small firms, all producing homogeneous goods. In the short term, such markets are productively inefficient as output will not occur where mc is equal to ac, but allocatively efficient, as output under perfect competition will always occur where mc is equal to mr, and therefore where mc equals ar. However, in the long term, such markets are both allocatively and productively efficient.^[1] In general a perfectly competitive market is characterized by the fact that no single firm has influence on the price of the product it sells. Because the conditions for perfect competition are very strict, there are few perfectly competitive markets.

A perfectly competitive market may have several distinguishing characteristics, including:

• Many buyers/Many Sellers – Many consumers with the willingness and ability to buy the product at a certain price, Many producers with the willingness and ability to supply the product at a certain price.
• Homogeneous Products – The products of the different firms are EXACTLY the same, e.g. salt.
• Low-Entry/Exit Barriers – It is relatively easy to enter or exit as a business in a perfectly competitive market.
• Perfect Information - For both consumers and producers.^[2]
• Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.

Some subset of these conditions is presented in most textbooks as defining perfect competition. More advanced textbooks (e.g. Mas-Colell et al. 1995 p. 315) try to reconcile these conditions with the definition of perfect competition as equilibrium price taking; that is whether or not firms treat price as a parameter or a choice variable. It is this distinction which differentiates perfectly competitive markets from imperfectly competitive ones. It should be noted that a general rigorous proof that the above conditions indeed suffice to guarantee price taking is still lacking (Kreps 1990, p. 265).

The importance of perfect competition derives from the fact that price taking by the firm guarantees that when firms maximize profits (by choosing quantity they wish to produce, and the combination of Factors of production to produce it with) the market price will be equal to marginal cost. An implication of this is that a factor's price (wage, rent, etc.) equals the factor's marginal revenue product. This allows for derivation of the supply curve on which the neoclassical approach is based (note that this is also the reason why "a monopoly does not have a supply curve"). The abandonment of price taking creates considerable difficulties to the demonstration of existence of a general equilibrium (Roberts and Sonnenschein 1977) except under other, very specific conditions such as that of monopolistic competition .

Contents [hide] 1 Approaches and conditions 2 Results 2.1 Profit 3 The shutdown point 4 Examples 5 Criticisms 6 See also 7 Notes 8 References

[edit] Approaches and conditions

The notion of perfect competition derives from the earlier classical notion of free competition. A freely competitive market was defined by Adam Smith as one in which there is no impediment to free contracting and free entry and exit of productive resources; the implication was that all units of the same type of productive resource (be it a kind of labor, or a kind of land, or capital) would tend to earn the same reward as in other freely competitive markets, and as a result product prices would tend toward their natural levels i.e. toward the levels allowing paying labor, land and capital their natural rates (determined by the classical theory of income distribution). This is a long-period theory of product price, in which what is essential is free mobility of productive resources, in particular free entry of firms, and competition is viewed as a dynamical process akin to competition in a race (McNulty 1967). In such a conception, competition in a product market is the stronger, the closer the price of the product gets to its natural level (later called long-period normal price by Alfred Marshall).

Historically, in neoclassical economics there have been two strands of looking at what perfect competition is. The first emphasis is on the inability of any one agent to affect prices. This is usually justified by the fact that any one firm or consumer is so small relative to the whole market that their presence or absence leaves the equilibrium price very nearly unaffected. This assumption of negligible impact of each agent on the equilibrium price has been formalized by Aumann (1964) by postulating a continuum of infinitesimal agents. The difference between Aumann’s approach and that found in undergraduate textbooks is that in the first, agents have the power to choose their own prices but do not individually affect the market price, while in the second it is simply assumed that agents treat prices as parameters. Both approaches lead to the same result.

The second view of perfect competition conceives of it in terms of agents taking advantage of – and hence, eliminating – profitable exchange opportunities. The faster this arbitrage takes place, the more competitive a market is. The implication is that the more competitive a market is under this definition, the faster the average market price will adjust so as to equate supply and demand (and also equate price to marginal costs). In this view “perfect” competition means that this adjustment takes place instantaneously. This is usually modeled via the use of the Walrasian auctioneer (see article for more information). The widespread recourse to the auctioneer tale appears to have favored an interpretation of perfect competition as meaning price taking always, i.e. also at non-equilibrium prices; but this is rejected e.g. by Arrow (1959) or Mas-Colell et al. (1995, p. 315)

Thus nowadays the dominant intuitive idea of the conditions justifying price taking and thus rendering a market perfectly competitive is an amalgam of several different notions, not all present, nor given equal weight, in all treatments. Besides product homogeneity and absence of collusion, the notion more generally associated with perfect competition is the negligibility of the size of agents, which makes them believe that they can sell as much of the good as they wish at the equilibrium price but nothing at a higher price (in particular, firms are described as each one of them facing a horizontal demand curve). However, also widely accepted as part of the notion of perfectly competitive market are perfect information about price distribution and very quick adjustments (whose joint operation establish the law of one price), to the point sometimes of identifying perfect competition with an essentially instantaneous reaching of equilibrium between supply and demand. Finally, the idea of free entry with free access to technology is also often listed as a characteristic of perfectly competitive markets, probably owing to a difficulty with abandoning completely the older conception of free competition. In recent decades it has been rediscovered that free entry can be a foundation of absence of market power, alternative to negligibility of agents (Novshek and Sonnenschein 1987.)

Free entry also makes it easier to justify the absence of collusion: any collusion by existing firms can be undermined by entry of new firms. The necessarily long-period nature of the analysis (entry requires time!) also allows a reconciliation of the horizontal demand curve facing each firm according to the theory, with the feeling of businessmen that "contrary to economic theory, sales are by no means unlimited at the current market price" (Arrow 1959 p. 49).

There are double the buyers in the market

[edit] Results

In the short-run, it is possible for an individual firm to make a profit. This situation is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost denoted by C .

However, in the long period, positive profit cannot be sustained. The arrival of new firms or expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (See cost curve.)

In a perfectly competitive market, a firm's demand curve is perfectly elastic.

As mentioned above, the perfect competition model, if interpreted as applying also to short-period or very-short-period behaviour, is approximated only by markets of homogeneous products produced and purchased by very many sellers and buyers, usually organized markets for agricultural products or raw materials. In real-world markets, assumptions such as perfect information cannot be verified and are only approximated in organized double-auction markets where most agents wait and observe the behaviour of prices before deciding to exchange (but in the long-period interpretation perfect information is not necessary, the analysis only aims at determining the average around which market prices gravitate, and for gravitation to operate one does not need perfect information).

In the absence of externalities and public goods, perfectly competitive equilibria are Pareto-efficient, i.e. no improvement in the utility of a consumer is possible without a worsening of the utility of some other consumer. This is called the First Theorem of Welfare Economics. The basic reason is that no productive factor with a non-zero marginal product is left unutilized, and the units of each factor are so allocated as to yield the same indirect marginal utility in all uses, a basic efficiency condition (if this indirect marginal utility were higher in one use than in other ones, a Pareto improvement could be achieved by transferring a small amount of the factor to the use where it yields a higher marginal utility).

A simple proof assuming differentiable utility functions and production functions is the following. Let w_j be the 'price' (the rental) of a certain factor j, let MP_j1 and MP_j2 be its marginal product in the production of goods 1 and 2, and let p₁ and p₂ be these goods' prices. In equilibrium these prices must equal the respective marginal costs MC₁ and MC₂; remember that marginal cost equals factor 'price' divided by factor marginal productivity (because increasing the production of good i by one very small unit through increase of the employment of factor j requires increasing the factor employment by 1/MP_ji and thus increasing the cost by w_j/MP_ji, and through the condition of cost minimization that marginal products must be proportional to factor 'prices' it can be shown that the cost increase is the same if the output increase is obtained by optimally varying all factors). Optimal factor employment by a price-taking firm requires equality of factor rental and factor marginal revenue product, w_j=p_iMP_ji, so we obtain p₁=MC₁=w_j/MP_j1, p₂=MC_j2=w_j/MP_j2.

