28 CONCEPTS YOU SHOULD KNOW ABOUT ECONOMICS

E C O N O M I C G R O W T H

A n i n c r e a s e i n t h e c a p a c i t y o f a n e c o n o m y t o p r o d u c e g o o d s a n d s e r v i c e s , c o m p a r e d f r o m o n e p e r i o d o f ti m e t o a n o t h e r .

Deliberately ignores some important aspects of macroeconomics, such as short-run fluctuations in employment and savings rates, in order to develop a model that attempted to describe the long-run evolution of the economy

S o l o w M o d e l o f E c o n o m i c G r o w t h

M e a s u r e m e n t D i f f e r e n c e s

Y = Aggregate OutputL = Quantity of LaborK = Quantity of CapitalA = Technological Knowledge or Total Factor Productivity

Y = AF (L,K)

DEVELOPING COUNTRIESDEVELOPED COUNTRIES

G r o s s D o m e s t i c P r o d u c t

The monetary value of all the finished goods and services produced within a country's

borders in a specific time period, though GDP is usually calculated on an annual basis. It

includes all of private and public consumption, government outlays, investments and exports

less imports that occur within a defined territory. 

GDP = C + G + I + NX

where:

"C" is equal to all private consumption, or consumer spending, in a nation's economy

"G" is the sum of government spending

"I" is the sum of all the country's businesses spending on capital

"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX =

Exports - Imports)

The recurring and fluctuating levels of economic activity that an economy experiences over

a long period of time. The five stages of the business cycle are growth (expansion), peak,

recession (contraction), trough and recovery. At one time, business cycles were thought to

be extremely regular, with predictable durations, but today they are widely believed to be

irregular, varying in frequency, magnitude and duration.

B U S I N E SS C I C L E S

The risk of business cycles or other economic cycles adversely affecting the returns of an

investment, an asset class or an individual company's profits. Cyclical risks exist because the

broad economy has been shown to move in cycles – periods of peak performance followed

by a downturn, then a trough of low activity. Between the peak and trough of a business or

other economic cycle, investments may fall in value to reflect the uncertainty surrounding

future returns as compared with the recent past. 

Cyclical risk can also be tied to inflationary risks, as some investors consider inflation to be

cyclical in nature.

C Y C L I C A L R I S K

A significant decline in activity across the economy, lasting longer than a few months. It is

visible in industrial production, employment, real income and wholesale-retail trade. The

technical indicator of a recession is two consecutive quarters of negative economic growth

as measured by a country's gross domestic product (GDP); although the National Bureau of

Economic Research (NBER) and other institutions do not necessarily need to see this occur

to call a recession. 

R E C E SS I O N

According to Keynesian economics, the amount left over when the

cost of a person's consumer expenditure is subtracted from the

amount of disposable income that he or she earns in a given period

of time.

S AV I N G S

A tri-lateral relationship among savings, consumption, and income is the key determinant of

the amount of personal savings. On the first side, given a certain income, the decision to

buy goods and services (=consumption) negatively affects savings. Savings passively adjust

to consumption and income. They represent a resource slack, buffering shocks in income

and consumption desires.

On a second side, savings can be actively planned in binding agreements, like many pension

schemes, with consumption passively adjusting to changes in income.

In other terms, savings can arise from a compulsory tendency of renouncing and postponing

even banal consumption (greediness) or, instead, they can be the result of sharply rising

income, with higher consumption taking place meanwhile.

By contrast, savings can be also the outcome of negative expectations about future income

(as when one is afraid of being dismissed)

The percentage of the total labor force that is unemployed but actively seeking employment and willing to work.

U N E M P L O Y M E N T R AT E

Structural unemployment

Unemployment that comes from

there being an absence of

demand for the workers that are

available

Changes in Technology

Changes in Tastes

Frictional Unemployment

Unemployment that comes from people moving between jobs, careers, and locations

People entering the workforce from school.

People re-entering the workforce after raising children.

People changing employers due to quitting or being fired (for reasons beyond structural ones).

People changing careers due to changing interests.

People moving to a new city (for non-structural reasons) and being unemployed when they arrive.

Cyclical Unemployment

Occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. So when GDP growth is small (or negative) unemployment is high.

Getting laid off due to a recession is the classic case of cyclical unemployment

Seasonal Unemployment

Unemployment due to changes

in the season - such as a lack of

demand for department store

Santa Clauses in January.

