Utility is a term used in economics to represent the level of satisfaction derived from the consumption of a good. It can be thought of as a measure of satisfaction. It may or may not be quantifiable, depending on the type of utility.
Utility depends upon the wants of an individual. When the wants of an individual go unsatisfied, the utility decreases. Whereas, when the wants of an individual are satisfied, utility increases. Thus, human wants are the basis of utility. Had it not been for these unlimited wants of humans, the concept of utility would not have existed.
When a consumer derives higher utility from a good, he would demand more of that good. Therefore, utility drives the demand. He will keep on purchasing that good until he is satisfied. For example, a bar of chocolate is only of value to a consumer till it fetches him utility. He will keep consuming the chocolate till he is satisfied. This can happen when either his appetite reaches its limit, or when the chocolate stops being appealing to him.
There are to ways to measure the utility:
The usefulness of a commodity may not always ensure a higher utility derived from it. A good that is useful to a consumer might not satisfy his wants at a given time. Alternatively, a good with no amount of usefulness, like cigarettes, may provide immense utility to a smoker. Therefore, utility must not be confused with usefulness.
Similarly, pleasure and satisfaction are used in the definition of utility. However, these terms are not to be confused with the concept of utility.
Utility can be expressed as Total Utility and Marginal Utility. Both concepts are important concepts in economics and are used for deriving various other concepts in economics.
Consider the following example:
A consumer has 7 apples, each unit of apple has a different level of utility attached to it. This is the marginal utility. However, the total utility achieved on eating all the apples at a given time is a total utility. When the consumer has eaten 4 apples, going for the fifth apple would give him a marginal utility of only 13 utils.
At the same time, the total utility upon consuming the fifth apple would be the total utility derived up till the fourth apple plus the marginal utility of the fifth apple.
Marginal utility is negative when the consumption of the good causes harm to the consumer and does not give him satisfaction.
The Law of diminishing marginal utility states that as an individual consumes more units of a good, the marginal utility of each subsequent good decreases. This means that no consumer would want to consume too much of the same good.
For instance, the first bar of chocolate would be highly satisfactory than the 10th bar of the same chocolate. Similarly, one scoop of ice cream would derive more utility for a consumer than the 15th scoop of the same ice cream.
Marginal utility and Total Utility can be represented through the following graphs:
Defining Macroeconomics Macroeconomics is a branch of Economics that evaluates the functioning of an economy as a whole. It studies the performance and behaviour of key economic indicators such as economy’s output of goods and service, exchange rates, the growth of output, the rate of unemployment and inflation, and balance of payments. Macroeconomics emphasises on the policies and economic behaviour that influence consumption and investment, exchange rates, trade balance, money flow, fiscal and monetary policy, interest rates, national debt, and factors influencing wages and prices. The scope of the subject goes beyond microeconomic topics like the behaviour of individuals, firms, markets, and households. History of Macroeconomics Macroeconomics originated with John Maynard Keynes post the great depression when the classical economist failed to explain the great economic fallout. Classical economics mostly comprised theories that studied pricing, distribution, and supply & demand. In 1936, John Maynard Keynes published – The General Theory of Employment, Interest and Money – effectively changing the perception of how macroeconomic problems should be addressed. The theories of Keynes shifted to focus on aggregate demand from the aggregate supply. Keynes said: ‘In the long run, we are all dead’. This statement was made to dismiss the notion that the economy would be in full employment in the long run. Later the theories developed by Keynes formed the basis for Keynesian economics, which gained popularity over other schools of thoughts including Neoclassical economics. Neoclassical economics emerged in the 1900s. It introduced imperfect competition models, which included marginal revenue curves, indifference curves. The theories in neoclassical economics argued about the efficient allocation of limited productive resource. Neoclassical economists explain consumption, production, pricing of goods and services through supply and demand. Some assumptions of this thought were an individual’s motive is to maximise utility as companies seek to maximise profits. Individuals make rational choices and act independently on perfect information. Over the years, many new schools of thought in Macroeconomics have found footing in the economics world. These include monetarist theories, new classical economics, new Keynesian economics, and supply-side macroeconomics. Difference between Macroeconomics and Microeconomics Major topics in Macroeconomics National income and output The estimation of national income includes the value of goods and services produced by a country in a financial year domestically and internationally. National income