Now choose any consumer purchasing both goods, and measure his utility in such units that in equilibrium his marginal utility of money (the increase in utility due to the last unit of money spent on each good), MU₁/p₁=MU₂/p₂, is 1. Then p₁=MU₁, p₂=MU₂. The indirect marginal utility of the factor is the increase in the utility of our consumer achieved by an increase in the employment of the factor by one (very small) unit; this increase in utility through allocating the small increase in factor utilization to good 1 is MP_j1MU₁=MP_j1p₁=w_j, and through allocating it to good 2 it is MP_j2MU₂=MP_j2p₂=w_j again. With our choice of units the marginal utility of the amount of the factor consumed directly by the optimizing consumer is again w, so the amount supplied of the factor too satisfies the condition of optimal allocation.

Monopoly violates this optimal allocation condition, because in a monopolized industry market price is above marginal cost, and this means that factors are underutilized in the monopolized industry, they have a higher indirect marginal utility than in their uses in competitive industries. Of course this theorem is considered irrelevant by economists who do not believe that general equilibrium theory correctly predicts the functioning of market economies; but it is given great importance by neoclassical economists and it is the theoretical reason given by them for combating monopolies and for antitrust legislation.

[edit] Profit

In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn economic profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. In order not to misinterpret this zero-long-run-profits thesis, it must be remembered that the term 'profit' is also used in other ways. Neoclassical theory defines profit as what is left of revenue after all costs have been subtracted, including normal interest on capital plus the normal excess over it required to cover risk, and normal salary for managerial activity. Classical economists on the contrary defined profit as what is left after subtracting costs except interest and risk coverage; thus, if one leaves aside risk coverage for simplicity, the neoclassical zero-long-run-profit thesis would be re-expressed in classical parlance as profits coinciding with interest in the long period, i.e. the rate of profit tending to coincide with the rate of interest. Profits in the classical meaning do not tend to disappear in the long period but tend to normal profit. With this terminology, if a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit only.

It is important to note that perfect competition is a sufficient condition for allocative and productive efficiency, but it is not a necessary condition. Laboratory experiments in which participants have significant price setting power and little or no information about their counterparts consistently produce efficient results given the proper trading institutions (Smith, 1987, p. 245).

[edit] The shutdown point

When a firm is making a loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.

If the firm is in the short run, and is making a loss whereby:

• Total costs (TC) is greater than total revenue (TR)
• and whereby total revenue is equal to or greater than total variable cost (TVC)

it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so that the only costs the firm will have to pay will be the fixed costs.

Even if the firm stops producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:

• Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
• Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.

In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve.

If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).

[edit] Examples

Some agricultural markets, with numerous suppliers and almost perfectly substitutable products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto efficiency to apply.

Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all requirements of the model) but as an approximation. The flaw in considering the stock exchange as an example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may solely influence the market price. This, of course, violates the condition that "no one seller can influence market price".

eBay auctions can be often seen as perfectly competitive. There are very low barriers to entry (anyone can sell a product, provided they have some knowledge of computers and the Internet), many sellers of common products and many potential buyers.

In the eBay market competitive advertising does not occur, because the products are homogeneous and this would be redundant. However, generic advertising (advertising which benefits the industry as a whole and does not mention any brand names) may occur.

Free software works along lines that approximate perfect competition. Anyone is free to enter and leave the market at no cost. All code is freely accessible and modifiable, and individuals are free to behave independently. Free software may be bought or sold at whatever price that the market may allow.

[edit] Criticisms

The use of the assumption of perfect competition as the foundation of price theory for product markets is often criticized as representing all agents as passive, thus removing the active attempts to increase one's welfare or profits by price undercutting, product design, advertising, innovation, activities that - the critics argue - characterize most industries and markets. These criticisms point to the frequent lack of realism of the assumptions of product homogeneity and impossibility to differentiate it, but apart from this the accusation of passivity appears correct only for short-period or very-short-period analyses, in long-period analyses the inability of price to diverge from the natural or long-period price is due to active reactions of entry or exit. A frequent criticism is that it is often not true that in the short run differences between supply and demand cause changes in price; especially in manufacturing, the more common behaviour is alteration of production without nearly any alteration of price (Lee 1998). Anyway, the critics of the assumption of perfect competition in product markets seldom question the basic neoclassical view of the working of market economies for this reason. The Neo-Austrian school insists strongly on this criticism, and yet the neoclassical view of the working of market economies as fundamentally efficient, reflecting consumer choices and assigning to each agent his/her contribution to social welfare, is esteemed to be fundamentally correct (Kirzner 1981). Some non-neoclassical schools, like Post-Keynesians, reject the neoclassical approach to value and distribution, but not because of their rejection of perfect competition as a reasonable approximation to the working of most product markets; the reasons for rejection of the neoclassical 'vision' are different views of the determinants of income distribution and of aggregate demand (Petri 2004). In particular, the rejection of perfect competition does not generally entail the rejection of free competition as characterizing most product markets; indeed it has been argued (Clifton 1977) that competition is stronger nowadays than in 19th century capitalism, owing to the increasing capacity of big conglomerate firms to enter any industry: therefore the classical idea of a tendency toward a uniform rate of return on investment in all industries owing to free entry is even more valid to-day; and the reason why General Motors, Exxon or Nestle do not enter the computers or pharmaceutical industries is not insurmountable barriers to entry but rather that the rate of return in the latter industries is already sufficiently in line with the average rate of return elsewhere as not to justify entry. On this few economists, it would seem, would disagree, even among the neoclassical ones. Thus when the issue is normal, or long-period, product prices, differences on the validity of the perfect competition assumption do not appear to imply important differences on the existence or not of a tendency of rates of return toward uniformity as long as entry is possible, and what is found fundamentally lacking in the perfect competition model is the absence of marketing expenses and innovation as causes of costs that do enter normal average cost.

The issue is different with respect to factor markets. Here the acceptance or denial of perfect competition in labour markets does make a big difference to the view of the working of market economies. One must distinguish neoclassical from non-neoclassical economists. For the former, absence of perfect competition in labour markets, e.g. due to the existence of trade unions, impedes the smooth working of competition, which if left free to operate would cause a decrease of wages as long as there were unemployment, and would finally ensure the full employment of labour: labour unemployment is due to absence of perfect competition in labour markets. Most non-neoclassical economists deny that a full flexibility of wages would ensure the full employment of labour and find a stickiness of wages an indispensable component of a market economy, without which the economy would lack the regularity and persistence indispensable to its smooth working. This was, for example, Keynes's opinion. Particularly radical is the view of the Sraffian school on this issue: the labour demand curve cannot be determined hence a level of wages ensuring the equality between supply and demand for labour does not exist, and economics should resume the viewpoint of the classical economists, according to whom competition in labour markets does not and cannot mean indefinite price flexibility as long as supply and demand are unequal, it only means a tendency to equality of wages for similar work, but the level of wages is necessarily determined by complex sociopolitical elements; custom, feelings of justice, informal allegiaces to classes, as well as overt coalitions such as trade unions, far from being impediments to a smooth working of labour markets that would be able to determine wages even without these elements, are on the contrary indispensable because without them there would be no way to determine wages (Garegnani 1990).