Seasonal unemployment is a

form of structural

unemployment, as the structure

of the economy changes from

month to month.

P R O D U C T I V I T Y

A m o u n t o f o u t p u t p e r u n i t o f i n p u t

Total factor productivity

Captures the contribution to

output of everything except labor and

capital: innovation, managerial skill,

organization, even luck

COMPETITIVENESS

Labor ProductivityOutput divided by the number of workers or, more often, by the number of hours worked.

A competitive advantage is one that an organization has over its

competitors, allowing it to generate greater sales or margins and/or

retain more customers than its competition. There can be many

types of competitive advantages including the firm's cost structure,

product offerings, distribution network and customer support.

C O M PA R AT I V E A D VA N TA G E

According to the classical theory of international trade, every country will produce their

commodities for the production of which it is most suited in terms of its natural endowments

climate quality of soil, means of transport, capital, etc. It will produce these commodities in

excess of its own requirement and will exchange the surplus with the imports of goods from

other countries for the production of which it is not well suited or which it cannot produce at

all. Thus all countries produce and export these commodities in which they have cost

advantages and import those commodities in which they have cost disadvantages.

O P P O RT U N I T Y C O S T

The cost of an alternative that must be forgone in

order to pursue a certain action. The benefits you

could have received by taking an alternative

action. The difference in return between a chosen

investment and one that is necessarily passed up.

Say you invest in a stock and it returns a paltry 2%

over the year. In placing your money in the stock,

you gave up the opportunity of another investment

- say, a risk-free government bond yielding 6%. In

this situation, your opportunity costs are 4% (6% -

2%).

Even though the concepts of supply and demand are introduced separately, it's the

combination of these forces that determine how much of a good or service is produced and

consumed in an economy and at what price. These steady-state levels are referred to as the

equilibrium price and quantity in a market. In the supply and demand model, the equilibrium

price and quantity in a market is located at the intersection of the market supply and

market demand curves. Note that the equilibrium price is generally referred to as P* and the

market quantity is generally referred to as Q*.

D E M A N D - S U P P LY

Selling price that includes direct, indirect, and hidden costs like downtime and opportunity cost.

P R I C E & Q U A N T I T Y

A measure of a variable's sensitivity to a change in another variable. In economics, elasticity

refers the degree to which individuals (consumers/producers) change their demand/amount

supplied in response to price or income changes.

Calculated as:

E L A S T I C I T Y

A financial benefit that is realized when the amount of revenue gained from a business

activity exceeds the expenses, costs and taxes needed to sustain the activity. Any profit that

is gained goes to the business's owners, who may or may not decide to spend it on the

business. 

Calculated as:

P R O F I T

I N F L AT I O N

The overall general upward price movement of goods and services in an economy (often

caused by a increase in the supply of money), usually as measured by the Consumer Price

Index and the Producer Price Index.

Demand-Pull Inflation

When spending on goods and services drives up prices.

Demand-pull inflation is fueled by income, so efforts to

stop it involve reducing consumer's income or giving

consumers more incentive to save than to spend.

Cost-Push Inflation

When the price of inputs increases. Businesses must

acquire raw materials, labor, energy, and capital to

operate. If the price of these were to rise, it would reduce

the ability of producers to generate output because their

unit cost of production had increased. If these increases in

production cost are relatively large and pervasive, the

effect is to simultaneously create higher inflation, reduce

real GDP, and increase the unemployment rate.

An economic theory that estimates the amount of adjustment needed on the exchange rate

between countries in order for the exchange to be equivalent to each currency's purchasing

power.

The relative version of PPP is calculated as:

Where: 

"S" represents exchange rate of currency 1 to currency 2 

"P1" represents the cost of good "x" in currency 1

"P2" represents the cost of good "x" in currency 2

One of the best comparison indicators is the Big Mac Index that

compares the price of the big mac around the world.

P O W E R P U R C H A S E PA R I T Y

According to a strict academic definition, a monopoly is a market

containing a single firm. In such instances where a single firm

holds monopoly power, the company will typically be forced

to divest its assets. Antimonopoly regulation protects free markets

from being dominated by a single entity.

M O N O P O LY

A type of monopoly that exists as a result

of the high fixed or start-up costs of

operating a business in a particular

industry. Because it is economically

sensible to have certain natural

monopolies, governments often regulate

those in operation, ensuring that

consumers get a fair deal.