essentially means the value of total output generated by an economy in a year. National income can also be referred as national expenditure, national output or national dividend. Financial systems Understanding financial systems is an important concept in macroeconomics. A financial market is a market for financial securities and commodities, including bonds, shares, precious metal, agriculture goods. It is important for an economy to have markets where buyers and sellers can exchange goods. A financial market helps in the allocation of resources. Financial markets facilitate savings mobilisation, i.e. financial intermediaries channelise funds from savers to borrowers. Investment remains on the agenda for policymakers to promote growth, and financial markets facilitate funds by allowing individuals to invest in bonds and stocks, which are issued by institutions seeking funds for investments. Business cycles A Business cycle or an economic cycle refers to fluctuations in production, trade or economic activities. The upward and downward movement generally indicates the fluctuations in gross domestic product. A business cycle has four different phases: expansion, peak, contraction, and trough. An expansion in an economy is when economic growth, employment, prices are rising. The peak is achieved when the economy is producing maximum output, inflation is visible, and employment levels are running high. After a peak, the economy enters into contraction, which leads to a fall in employment, depleting economic activity, and stabilisation in prices. At trough, the economy is at the bottom of the cycle, and the next phase of expansion starts after the trough. Interest rates Macroeconomics also deals with interest rates in the economy. Interest rate policy of an economy is formulated and maintained by the central bank. A central bank manages the money supply in the economy. The intervention by the central bank to propel economic growth is called monetary policy. The monetary policy of an economy seeks to maintain employment and inflation in the economy. The motive of the monetary policy is to achieve full employment and maintain stable prices.
What are the Factors of Production? Production of anything requires inputs to produce an output, and the inputs used in the production are known as factors of production. Alternatively, these are resources used in the production of goods and services. Factors of production are also critical to economic growth given the economic growth requires expansion in output/national income or total production. Factors are a class of productive elements, which individually are known as units. Units are interchangeable and homogenous, moreover, they are perfect substitutes for each other. Factors, which constitute a group of units, are not a perfect substitute for each other. Modern economists prefer using ‘inputs’ instead of conventional factors of production: land, labour, capital and entrepreneurship. Classification of Factors of production Land Land includes all the natural resources available such as water and air. It constitutes a natural resource that yields income and is exchangeable for a consideration. In the absence of land, water and sun, a farmer cannot produce crops. Every commodity traded in the world can be traced back to land directly or indirectly. Such as gold is extracted from mines, crude oil is explored and extracted from oil fields, grains are produced in agricultural land. Moreover, the land is arguably the ultimate origination of commodities. Meanwhile, the quantity and quality of land are vital to yield an acceptable utility for the user. But the availability of land does not guarantee economic growth because the ability to use resource determines the optimal use of the resource. Land can be further classified as renewable and non-renewable. Renewable resources can be used again and again in the production like an agricultural land used year after year for the cultivation of food, grains etc. Non-renewable land is not usable again and again and is exhausted as the consumption increases. A gold mine may not yield additional income for a business when ore reserves are exhausted. And a new discovery would provide additional resource. Land, as a blessing of nature, is fixed in supply. Whether the demand increases or decreases, the supply of land will remain the same. As a result, it is not dependent on the price, therefore supply of land is perfectly inelastic. Labour Labour does include not only physical but also mental abilities that are done by humans for a monetary benefit. The contribution of labour depends on the size and quality of labour. For instance, Japan has been successful in the production of small and compact cars, while the US producers were efficient in slightly heavy cars. Higher productivity of labour will likely deliver favourable benefits. As a human factor, labour cannot be exchanged for value, unlike land and capital. Labour is used with land and capital and cannot be separated. Labour is available in return of wages and is not a saleable commodity. While one cannot store labour for future use, the supply of labour is dependent on the need for production. Labour supply is elastic, and it takes time to develop overall supply. Division of labour emphasises on the speciality of labour in a particular work. Every labour group in an organisation is further classified into various divisions, depending on the quality, skills, knowledge and demand. Capital Capital is a critical factor of production and largely means wealth, which includes stock of raw