The Multiplier-Accelerator Model (also known as the Accelerator-Multiplier Model) is proposed by the English economist Roy Harrod (1900-1978) and the American economist Paul Samuelson (1915- ). Their work was an extension of the works of English economists John Maynard Keynes (1883-1946) and Richard Kahn (1905-1989).
The Multiplier-Accelerator Model analyzes economic fluctuations by combining the assertions of the acceleration and multiplier models. The cyclical process this model holds can be summarized in the following 4-step example:
1- Government expenditure increases, and boosts consumer income.2- Consumer income raises aggregate output (through the multiplier effect).3- Net investment also increases (through the acceleration process). 4- The process starts to repeat itself.
Also see: Kondratieff cycles, sunspot theory, product life-cycle theory, acceleration principle, fine-tuning, political business cycle, trade cycle

Acceleration Principle
(1917)
Acceleration principle is formulated by American economist John Maurice Clark (1884-1963).
Acceleration principle is a theory of investment in modern macroeconomics. It asserts that the level of investment is accelerated only through the rate of increase in output, which is the gross domestic product. Since the acceleration principle links investment to output, it is has explanatory value also in understanding the development of business cycles.
According to the acceleration principle, each level of output needs a specific amount of capital. Therefore, if output (and the capital required to procure the necessary machinery) is expected to rise, the amount of capital within an economy will also increase. The accelerator equation is:
I = Α Δt, where:
I is net investment in year t,Α is the accelerator coefficient, andΔt is the annual change in income.
Also see: business cycle, Harrod-Domar growth model, trade cycle

Ability-to-Pay Principle
(16th century)
Ability-to-pay principle envisages that taxation should be levied according to an individual's ability to pay; that is, individuals with higher incomes should be charged higher taxes.
Individuals with higher incomes are charged more taxes not because they use more government goods and services but because they have the ability to pay more. The primary indicator of ability to pay is commonly agreed to be income. Ability-to-pay principle is therefore in contrast with the benefit approach principle, which determines the amount of taxes a person should pay by the benefits received in public services. Ability-to-pay principle is based not on the benefits received but on the notion of equal sacrifice. It is considered to be characteristic of a socialist sentiment, and is used in most industrialized economies; but equality of sacrifice, is open to interpretation as it can be easured in absolute, proportional or marginal terms.
The main downside of the ability-to-pay principle is that it diminishes the incentive to work, since a higher portion of the generated income will be collected by the government as taxes.
Ability-to-pay principle was extended by the Swiss philosopher Jean-Jacques Rousseau (1712-1778), the French political economist Jean-Baptiste Say (1767-1832) and the English economist John Stuart Mill (1806-1873).
The most popular variant of the ability-to-pay principle is called the equal marginal sacrifice principle.
Absolute advantage theory asserts that a nation benefits from manifacturing more output than others since it is in the possession of a particular resource or commodity. This particular resource can also be a certain method or knowledge that increases the production efficiency, and thus reduces the relative need to resources.
Also see: comparative advantage theory, comparative costs, Heckscher-Ohlin trade theory, technological gap theory

components of aggregate demand

Components of Aggregate Demand Introduction Aggregate demand tells the quantity of goods and services demanded in an economy at a given price level. In effect, the aggregate demand curve is a just like any other demand curve, but for the sum total of all goods and services in an economy. It tells the total amount that all consumers, businesses, and the government are willing to spend on goods and services at different price levels. The aggregate demand curve can be thought of just like a demand curve for a firm. When the price level is high, aggregate demand is low; when the price level is low, aggregate demand is high. The aggregate demand curve lies in a plane consisting of the price level and income or output. It shows a downward slope with price level on the vertical axis and income or output on the horizontal axis. As such, the aggregate demand curve outlines the relationship between income or output and the price level. It is important to notice that aggregate demand is a schedule because as the price level changes, the income or output also changes. There are four major components of aggregate demand. The equation for aggregate demand, Y = C(Y - T) + I(r) + G + NX(e), tells much about the nature of both aggregate demand and the curve that represents this schedule. Components of aggregate demand The equation for aggregate demand proposed by the Mundell-Fleming model of a large open economy is Y = C(Y - T) + I(r) + G + NX(e). Y represents income or output. C(Y - T) represents consumption as a function of disposable income, defined as income less taxes. I(r) represents investment as a function of the interest rate, where an increase in the interest rate decreases investment. G represents government spending, which is predominately unaffected by interest rates. Finally, NX(e) represents net exports, defined as exports less imports as a function of the real exchange rate, where an increase in the real exchange rate decreases net exports. Understanding the details of each component of aggregate demand is an important first step toward understanding aggregate demand. The first piece of the aggregate demand equation is Y. This represents output or income. Because Y is the total amount of goods and services purchased by consumers, businesses, and the government, taking into account foreign trade, it is necessarily the output for the economy. This number is also the gross domestic product of an economy. Because every unit of output within an economy turns into income for members of the economy, it is reasonable to call output income. More specifically, the output of an economy is the national income for the economy. The per capita income is the national income for the economy divided by the population. This number is useful for comparing the standard of living across countries. All of this information directly results from the aggregate demand equation. The second piece of the aggregate demand equation is C(Y - T). This signifies that consumption is a function of disposable income. Disposable income is the money that consumers have left to spend after taxes. The function for consumption is aggregated across all consumers and thus is applicable for all incomes and tax brackets. Consumption captures spending by households on goods and services. Examples include purchasing food, movie tickets, and vacations. The third piece of the aggregate demand equation is I(r). This signifies that investment spending is a function of the real interest rate. That is, as the real interest rate increases, investment spending falls because the cost of borrowing money increases. The real interest rate is simply the nominal interest rate as published in the media corrected for expected inflation. When firms consider investment spending, they routinely take into account the nominal interest rate, inflation, and the real interest rate. Examples of investment spending include machinery, buildings, education, and new housing. The fourth piece of the aggregate demand equation is G. Government spending encompasses every expenditure made by the government. The total amount of money spent by the government is often surprising. In fact, it is not unusual for government spending to constitute upwards of one third of gross domestic product. The level of government spending is a hotly debated topic as political parties vie for their programs in the annual budget. Examples of government spending include salaries to government employees, defense spending, welfare and social security programs, and foreign aid. The fifth piece of the aggregate demand equation is NX(e). Net exports are defined as the difference between exports and imports. It is important to recognize that net exports are dependent upon the real exchange rate. As the real exchange rate rises, domestic currency is relatively more valuable and thus the price of domestic goods is relatively more expensive than the price of foreign goods. In this case, exports fall and imports rise, causing net exports to decline. Interestingly, a thriving domestic economy will result in a higher real exchange rate and thus lower net exports. Examples of exports include cars and electronics made in the US and sold Asian countries. Examples of imports include fruits and vegetables grown in New Zealand and sold in the US. The equation for aggregate demand of Y = C(Y - T) + I(r) + G + NX(e) has now been deciphered. This equation has many meanings such as output, national income, and GDP. It is difficult, or impossible, to think of economic activity that is not represented in the aggregate demand equation. This is the idea of aggregate demand: to capture all economic activity within an economy