Natural Monopoly

The increase in efficiency of production as the number of goods being produced

increases. Typically, a company that achieves economies of scale lowers the average

cost per unit through increased production since fixed costs are shared over an

increased number of goods. 

There are two types of economies of scale:

-External economies - the cost per unit depends on the size of the industry, not the

firm.

-Internal economies - the cost per unit depends on size of the individual firm.

E C O N O M I E S O F S C A L E

M O N E TA RY P O L I C Y

The actions of a central bank, currency board or other regulatory committee that determine

the size and rate of growth of the money supply, which in turn affects interest rates.

Monetary policy is maintained through actions such as increasing the interest rate, or

changing the amount of money banks need to keep in the vault (bank reserves).

The amount charged, expressed as a percentage of principal, by a lender to a borrower for

the use of assets. Interest rates are typically noted on an annual basis, known as the annual

percentage rate (APR). The assets borrowed could include, cash, consumer goods, large

assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the

borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the

interest rate is sometimes known as the "lease rate". When the borrower is a low-risk party,

they will usually be charged a low interest rate; if the borrower is considered high risk, the

interest rate that they are charged will be higher. 

I n t e r e s t R a t e

A foreign currency held by central banks and other major financial institutions as a means to

pay off international debt obligations, or to influence their domestic exchange rate. A large

percentage of commodities, such as gold and oil, are usually priced in the reserve currency,

causing other countries to hold this currency to pay for these goods. Holding currency

reserves, therefore, minimizes exchange rate risk, as the purchasing nation will not have to

exchange their currency for the current reserve currency in order to make the purchase. 

R E S E R V E C U R R E N C Y

Government spending policies that influence macroeconomic conditions. These policies

affect tax rates, interest rates and government spending, in an effort to control the economy.

F I S C A L P O L I C Y

TA X E S

Payroll Tax: A tax an employer withholds and/or pays on behalf of their employees based

on the wage or salary of the employee.

Sales Tax: A tax imposed by the government at the point of sale on retail goods and

services. It is collected by the retailer and passed on to the state. Sales tax is based on a

percentage of the selling prices of the goods and services and is set by the state.

Technically, consumers pay sales taxes, but effectively, business pay them since the tax

increases consumers costs and causes them to buy less.

Foreign Tax: Income taxes paid to a foreign government on income earned in that country.

Value-Added Tax: A national sales tax collected at each stage of production or

consumption of a good. Depending on the political climate, the taxing authority often

exempts certain necessary living items, such as food and medicine from the tax.

A record of all transactions made between one particular country and all other countries

during a specified period of time. BOP compares the difference of the amount of exports and

imports, including all financial exports and imports. A negative balance of payments means

that more money is flowing out of the country than coming in, and vice versa.

B A L A N C E O F PAY M E N T S

An economic scenario that occurs when there is an intervention in a given market by a

governing body. The intervention may take the form of price ceilings, price floors or tax

subsidies. Market distortions create market failures, which is not an economically ideal

situation.

M A R K E T D I S T O RT I O N

An economic term that encompasses a situation where, in any given market, the quantity of

a product demanded by consumers does not equate to the quantity supplied by suppliers.

This is a direct result of a lack of certain economically ideal factors, which prevents

equilibrium.

M A R K E T FA I L U R E

I N N O VAT I O N

Product Innovation

The development and market introduction of a new, redesigned or substantially improved

good or service. Examples of product innovation by a business might include a

new product's invention; technical specification and quality improvements made to a

product; or the inclusion of new components, materials or desirable functions into an

existing product.

Process Innovation

The implementation of a new or significantly

improved production or delivery method. It

involves the development of a new way to

produce a product using a newly developed

machine, a new or the use of new software.

Deliberate assumption of above average (but analyzed, measured, and usually hedged) short-

term risk of financial loss, in expectation of above average gain from an

anticipated change in prices. Organized speculation (as conducted

through commodity and stock exchanges) adds capital and liquidity to financial markets, and

helps dampen wild fluctuations in prices in normal times. In times of speculative hysteria or

economic/political crises, however, speculation exacerbates price swings and may swamp

usual trading activity. In terms of degree of risk assumed, speculation (short-

term acquisition of assets) falls between investment (long-term acquisition of assets

for income and/or capital appreciation) and gambling (wagering on random outcomes without

acquisition of assets).

S P E C U L AT I O N