material, machinery, tools, building etc. It is also the money available for productive and investment purposes. Capital also extends to physical assets such as machinery, raw material that are directly used in the production. Securities such as shares and bonds are not classified because they are not used in production, thus not the factor of production. It is largely classified into fixed capital and working capital. Fixed capital is used in the production continuously and incur wear and tear. Fixed capital does not mean it is immovable, but the essence of fixed is the cost incurred, which largely remains fixed over the period of production. The cost incurred in working capital is, however, recovered when the product is sold. Such as the cost of raw material, along with other inputs, is a component of the total cost of the good. Capital also includes human capital. Human capital is also a vital unit of production and means the education, skills, and health of people. It is essential for the improvement in productivity. It is now understood that investments in human capital provide favourable growth. Entrepreneurship Entrepreneurship is vital to confluence the factors of production and manages risk & uncertainty associated with the production. Now it is understood that production is a function of land, labour, capital, and entrepreneurship. Entrepreneurship is more concerned with the incorporation of production, rather business affairs, which are managed by other people working on wages. Therefore, an entrepreneur takes the risk and uncertainty associated with production. An entrepreneur is responsible for initiating a business enterprise and is engaged in assembling the factors of production, including land, labour, capital and entrepreneurship. Innovation and development are also associated with entrepreneurship. Entrepreneurs undertake crucial decision of capital allocation, which may include setting up new factors, purchasing machinery, upgrading skills of human capital, innovating units of production etc. Elon Musk is an entrepreneur aspiring to reach mars, produce e-vehicles, launch space travel. He is effectively managing and bringing about the factor of production to achieve results.
Behavioural Economics According to the school of classical economics, people are intrinsically rational, looking to maximise their utility, and make decisions that are best for oneself. A behaviourist is likely to challenge this school of thought, opining that people often times work irrationally, whether on purpose or not. How should the best parts of psychology and economics interrelate in an enlightened economist's mind? One of the greatest minds of the 20th century, Mr Charlie Munger stated that- “I don't think it's going to be that hard to bend economics a little to accommodate what's right in psychology.” Humans are emotional and easily distracted beings. Consequently, decision making may or may not be made in their self-interest always. Every day, humans make decisions as basic as what amount should one pay for lunch, whether one should pursue a course, invest in gym equipment or how much should be kept aside as monthly savings to making personal finance decisions. There is a dedicated branch of economics that seeks to explain why people decide, what they decide. This branch is called behavioral economics. Your brain effects your thinking- Making Wrong Investment Decision? Blame Your Amygdala! Let us deep dive- What Is Behavioural Economics? Behavioral economics combines understandings from psychology, judgment, decision making and economics with an intent to produce an accurate understanding of human behaviour. It relates to the economic decision-making processes of individuals and institutions. The concept explores reasons as to why people sometimes tend to make irrational decisions, why and how their behaviour does not follow predictions of economic models. It should be noted that behavioural economics focuses on the observable behaviour of humans and does not have strong theoretical or normative assumptions about how an economic system/ business sector or stock market works or should work. Read: Understanding Behavioural Finance & Investment Decisions Let us further break this down with an example: Unlike the field of classical economics, in which decision-making is entirely based on logic, behavioural economics gives room to irrational behaviour and further attempts to understand reasons behind the same. Brexit, for instance is a classic example of how behavioural economics can be useful because behavioural economics can help illuminate how the narrow vote to leave the European Union (EU referendum) was influenced majorly by gut choices, as some experts suggest, as opposed to rational decision-making. The Origin Of Behavioural Economics A keen observer of human behaviour, American economist Richard H. Thaler is broadly believed to be the founder of behavioural economics. He was awarded the 2017 Nobel Memorial Prize in Economic Sciences for his significant contributions to behavioural economics. Thaler’s opinions on the branch is believed to have been inspired by notable works of Israeli psychologist and economist Daniel Kahneman and cognitive and mathematical psychologist Amos Nathan Tversky. Daniel Kahneman also won a Nobel Memorial Prize in Economic Sciences in 2002 for his brilliant work on prospect theory, which he developed along with Tversky. Thaler is best known for incorporating psychological assumptions into analyses of economic decision-making. One of Thaler’s popular ideas – Nudge: Why Move the