The Aggregate Demand Curve Downward sloping aggregate demand curve
Figure 2.1: Graph of the aggregate demand curve. The most noticeable feature of the aggregate demand curve is that it is downward sloping, as seen in figure 2.1. There are a number of reasons for this relationship. Recall that a downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together. The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand. The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans--that is, the interest rate--decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand. The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases. IS-LM model of aggregate demand There is another major model that is useful for explaining the nature of the aggregate demand curve. This model is called the IS-LM model after the two curves that are involved in the model. The IS curve describes equilibrium in the market for goods and services where Y = C(Y - T) + I(r) + G and the LM curve describes equilibrium in the money market where M/P = L(r,Y). The IS-LM model exists in a plane with r, the interest rate, on the vertical axis and Y, being both income and output, on the horizontal axis. The IS-LM model has the same horizontal axis as the aggregate demand curve, but a different vertical axis.
Figure 2.2: Graph of the IS-LM curves. The IS curve describes equilibrium in the market for goods and services in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium in the market for money. The LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level. The IS curve and the LM curve shift in response to economic activities. The IS curve shifts outward as a result of increased government purchases, exogenous increases in investment, decreases in taxes, and exogenous increases in consumption. The IS curve shifts inward as a result of decreases in government purchases, exogenous decreases in investment, increases in taxes, and exogenous decreases in consumption. The LM curve shifts outward as a result of increases in the money supply and decreases in the price level. The LM curve shifts inward as a result of decreases in the money supply and increases in the price level. The aggregate demand curve can be derived using the IS-LM model. Recall that the aggregate demand curve relates price level to income and output. The simplest way to derive the downward sloping aggregate demand curve from the IS-LM model is to look at the effects of an increase in the price level on output or income. When the price level increases, the LM curve shifts inward. An inward shift in the LM curve results in an intersection of the IS-LM model at a lower level of output and income and a higher interest rate. When a line connecting the old price level and the old output and income to the new price level and the new output and income in the price level and output and income space, the downward sloping aggregate demand curve appears. In general, from the IS-LM model, it is clear that aggregate demand slopes downward because as the price level increases, output and income decrease. The IS-LM curve is a useful way to incorporate the money market into the logic driving the aggregate demand curve. By understanding the basics of the IS-LM model and the three reasons that the aggregate demand curve is downward sloping as presented under the previous heading, the nature of the aggregate demand curve is clear. The next step to work through is how shifts of and shifts along the aggregate demand curve function. In this capacity, the IS-LM model will become very useful.
Shifts in the Aggregate Demand Curve Shifts to the left There are many actions that will cause the aggregate demand curve to shift. When the aggregate demand curve shifts to the left, the total quantity of goods and services demanded at any given price level falls. This can be thought of as the economy contracting. To understand what causes the economy to contract, let's start with the basic equation for the demand curve. Recall that the price level is not directly in the equation for aggregate demand. Rather, it is implicit in each of the terms in the equation. We know that aggregate demand is comprised of C(Y - T) + I(r) + G + NX(e) = Y. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left. The first term that will lead to a shift in the aggregate demand curve is C(Y - T). This term states that consumption is a function of disposable income. If disposable income decreases, consumption will also decrease. There are many ways that consumption can decrease. An increase in taxes would have this effect. Similarly, a decrease in income--holding taxes stable--would also have this effect. Finally, a decrease in the marginal propensity to consume or an increase in the savings rate would also decrease consumption. The second term that will lead to a shift in the aggregate demand curve is I(r). This term states that investment is a function of the interest rate. If the interest rate increases, investment falls as the cost of investment rises. There are a number of ways that investment can fall. If the interest rate rises, say due to contractionary monetary or fiscal policy, investment will fall. Similarly, in the short run, expansionary fiscal policy will also cause investment to fall as crowding out occurs. Another interesting cause of a fall in investment is an exogenous decrease in investment spending. This occurs when firms simply decide to invest less without regard for the interest rate. The term variable that will lead to a shift in the aggregate demand curve is G. This term captures the whole of government spending. The only way that government spending is changed is though fiscal policy. Recall that the budgetary debate is an ongoing political battlefield. Thus, government spending tends to change regularly. When government spending decreases, regardless of tax policy, aggregate demand decrease, thus shifting to the left. The fourth term that will lead to a shift in the aggregate demand curve is NX(e). This term means that net exports, defined as exports less imports, is a function of the real exchange rate. As the real exchange rate rises, the dollar becomes stronger, causing imports to rise and exports to fall. Thus, policies that raise the real exchange rate though the interest rate will cause net exports to fall and the aggregate demand curve to shift left. Again, an exogenous decrease in the demand for exported goods or an exogenous increase in the demand for imported goods will also cause the aggregate demand curve to shift left as net exports fall. An example of this type of exogenous shift would be a change in tastes or preferences. Shifts to the right The aggregate demand curve also can shift right as the economy expands. When the aggregate demand curve shifts right, the quantity of output demanded for a given price level rises. Therefore, a shift of the aggregate demand curve to the right represents an economic expansion. A shift of the aggregate demand curve to the right is simply effected by the opposite conditions that cause it to shift to the left. Limits of aggregate demand The aggregate demand curve alone is useful. It tells how the price level and output or income are related. It shows the general effects of changes in many economic variables and the relationship between price level and output or income. But there are limits to its usefulness. It cannot show where the economy currently sits. Similarly, it cannot predict the effects of an economic policy upon the economy. In the next section, we will look at aggregate supply. This counterpart to aggregate demand completes the AS-AD model of the macroeconomy. That is, the aggregate supply and aggregate demand model of the economy is based on the total demand for goods and services and the total supply of goods and services. Once you are comfortable with the reasons for the downward sloping aggregate demand curve and with the ways and directions that the aggregate demand curve shifts, you are prepared to move on to the aggregate supply curve. The aggregate demand curve tells how the price level and output and income are related. It shows the general effects of changes in many economic variables on the relationship between price level and output and income.
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aggregate demand