Earth When A Nudge Can Do! Simple Solutions to Complicated Problems What Are Various Themes Of Behavioural Economics? Three prevalent themes in behavioural economics comprise heuristics, framing and market efficiencies. Why Is Behavioural Economics Important? Behavioural economics provides new ways to think about barriers and drivers to a range of behaviours. This makes it significant, as traditional economic theory does not use insights from psychology, sociology and neuroscience to explain people’s decisions. So much so, behavioural economics seems to have the power to change the way economists and policymakers think about real world problems. Must read: How To Use Psychology To Aptly React To The Coronavirus Pandemic The field also builds a bridge between economic theory and reality- a bridge based on scientific evidence coming from disciplines in behavioural science. Some experts even regard behavioural economics as a counter-revolution, which takes economics closer to its roots, based on psychological intuition and introspection wherein psychology enacts a scientific discipline that can offer much more than merely intuitions and introspection. Besides, understanding basic concepts from behavioural economics can be very useful. It can help people be better negotiators. How Does Behavioural Economics Influence Market Participants? Clearly, people don’t behave as rational, as traditional economists have assumed. They are affected by cognitive biases, are extremely influenced by other people and often practice herd mentality, have different perceptions about attitudes and behaviours. In context to the stock market, erroneous, irrational financial decisions are the result of different unpredictable reactions by market participants subject to losses and high market risks. Therefore, for decision-making, it is essential to consider all the factors in the market-which creates a place for behavioural economics besides accounting fundamentals, macro and micro-economic factors, economic projections, etc. Consider this- a sudden drop in the value of a few stocks followed by an equally rapid recovery, demonstrates that market participants did not cause such movements by rational choices but rather emotional reactions. Read: What does Fear Do to your Portfolio? Stocks that Scared Investors in 2019 No wonder Benjamin Graham, the father of value investing, and mentor of Warren Buffett the world’s best investor coined the term ‘Mr. Market.” Clearly, he understood there is more to market than numbers. Read: Are you a Growth Investor? Then You Must Wear the Hat of a Psychologist! Why Has Behavioural Economics Concept Risen Over The Years? Let us take cues from dramatic global events over the years- for instance the Great Financial Crisis of 2008 or the novel coronavirus crisis of 2020 (Global Virus Crisis, as some call it). Read: Things to Learn from Past Crises: Role of Financial Planners During Times of Crisis These could not be explained by traditional neoclassic economic models though the impact of these events has been beyond massive. Therefore, other schools of economic thought gained traction and behavioural economics was one such concept. Businesspersons seemed to make decisions based on their emotional state of mind while investors demonstrated nervousness that caused a massive sell off to an extent that circuit breakers had to be launched while. Acts of spontaneity, irrationality, impatience, and herd mentality amid incidents of recent years have paved the way for economists to believe that the human mind is a crucial key to understand economic patterns, financial decisions and eventually- market and economic stances. Do You Know Few Top Behavioural Economists? Besides the foundation setters Kahneman, Tversky and Thaler, a number of economists, and psychologists have emerged as prominent figures within the field of behavioural economics over the years- Behavioural economics enhances the explanatory power of economics as it provides it with a firm and more rational psychological basis. It surely is a way to make economics more accurate by incorporating more realistic assumptions about how humans behave. Besides, good understanding of human decision-making, its rational and irrational aspects, offers opportunities of influencing choices that take better account of how people actually respond to the context within which their decisions are made. There are various to help one not fall prey to behavioural traps, mind you, knowledge alone does not help, but an ability to look at bigger picture and through the eyes of various mental models would help one reduce the errors. Eliminating behavioural errors would not be possible or rather would one be flawless and loose the human touch? Read: All I want to know is where I am going to die so that I’ll never go there- Inversion a Power Tool