Aggregate demandFrom Wikipedia, the free encyclopedia(Redirected from Aggregation of individual demand to total, or market, demand)Jump to: navigation, searchThis article does not cite any references or sources.Please help improve this article by adding citations to reliable sources. (help, get involved!)Any material not supported by sources may be challenged and removed at any time. This article has been tagged since December 2006.In economics, aggregate demand is the total demand for goods and services in the economy (Y) during a specific time period. An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand has five main parts[1]:
where
is consumption, is Investment, is Government spending, is Net export, is total exports, and is total imports. In fact, many people would ask about the relationship between output and the price level. Does changing prices affect the output? The answer is yes, but many economics books assume that the price level is constant, just to keep the relationships between the economic factors simple. It is often called effective demand. Put another way, it is the demand for the gross domestic product of a country when, and only when, it is in equilibrium (i.e. without changes in inventory). This demand consists of four major parts, which can be stated in either nominal or "real" terms:
personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function. The consumption function is C= a + (mpc)(Y-T) a is autonomous consumption, mpc is the marginal propensity to consume, (Y-T) is the disposable income.
gross private domestic investment (I), demand by business firms and some individuals, for new factories, machinery, computer software, housing, other structures, and inventories. In addition, Investment is effected by the output and the interest rate (i). Consequently, we can write it as I(Y,i). Investment has positive relationship with the output and negative relationship with the interest rate. For example, when Y goes up, the investment will increase. gross government investment and consumption expenditures (G). net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output. In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand.
In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + (X-M). Strictly speaking, it is questionable whether this aggregation is possible, as it is impossible to form such macrovariables from some microvariables: how do you add up litres of gasoline and toothbrushes? In the sense of nominal monetary values (prices) this is possible; but in the sense of real goods it is not. Therefore it might be argued that an "aggregate demand curve" does not even exist in an (income,spending)-space.
Contents [hide]1 Two Concepts of the "Aggregate Demand Curve" 1.1 Keynesian Cross 1.2 Marshallian Cross 1.3 Marxian critique 2 See also 3 External links
[edit] Two Concepts of the "Aggregate Demand Curve"Understanding of the aggregate demand curve depends on whether it is examined based on changes in demand as income changes, or as price change.
[edit] Keynesian CrossIn the "Keynesian cross diagram," a desired total spending (or aggregate expenditure, or "aggregate demand") curve is often drawn as a rising level of D as total national output and income rise. This increase is due to the positive relationship between C and consumers' disposable income in the consumption function. It may also rise due to increases in investment (due to the accelerator effect), while this rise is reduced if imports and tax revenues rise with income. Equilibrium in this diagram occurs where total spending (D) equals the total amount of national income (which corresponds to total national output or production). Here, a total demand equals total supply.
In the diagram, the equilibrium level of output, income, and demand is determined where this desired spending curve intersects the "Z curve," a line that represents the equality of total income and output. This is at point E, determining the equilibrium levels of output and income on the horizontal axis (where the arrow points).
The movement toward equilibrium is mostly via changes in inventories inducing changes in production and income. If current output exceeds the equilibrium, inventories accumulate, encouraging businesses to cut back on production, moving the economy toward equilibrium. Similarly, if the level of production is below the equilibrium, then inventories run down, encouraging an increase in production and thus a move toward equilibrium. This equilibration process occurs when the equilibrium is stable, i.e., when the D line is steeper than the Z line.
The equilibrium level of output determines the equilibrium level of employment in the model. (In a dynamic view, these are connected by Okun's Law.) There is no reason within the model why the equilibrium level of employment should correspond to full employment. Bringing in other considerations may imply this correspondence, though.
If any of the components of aggregate demand (C + Ip + G + NX) rises at each level of income, for example because business becomes more optimistic about future profitability, that shifts the entire D line upward. This raises equilibrium income and output. Similarly, if the elements of D fall, that shifts the line downward and lowers equilibrium output. (The Z line does not shift under the definition used here.)
[edit] Marshallian CrossSometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.
Thus, that we could refer to an "aggregate quantity demanded" (Yd = C + Ip + G + NX in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator), P.
In these diagrams, typically the Yd rises as the average price level (P) falls, as with the AD line in the diagram. The main theoretical reason for this is that if the nominal money supply (Ms) is constant, a falling P implies that the real money supply (Ms/P)rises, encouraging lower interest rates and higher spending. This is often called the "Keynes effect."
Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to which increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation). In the diagram, an increase in any of the components of AD (at any given P) shifts the AD curve to the right. This increases both the level of real production (Y) and the average price level (P).
But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of real gross domestic product and thus large amounts of unemployed resources, most economists of the Keynesian school suggest that most of the change would be in the form of output and employment increases. As the economy gets close to potential output (Y*), we would see more and more price increases rather than output increases as AD increases.
Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater than Y* cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in operating above potential, the AS curve will shift to the left, making the increases in real output transitory.
At low levels of Y, the world is more complicated. First, most modern industrial economies experience few if any falls in prices. So the AS curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.
[edit] Marxian critiqueIn Marxian economics, the equation of aggregate demand with expenditure on GDP is rejected as false, on conceptual and statistical grounds.
Firstly, GDP as a measure of value added excludes purchases of all intermediate goods used up in production.
Secondly, Gross Output from which GDP is derived by deducting intermediate expenditures, encompasses only those flows of income or expenditure regarded as related to production. Property income in the form of certain types of interest, transfers, land rents and realised capital gains from asset sales are excluded from gross output and GDP. Therefore, if the amount of property income (or transfers) increases, although GDP remains constant, national income receipts can nevertheless increase, and consequently aggregate demand can also increase.
Thirdly, Gross fixed capital formation measures only investment in productive fixed assets and does not constitute total investment, which includes also purchases of financial assets.
Fourthly, GDP in principle excludes sales of second-hand assets except for those modified by some prior productive activity (e.g. reconditioned cars).
Finally, expenditure on GDP obviously disregards the creation of credit money by banks and governments, which boosts aggregate demand.
Thus, it is argued, the catch-all Keynesian notion of aggregate demand:
obscures the distribution of income between social classes with different propensities to save, consume and invest, and fails to differentiate appropriately between different kinds of investment and consumption expenditure. The implication is that restraining consumption and a higher savings rate does not automatically imply more investment, and lower investment does not automatically mean higher consumption expenditure. Funds may (as Keynes himself acknowledges) be hoarded in some form, diverted to luxury consumption, used for speculation or spent on arms procurement for example..
Unlike the aggregate demand curve, the aggregate supply curve does not usually shift independently. This is because the equation for the aggregate supply curve contains no terms that are indirectly related to either the price level or output. Instead, the equation for aggregate supply contains only terms derived from the AS-AD model. For this reason, to understand how the aggregate supply curve shifts, we must work from the AS-AD model as a whole. Figure 3.1: Graph of the AS-AD model Figure 3.1 depicts the AS-AD model. The intersection of the short-run aggregate supply curve, the long-run aggregate supply curve, and the aggregate demand curve gives the equilibrium price level and the equilibrium level of output. This is the starting point for all problems dealing with the AS- AD model. Shifts in Aggregate Demand in the AS-AD Model The primary cause of shifts in the economy is aggregate demand. Recall that aggregate demand can be affected by consumers both domestic and foreign, the Fed, and the government. For a review of the shifters of aggregate demand, see the SparkNote on aggregate demand. In general, any expansionary policy shifts the aggregate demand curve to the right while any contractionary policy shifts the aggregate demand curve to the left. In the long run, though, since long-term aggregate supply is fixed by the factors of production, short-term aggregate supply shifts to the left so that the only effect of a change in aggregate demand is a change in the price level. Figure 3.2: Graph of an expansionary shift in the AS-AD model. Let's work through an example. For this example, refer to Figure 3.2. Notice that we begin at point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand curve 1. The point where the short-run aggregate supply curve and the aggregate demand curve meet is always the short-run equilibrium. The point where the long-run aggregate supply curve and the aggregate demand curve meet is always the long-run equilibrium. Thus, we are in long-run equilibrium to begin. Now say that the Fed pursues expansionary monetary policy. In this case, the aggregate demand curve shifts to the right from aggregate demand curve 1 to aggregate demand curve 2. The intersection of short- run aggregate supply curve 1 and aggregate demand curve 2 has now shifted to the upper right from point A to point B. At point B, both output and the price level have increased. This is the new short-run equilibrium. But, as we move to the long run, the expected price level comes into line with the actual price level as firms, producers, and workers adjust their expectations. When this occurs, the short-run aggregate supply curve shifts along the aggregate demand curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect. This is represented by point C and is the new equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus, expansionary policy causes output and the price level to increase in the short run, but only the price level to increase in the long run. Figure 3.3: Graph of a contractionary shift in the AS- AD model The opposite case exists when the aggregate demand curve shifts left. For example, say the Fed pursues contractionary monetary policy. For this example, refer to Figure 3.3. Notice that we begin again at point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand curve 1. We are in long-run equilibrium to begin. If the Fed pursues contractionary monetary policy, the aggregate demand curve shifts to the left from aggregate demand curve 1 to aggregate demand curve 2. The intersection of short-run aggregate supply curve 1 and the aggregate demand curve has now shifted to the lower left from point A to point B. At point B, both output and the price level have decreased. This is the new short-run equilibrium. But, as we move to the long run, the expected price level comes into line with the actual price level as firms, producers, and workers adjust their expectations. When this occurs, the short-run aggregate supply curve shifts down along the aggregate demand curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect. This is represented by point C and is the new equilibrium where short-run aggregate supply curve 2 meets the long-run aggregate supply curve and aggregate demand curve 2. Thus, contractionary policy causes output and the price level to decrease in the short run, but only the price level to decrease in the long run. This is the logic that is applied to all shifts in aggregate demand. The long-run equilibrium is always dictated by the intersection of the vertical long-run aggregate supply curve and the aggregate demand curve. The short-run equilibrium is always dictated by the intersection of the short-run aggregate supply curve and the aggregate demand curve. When the aggregate demand curve shifts, the economy always shifts from the long-run equilibrium to the short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules and the examples above in mind it is possible to interpret the effects of any aggregate demand shift in both the short run and in the long run. Shifts in Aggregate Supply in the AS-AD Model Shifts in the short-run aggregate supply curve are much rarer than shifts in the aggregate demand curve. Usually, the short-run aggregate supply curve only shifts in response to the aggregate demand curve. But, when a supply shock occurs, the short-run aggregate supply curve shifts without prompting from the aggregate demand curve. Fortunately, the correction process is exactly the same for a shift in the short-run aggregate supply curve as it is for a shift in the aggregate demand curve. That is, when the short-run aggregate supply curve shifts, a short- run equilibrium exists where the short-run aggregate supply curve intersects the aggregate demand curve. Then the aggregate demand curve shifts along the short-run aggregate supply curve until the aggregate demand curve intersects both the short-run and the long-run aggregate supply curves. Once the economy reaches this new long-run equilibrium, the price level is changed but output is not. There are two types of supply shocks. Adverse supply shocks include things like increases in oil prices, a drought that destroys crops, and aggressive union actions. In general, adverse supply shocks cause the price level for a given amount of output to increase. This is represented by a shift of the short-run aggregate supply curve to the left. Positive supply shocks include things like decreases in oil prices or an unexpected great crop season. In general, positive supply shocks cause the price level for a given amount of output to decrease. This is represented by a shift of the short-run aggregate supply curve to the right. Figure 3.4: Graph of a positive supply shock in the AS- AD model Let's work through an example. For this example, refer to Figure 3.4. Notice that we begin at point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand curve 1. Thus, we are in long-run equilibrium to begin. Now say that a positive supply shock occurs: a reduction in the price of oil. In this case, the short-run aggregate supply curve shifts to the right from short-run aggregate supply curve 1 to short-run aggregate supply curve 2. The intersection of short- run aggregate supply curve 2 and aggregate demand curve 1 has now shifted to the lower right from point A to point B. At point B, output has increased and the price level has decreased. This is the new short-run equilibrium. However, as we move to the long run, aggregate demand adjusts to the new price level and output level. When this occurs, the aggregate demand curve shifts along the short-run aggregate supply curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect. This is represented by point C and is the new equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus, a positive supply shock causes output to increase and the price level to decrease in the short run, but only the price level to decrease in the long run. Figure 3.5: Graph of an adverse supply shock in the AS- AD model Let's work through another example. For this example, refer to Figure 3.5. Notice that we begin at point A where short-run aggregate supply curve 1 meets the long run aggregate supply curve and aggregate demand curve 1. Thus, we are in long-run equilibrium to begin. Now say that an adverse supply shock occurs: a terrifying increase in the price of oil. In this case, the short-run aggregate supply curve shifts to the left from short-run aggregate supply curve 1 to short-run aggregate supply curve 2. The intersection of short-run aggregate supply curve 2 and aggregate demand curve 1 has now shifted to the upper left from point A to point B. At point B, output has decreased and the price level has increased. This condition is called stagflation. This is also the new short- run equilibrium. However, as we move to the long run, aggregate demand adjusts to the new price level and output level. When this occurs, the aggregate demand curve shifts along the short-run aggregate supply curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect. This is represented by point C and is the new equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus, an adverse supply shock causes output to decrease and the price level to increase in the short run, but only the price level to increase in the long run. This is the logic that is applied to all shifts in short-run aggregate supply. The long-run equilibrium is always dictated by the intersection of the vertical long run aggregate supply curve and the aggregate demand curve. The short-run equilibrium is always dictated by the intersection of the short-run aggregate supply curve and the aggregate demand curve. When the short-run aggregate supply curve shifts, the economy always shifts from the long-run equilibrium to the short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules and the examples above in mind, it is possible to interpret the effects of any short-run aggregate supply shift, or supply shock, in both the short run and in the long run. Conclusions from the AS-AD Model This section has served a number of purposes. First, we covered how and why the short-run aggregate supply curve shifts. Second, we reviewed how and why the aggregate demand curve shifts. Third, we introduced the mechanism that moves the economy from the long run to the short run and back to the long run when there is a change in either aggregate supply or aggregate demand. At this stage, you have the ability to use the highly realistic model of the macroeconomy provided by the AS-AD diagram to analyze the effects of macroeconomic policies. This will prove to be the most powerful tool in your collection for understanding the macroeconomy. Use it wisely!
CompetitionFrom Wikipedia, the free encyclopediaJump to: navigation, searchCompetition is the act of striving against others for the purpose of achieving dominance. It is a term that is commonly used in numerous fields, including business, ecology, economics, music, politics, and sports. Competition may be between two or more forces, systems, individuals, or groups, depending on the context in which the term is used.
Competition may yield various results, including both intrinsic and extrinsic rewards. Some results, such as resources or territory, may be biologically motivated because they provide survival advantages. Others, such as competition in business and politics, are learned aspects of human culture. Additionally, extrinsic symbols such as trophies, plaques, ribbons, prizes, or laudations may be given to the winner. Such symbolic rewards are commonly used in human sporting and academic competitions.
The Latin root for the verb "to compete" is "competere" which means "to seek together" or "to strive together." [1]
However, even the general definition stated above is not universally accepted. Social theorists, most notably Alfie Kohn (No Contest: The Case Against Competition [1986]), and cooperativists in general argue that the traditional definition of competition is too broad and too vague. Competition that originates internally and is biologically motivated can and should be defined as either amoral competition or simply survival instinct, behavior that is neither good nor bad but exists to further the survival of an individual or species (e.g., hunting), or behavior that is coerced (e.g., self-defense).
They offer a definition of competition that distinguishes between amoral and moral behavior: Competition is a mutually voluntary activity in which success is based upon the forced failure of someone else.