What is operating leverage? Operating leverage is a measure to evaluate the transition of top-line movement into bottom-line change. It essentially measures the change in operating profits as a function of change in sales. Operating profit is alternatively referred to as Earnings Before Interest & Taxes (EBIT). High operating leverage means when a slight increase/decrease in sales for business results in even higher/lower increase in operating profits. Similarly, operating leverage is low when an increase in sales results in almost no or a slight increase in operating profits. It specifies the degree to which firms incur the mix of fixed and variable costs. Fixed costs are incurred one time and remain same irrespective of change in volume, while variable costs change alongside a change in volumes. In an effort to improving operating leverage, the company would intend to substitute its variable costs with fixed costs, thus the growth rate of earnings will be relatively higher compared to the growth rate of revenue. But the company will be required to break-even to see operating leverage. Since variable costs are decreased, the contribution to the profits from each unit would be more than earlier. With high operating leverage, the production volumes should increase to cover the fixed costs, and firms with low output levels may not benefit from the operating leverage. Capital intensive businesses like manufacturing firms have higher fixed costs, and operating leverage becomes appropriate to evaluate such firms. How to calculate operating leverage? Since the information in financial statements is limited, there are several formulas to calculate operating leverage. Financial statements of a business would not necessarily provide the elements of cost. It depends on the information in hand to use the formula. The audited financial statements of a company may not provide you with items likes fixed costs, variable cost or contribution margin. Therefore, formula 3 is an appropriate measure to calculate operating leverage, especially when the information is limited. How to interpret operating leverage? It is important that comparison of operating leverage should be an apple to apple comparison and certainly not apple to oranges. Moreover, similar businesses should be compared on the basis of operating leverage for an effective assessment. Consider firm A has revenue of $2 billion, operating income of $400 million, and operating leverage of 2x. Firm B also has the same revenue and operating income, but operating leverage is 1x. With operating leverage of 2x, a 10% increase in revenue for firm A to $2.2 billion would result in operating income of $480 million. In contrast, firm B has operating leverage of 1x, which means a 10% increase in revenue to $2.2 billion translates to operating income of $440 million. When sales are increasing for firm A, it means that operating income will increase for the firm more than the rate of growth in sales. However, when sales are falling for firm A, the operating income will fall at a rate more than the rate of fall in sales. What impacts operating profits or margins? Although operating leverage defines the operating profits for a firm, there are many other factors that also impact the operating profits for the firms. These factors can be broadly classified into two categories: sales and economics. Sales of a firm Until now, we have argued that sales impact the operating profit of a firm, and the degree of the impact on operating profit is defined by operating leverage. Now we discuss how sales are impacted for a firm. Economic Growth: Sales forecast for a firm is also based on the economic forecast of the region. When overall economic growth is expected to decline, it is highly likely that sales for the firm would also decline as a result. But this is not true for all businesses since non-cyclical businesses like consumer staples, the utility could remain unscathed from the decline in economic growth. Meanwhile, economic growth also sets the trajectory for the growth of the company. Industry Growth: Sales of a company are likely to move consistently with growth in the industry. However, a firm could grow even while industry growth is declining, largely because of short-term factors like new business/product, acquisition, price competition. Forecasting industry growth remains crucial to forecast company sales, while the industry cycle is also important to consider. Market Share: A firm can drive its sales when market share is increasing, and incumbent competitors are losing market share regardless of economic growth and industry growth. Firms are able to improve market share through product innovation, marketing, price wars etc. Inorganic Growth: Companies could also increase sales through mergers and acquisition, while also getting rid of competition concurrently. The intent behind inorganic growth options is to improve market share, customer base and economies of scale. Economics of a firm The impact of sales on profits is determined by the economics of the firm. Operating leverage is also a part of the economics of a firm along with other factor defined below. Volumes: Earlier, we noted that a firm is required to increase the volume of production to lower the variable cost per unit. The growth in sales should also be backed by the increase in production to gain operating leverage. Price mix: When firms have pricing power, they can increase the price of the products without losing much of the demand. Increase in price with a relatively smaller increase in quantity would add to the profit margins for the firm. Economies of Scale: Companies exercise economies of scale when enhancement to processes and scale leads to lower per-unit cost of production. For example, when a large firm acquires a small firm, the marketing and sales could be integrated with a large firm, therefore saving costs incurred by the target company. Margin expansion through economies of scale is a result of the allocation of costs across larger volumes. Cost efficiencies: Cost efficiencies could be achieved by the company irrespective of sales growth and contribute to the operating profit margin for a firm. This could be undertaken through innovation, research and development, therefore replacing old processes with new ones at lower costs.