Contents [hide]1 Sizes and levels of competition 2 Consequences of competition 3 Competition in different fields 3.1 Economics and business competition 3.2 Competition in politics 3.3 Sports competition 3.4 Competition in education 3.5 Competition in biology and ecology 4 The study of competition 4.1 Competitiveness 4.2 Hypercompetitiveness 5 See also 6 External links 7 References
[edit] Sizes and levels of competitionCompetition may also exist at different sizes; some competitions may be between two members of a species, while other competitions can involve entire species. In an example in economics, a competition between two small stores would be considered small compared to competition between several mega-giants. As a result, the consequences of the competition would also vary- the larger the competition, the larger the effect.
In addition, the level of competition can also vary. At some levels, competition can be informal and be more for pride or fun. However, other competitions can be extreme and bitter; for example, some human wars have erupted because of the intense competition between two nations or nationalities.
[edit] Consequences of competitionCompetition can have both beneficial and detrimental effects. Many evolutionary biologists view inter-species and intra-species competition as the driving force of adaptation and ultimately, evolution. However, some biologists, most famously Richard Dawkins, prefer to think of evolution in terms of competition between single genes, which have the welfare of the organism 'in mind' only insofar as that welfare furthers their own selfish drives for replication. Some social Darwinists claim (controversially) that competition also serves as a mechanism for determining the best-suited group, politically, economically, and ecologically.
On the negative side, competition can cause injury to the organisms involved, and drain valuable resources and energy. Human competition can be expensive, as is the case with political elections, international sports competitions, and advertising wars. It can lead to the compromising of ethical standards in order to gain an advantage; for example, several athletes have been caught using banned steroids in professional sports in order to boost their own chances of success or victory. And it can be harmful for the participants, such as athletes who injure themselves exceeding the physical tolerances of their bodies, or companies that pursue unprofitable paths while engaging in competitive rivalries.
[edit] Competition in different fields
[edit] Economics and business competitionMerriam-Webster defines competition in business as "the effort of two or more parties acting independently to secure the business of a third party by offering the most favorable terms." [2] Seen as the pillar of capitalism in that it may stimulate innovation, encourage efficiency, or drive down prices, competition is touted as the foundation upon which capitalism is justified. According to microeconomic theory, no system of resource allocation is more efficient than pure competition. Competition, according to the theory, causes commercial firms to develop new products, services, and technologies. This gives consumers greater selection and better products. The greater selection typically causes lower prices for the products compared to what the price would be if there was no competition (monopoly) or little competition (oligopoly).
However, competition may also lead to wasted (duplicated) effort and to increased costs (and prices) in some circumstances. For example, the intense competition for the small number of top jobs in music and movie acting leads many aspiring musicians and actors to make substantial investments in training that are not recouped, because only a fraction become successful. Similarly, the psychological effects of competition may result in harm to those involved.
Three levels of economic competition have been classified. The most narrow form is direct competition (also called category competition or brand competition), where products that perform the same function compete against each other. For example, a brand of pick-up trucks competes with several different brands of pick-up trucks. Sometimes two companies are rivals and one adds new products to their line so that each company distributes the same thing and they compete. The next form is substitute competition, where products that are close substitutes for one another compete. For example, butter competes with margarine, mayonnaise, and other various sauces and spreads. The broadest form of competition is typically called budget competition. Included in this category is anything that the consumer might want to spend their available money on. For example, a family that has $20,000 available may choose to spend it on many different items, which can all be seen as competing with each other for the family's available money.
Competition does not necessarily have to be between companies. For example, business writers sometimes refer to "internal competition". This is competition within companies. The idea was first introduced by Alfred Sloan at General Motors in the 1920s. Sloan deliberately created areas of overlap between divisions of the company so that each division would be competing with the other divisions. For example, the Chevy division would compete with the Pontiac division for some market segments. Also, in 1931, Procter & Gamble initiated a deliberate system of internal brand versus brand rivalry. The company was organized around different brands, with each brand allocated resources, including a dedicated group of employees willing to champion the brand. Each brand manager was given responsibility for the success or failure of the brand and was compensated accordingly. This form of competition thus pitted a brand against another brand. Finally, most businesses also encourage competition between individual employees. An example of this is a contest between sales representatives. The sales representative with the highest sales (or the best improvement in sales) over a period of time would gain benefits from the employer.
It should also be noted that business and economical competition in most countries is often limited or restricted. Competition often is subject to legal restrictions. For example, competition may be legally prohibited as in the case with a government monopoly or a government-granted monopoly. Tariffs, subsidies or other protectionist measures may also be instituted by government in order to prevent or reduce competition. Depending on the respective economic policy, the pure competition is to a greater or lesser extent regulated by competition policy and competition law. Competition between countries is quite subtle to detect, but is quite evident in the World economy, where countries like the US, Japan, the European Union and the East Asian Tigers each try to outdo the other in the quest for economic supremacy in the global market, harkening to the concept of Kiasuism.Such competition is evident by the policies undertaken by these countries to educate the future workforce. For example, East Asian economies like Singapore, Japan and South Korea tend to emphasize education by allocating a large portion of the budget to this sector, and by implementing programmes such as gifted education, which some detractors criticise as indicative of academic elitism.
See separate sub-markets principle.
[edit] Competition in politicsCompetition is also found in politics. In democracies, an election is a competition for an elected office. In other words, two or more candidates strive and compete against one another to attain a position of power. The winner gains the seat of the elected office for a set amount of time, when another election is usually held to determine the next holder of the office.
In addition, there is inevitable competition inside a government. Because several offices are appointed, potential candidates compete against the others in order to gain the particular office. Departments may also compete for a limited amount of resources, such as for funding. Finally, where there are party systems, elected leaders of different parties will ultimately compete against the other party for laws, funding, and power.
Finally, competition is also imminent between governments. Each country or nationality struggles for world dominance, power, or military strength. For example, the United States competed against the Soviet Union in the Cold War for world power, and the two also struggled over the different types of government (in this case, representative democracy and communism). The result of this type of competition often leads to worldwide tensions and may sometimes erupt into warfare.
[edit] Sports competitionWhile some sports, such as fishing, have been viewed as primarily recreational, most sports are considered competitive. The majority involve competition between two or more persons, (or animals and/or mechanical devices typically controlled by humans as in horse racing or auto racing). For example, in a game of basketball, two teams compete against one another to determine who can score the most points. While there is no set reward for the winning team, many players gain an internal sense of pride. In addition, extrinsic rewards may also be given. Athletes, besides competing against other humans, also compete against nature in sports such as whitewater kayaking or mountain climbing, where the goal is to reach a destination, with only natural barriers impeding the process. A regularly scheduled (such as annual) competition meant to determine the "best" competitor of that cycle is called a championship.
While professional sports have been usually viewed as intense and extremely competitive, recreational sports, which are often less intense, are considered a healthy option for the competitive urges in humans. Sport provides a relatively safe venue for converting unbridled competition into harmless competition, because sports competition is restrained. Competitive sports are governed by codified rules agreed upon by the participants. Violating these rules is considered to be unfair competition. Thus sports provide artificial not natural competition; for example, competing for control of a ball or defending territory on a playing field is not an innate biological factor in humans. Athletes in sports like gymnastics and competitive diving "compete" against a conceptual ideal of a perfect performance, which incorporates measurable criteria and standards that are translated into numerical ratings and scores.
Sports competition is generally broken down into three categories: individual sports, such as archery, dual sports, such as doubles tennis, or team sports competition, such as football. While most sports competitions are recreation, there exists several major and minor professional sports leagues throughout the world. The Olympic Games, held every four years, is regarded as the international pinnacle of sports competition.
[edit] Competition in educationCompetition is a factor in education. On a global scale, national education systems, intending to bring out the best in the next generation, encourage competitiveness among students by scholarships. Countries like Singapore and England have a special education program which caters to special students, prompting charges of academic elitism. Upon receipt of their academic results, students tend to compare their grades to see who is better. For severe cases, the pressure to perform in some countries is so high that it results in stigmatization of intellectually deficient students or even suicide as consequence of failing the exams, Japan being a prime example (see Education in Japan). This has resulted in critical revaluation of examinations as a whole by educationists[citation needed]. Critics of competition as opposed to excellence as a motivating factor in education systems, such as Alfie Kohn, assert that competition actually has a net negative influence on the achievement levels of students and that it "turns all of us into losers." (Kohn 1986)
Competitions also make up a large proponent of extracurricular activities that students partake in. Such competitions include TVO's broadcast Reach for the Top competition, FIRST Robotics, Duke Annual Robo-Climb Competition (DARC) and the University of Toronto Space Design Contest.
[edit] Competition in biology and ecologyMain article Competition (biology). Competition within and between species is an important topic in biology, specifically in the field of ecology. Competition between members of a species ("intraspecific") is the driving force behind evolution and natural selection; the competition for resources such as food, water, territory, and sunlight results in the ultimate survival and dominance of the variation of the species best suited for survival. Competition is also present between species ("interspecific"). A limited amount of resources are available and several species may depend on these resources. Thus, each of the species competes with the others to gain the resources. As a result, several species less suited to compete for the resources may either adapt or die out. According to evolutionary theory, this competition within and between species for resources plays a critical role in natural selection.
[edit] The study of competitionCompetition has been studied in several fields, including psychology, sociology, and anthropology. Social psychologists, for instance, study the nature of competition. They investigate the natural urge of competition and its circumstances. They also study group dynamics to detect how competition emerges and what its effects are. Sociologists, meanwhile, study the effects of competition on society as a whole. In addition, anthropologists study the history and prehistory of competition in various cultures. They also investigate how competition manifested itself in various cultural settings in the past, and how competition has developed over time.
[edit] CompetitivenessMain article: CompetitivenessMany philosophers and psychologists have identified a trait in most living organisms that drive the particular organism to compete. This trait, called competitiveness, is viewed as an innate biological trait that coexists along with the urge for survival. Competitiveness, or the inclination to compete, though, has become synonymous with aggressiveness and ambitiousness in the English language. More advanced civilizations integrate aggressiveness and competitiveness into their interactions in order to adapt and ethically share resources. Most plants compete for higher spots on trees to receive more sunlight.
The term also applies to econometrics. Here it is a comparative measure of the ability and performance of a firm or sub-sector to sell and produce/supply goods and/or services in a given market. The two academic bodies of thought on the assessment of competitiveness are the Structure Conduct Performance Paradigm and the more contemporary New Empirical Industrial Organisation model. Predicting changes in the competitiveness of business sectors is becoming an integral and explicit step in public policy making. Within capitalist economic systems, the drive of enterprises is to maintain and improve their own competitiveness.
[edit] HypercompetitivenessThe tendency toward extreme, unhealthy competition has been termed hypercompetitive. This concept originated in Karen Horney's theories on neurosis, specifically the highly aggressive personality type that is characterized as "moving against people." In her view, some people have a need to compete and win at any cost as a means of maintaining their self-worth. These individuals are likely to turn any activity into a competition, and they will feel threatened if they find themselves losing. Researchers have found that men and women who score high on the trait of hypercompetitiveness are more narcissistic and less psychologically healthy than those who score low on the trait (Ryckman et al. 1994). Hypercompetitive individuals generally believe that "winning isn't everything; it's the only thing."

Effects of financial turmoil on sub saharan courntires

Global Financial Turmoil—How Does it Affect Sub-Saharan Africa?speech by Antoinette M. Sayeh, Director, African Department, IMFAt the 14th Conference of Financial InstitutionsSecond Generation Financial Sector Reforms, November 6-7, 2008Arusha, Tanzania
President Kikwete, Minister Mkulo, Governor Ndulu, Ladies & Gentlemen:
It is a great pleasure for me to join you here in Arusha. This conference takes place in difficult times for the world economy. What started as a localized problem in the sub-prime mortgage market in the United States has turned into the most serious global financial crisis since the 1930s. Its center of gravity remains for now in the advanced economies. But its impact is increasingly being felt throughout the world. What I would like to do today is provide you with a perspective from the IMF on global events. How will the financial crisis affect global growth? What will be its impact on Africa? And how should economic policies respond?
The global financial crisis started with the bursting of the housing bubble in the United States over a year ago, which was prompted by a rise in defaults in subprime mortgages. Bank losses on these mortgages, and particularly on the related heavily-securitized credit derivatives, put a lot of stress on the financial systems in advanced economies. This was exacerbated by a broadening of credit quality concerns and unanticipated contagion to—and additional losses on—other financial assets. High leverage and rising uncertainty about the ultimate distribution of risk caused confidence in the banking sector to collapse, leading to a virtual closure of interbank and money markets and a sharp retrenchment of credit.
The United States and several European countries have responded with massive liquidity injections by central banks and the mobilization of public resources to recapitalize banks, insure deposits, guarantee money market transactions, and buy back troubled assets. These steps, and the increased coordination between major financial centers, are welcome and necessary. The IMF itself is also providing financial support to the economic programs of a number of countries most heavily affected.
Despite these efforts, the impact of financial sector distress on global growth will likely be significant. The IMF's World Economic Outlook released in October estimated that advanced economies would see economic growth falling to an average of ½ percent in 2009. With several countries now facing a recession that may turn out to have been an optimistic projection.
Some were hopeful that contagion to emerging market economies would remain limited. However, events of the past few weeks indicate clearly that there has been no decoupling of these economies. They are now also at the center of the deleveraging storm, and heightened risk aversion has already led to a sharp decline in capital flows to emerging economies. As investors have rushed towards the safest assets—notably U.S. treasury securities—equity markets in emerging economies have sold off sharply, bond spreads have widened, and domestic currencies have come under severe pressure. Ample reserves, low levels of sovereign debt, and sound economic policies will help some countries weather the storm more easily than in the late 1990s. Others are facing a more difficult situation. But all will be faced with reduced growth prospects in 2009.
Sub-Saharan Africa remains less integrated in global financial markets and the direct impact of global financial turmoil is likely to be less severe than in the advanced and emerging economies. But Africa is not immune from global events. And in the short term, many countries in Sub-Saharan Africa are more vulnerable since the food and fuel price shock caused higher inflation and rising current account deficits.
Africa is likely to be affected through three principal transmission channels:
• Lower global growth, already a reality, is likely to reduce the demand for African exports, exert downward pressure on commodity prices, and curtail the flow of remittances from abroad;
• The tightening of global credit conditions is likely to lower foreign direct investment flows and reduce or reverse portfolio inflows as investors flee into more liquid or safer assets. Trade finance flows may also be affected;
• Finally, banking systems may be weakened through a decline in the quality of their credit portfolios, losses on other financial assets, such as deposits with troubled foreign correspondent banks, or capital repatriations by troubled parent banks—which are often foreign-owned.
The IMF's Regional Economic Outlook for Sub-Saharan Africa, published in early October, already pointed to an expected slowdown in real GDP growth in 2008-09 by about ½ percentage point over its level of 6½ percent in 2007. Based on continued weaknesses in international financial markets and weak data from developed and emerging market countries—including South Africa—it is highly likely that this forecast will need to be revised downward.
The global financial crisis is also being felt in the region's capital and foreign exchange markets. Exchange rates in many countries in Africa, including in this region, have come under severe pressure in recent weeks, and equity markets have fallen sharply in some countries, including in Côte d'Ivoire, Kenya, Nigeria, and Mauritius.
But all is not dire. There are also reasons to expect some resilience on the part of sub-Saharan African countries:
• Of course, reduced demand for African exports will dampen growth. However, the strong underlying growth trend of recent years has reflected in part improving domestic fundamentals—fewer conflicts, liberalization and reform, macroeconomic stability, and debt relief.
• While lower commodity prices will produce negative income shocks in exporting countries, they will also help reduce the import bill for net importers.
• Financial systems in sub-Saharan Africa are less integrated with global financial markets and thus less vulnerable to deleveraging. They are generally not exposed to risks arising from complex derivative instruments and have not relied substantially on foreign borrowing to finance their operations. As a result, financial institutions in the region have by and large remained unaffected and domestic money markets are generally functioning normally.
What are the implications of the current environment for economic policies? While the impact on Africa may be less severe, the risks are important and macroeconomic stability is at a premium. Circumstances differ sharply across countries and there is no single recipe. But I would like to suggest three key principles for economic policy makers in difficult times:
First, seize the opportunity to bring inflation down. Inflation remains above most countries' comfort levels as the impact of the global food and fuel price surge continues to linger. In principle, the sharp decline of commodity prices will provide a disinflationary impulse, reducing the need for monetary policy tightening. However, price rigidities and the build-up of inflationary expectations in some countries suggest that the process will not be automatic. In Tanzania, for instance, the continued persistence in inflation, in the face of a planned loosening of the fiscal stance, calls for caution on the part of the central bank to avoid an increase in inflationary expectations and second round effects.
Second, use available fiscal space judiciously. Many countries have created fiscal space in recent years through debt reduction and strong policies. Thus, where fiscal sustainability and financing are not immediate concerns and demand conditions are weak, some stimulus or smoothing of negative demand shocks may be in order. In Tanzania, the 2008/09 budget provides for such a stimulus. But where external financing for public spending is falling, or commodity price changes threaten medium-term fiscal sustainability, restraint is required. In any case, current market conditions are not conducive to a dramatic expansion of public investment programs funded on commercial terms. Therefore any planned access to international capital markets should be postponed to avoid prohibitive costs.
Third, increase vigilance and stand ready to react flexibly. The liquidity and usability of reserve assets and the availability of trade credit need to be monitored carefully. And governments should seek to identify banking system vulnerabilities, and develop plans on how to react should a banking crisis erupt.
Finally, I would also like to underline that, even though the circumstances and policies implemented in reaction to the crisis may vary sharply across countries, these should not derail the growth strategies that have been put in place in the past decade and have started to bear fruit. Sustaining the reform effort today, in spite of the crisis, will be crucial to boosting growth over the medium term and making headway towards the Millennium Development Goals.
For this reason, I welcome the focus of this conference on second generation financial sector reforms, a critical ingredient to sustained economic growth in Tanzania. And I see two broad objectives for these reforms.
• First, and this is even more relevant today, there is a need to strengthen financial stability by reinforcing prudential regulation and supervision. One important aspect is to extend supervision to key nonbank institutions, such as the fast-growing pension funds. More generally, promoting the early identification of vulnerabilities and improving the monitoring of risks is critical. Financial stability assessments, as currently under preparation, can be a useful vehicle for this purpose.
• Second, financial sector reforms should aim at enhancing the contribution of the financial sector to private sector development. Establishing an operational credit reference databank, for instance, will facilitate a healthy expansion of credit, and promote further financial deepening - a critical ingredient for sustained high growth.
In conclusion, the international environment will be more challenging, probably for some years to come. But challenges are always also opportunities. The high-level conference that President Kikwete and the IMF will be co-hosting in Dar es Salaam early next year will provide an important occasion to bring together policy makers from all over Africa and beyond to address these questions. I look forward to meeting many of you again on that occasion.
Thank you.