Aggregate Demand

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Aggregate Demand – Concept

We’ve studied the Law of Demand, we know it is a negative relationship between the price of a commodity and its demand. We also have studied how it affects the consumer and subsequently how a change in the consumer’s behavior encourages a firm to alter its decisions in and around the market. In effect, demand not only sets the tone for supply alone, it also shows how supply of a specific commodity influences demand.

No matter what type of commodity (referring to both; goods and services) we may choose to discuss as economists, a commodity will continue to be demanded as long as it has the power to satisfy the need (or in other words, have utility to a particular consumer or a group of people; goods that may appear luxuries to one group of consumers may for the other group be, bare necessities). The economy of the country, produces, or at the least, makes available such goods and services for all.

Now tilt your head slightly and allow the next paragraph to sink-in.

Goods and services, in total, for a given period (one year, usually) are demanded at prevailing prices in a country, this is known as aggregate demand.

Mathematically, this is

C + I + G – (Net Exports)

Where,

C = consumer spending/expenditure
I = Investments by firms/capitalists
G = Government spending/expenditure
Net Exports = Total Exports minus Total Imports

Now if you look closely at this equation, you’d notice this is no different from the Gross Domestic Product ‘GDP’ equation, demand for your GDP is, in other words, your aggregate demand ‘AD.’

The AD curve shows an inverse relationship between AD and the price level. The AD is assumed left to right because all the components of AD, other than imports, are inversely related to the price level.

The downward slope of the AD curve reflects a 'normal' macro-economic condition of the economy (an economy with generally favorable cross sectional economic indicators) and that in a recession, the AD curve could become vertical.

Understanding the Application of the concept

AD is used to explain how national income is determined. This model is derived from the basic circular flow concept, which is used to explain how income flows between consumers and firms.

C = Consumer spending/expenditure
I = Investments by firms/capitalists
G = Government spending/expenditure
X = Net Exports
S = Savings
T = Tax on income
M = Various dimensions/dynamics

 

Trade, Liquidity and Wealth Effects

Price changes have a number of important effects on aggregate behavior of a consumer and firms. There are three main effects to consider.

The Trade Effect

The first effect, overseas trade, is perhaps the most noticeable. A rise in domestic prices raises the total costs of production, making it harder to find buyers in the global market (at these new higher prices) and imports on the contrary seems a better option viz-a-viz soaring local costs of production, hence exports 'X' are likely to fall on one hand and imports 'M' are rise on the other. This see-saw of rise and fall creates a trade effect; low AD at the higher price level.

The Interest Rate Effect

When the price level increases, consumers and firms need more money to spend so as to continue to purchase commodities they need. This relative shortage of cash linked to a rise in the price level forces some consumers and firms to borrow from banks, which in turn reduces the liquidity levels of banks. In response, banks are likely to raise interest rates as compensation for this lost liquidity along with the country’s central bank raising interest rates as part of its monetary measures to curb inflation. Furthermore, banks also are required by the central banks to maintain a reserve ratio to meet any unexpected increase in demand for cash.

As a result of the lost liquidity, interest rates are forced to rise and both consumer and firms' spending may fall. Hence, AD is lower at the higher price level.

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The Wealth Effect

As financial markets readjust to the higher price level there are effects that eventually pass on to the consumer and firms’ wealth. Higher rates may lead to a reduced activity if not a possible fall in real estate, for example, resulting in negative wealth effect  (by virtue of loss in value of the real estate/property). Likewise, those consumers and firms that rely on income from shares, rising interest rates eventually lead to shrinking corporate profits and lower share values, again creating a negative wealth effect.

A lower price level will, of course, have the inverse effect, it creates a positive wealth effect on AD. When combined, the above effects explain why aggregate demand responds inversely to changes in the price level.

These effects should not be confused with other exogenous affects, which actually, will shift the AD curve.

Social Entrepreneurship

Corporate Social Responsibility 'CSR' is the new hip in the business world. More and more companies around the globe talk of being more responsible towards the environment, their contribution to the society and so on.

CSR is the dedication of resources by a commercial entity towards developing and sustaining social value in the society it exists in. Repaying, or more specifically sharing its profits with the community/society as a whole.

The idea is to provide a better life to the people that help it make money/profits; more like repaying its moral debt to the community. Companies that operate across geographical territories and manage such projects on a global scale, at heart, have the same spirit like for example the Coca Cola Happiness Booths in the UAE - now were the Coke bottles handed out free to the blue collar populace, is in itself another discussion.

Entrepreneurship is the process of starting a business or a commercial entity with a view to make money in a way that is either different or no one has thought about; that is why probably they call it innovation.

Innovative entrepreneurship is about bringing to life an idea/venture in a manner that is new and preferably simple and entails economic benefits to the person(s) directly involved in its conception.

Social Entrepreneurship 'SE' is the process of bringing about innovative solutions to problems people face on a daily basis in the society. Helping those in need in a manner that they work towards gaining independent sources of income and breaking barriers of poverty and even physical disabilities.

Social entrepreneurship programs are basically charity based or not-for-profit, having said that, please do bear in mind that not all SE programs are purely not-for-profit, some organizations may have tendencies of being a for-profit organization but the underlying concept is always community and social services and development; so much so that many of them may even share profits with those that are directly associated with the organization, take AMUL from India as an example.

Being a philanthropist was more of a religious affair and an individual matter. SE has gone to raising the bar from individual helping another individual to selfless actions directed at helping others. Helping people to help themselves to be able to live a better life.

SE was popularized recently by a book titled 'the rise of the social entrepreneur' by Charles Leadbeater. The term SE is relatively new it has been around for quite some time.
 

Below are few names history has silently recorded:

Florence Nightingale 

(1820-1910)
England

Founder of the first nursing school  
Robert Owen 

(1771-1858)    
England  
Founder of the first cooperative movement  
Vinoba Bhave  
(1895-1982)  

India 

Founder of the Bhoodan Movement   
Akhter Hameed Khan  
(1914-1999)  
Pakistan 
Founder of the Orangi Pilot Program   
Muhammad Yunus 
(1940 - todate) 
Bangladesh 
Founder of the Grameen Bank

 

Porter's Five Forces

If you look to understand the Porter’s model, well, good luck. It took me ages to get around the concept. Primarily, the person who taught me the concept made the same mistake while teaching it that most people make while learning it, trying to understand the concept in isolation. Each area one-by-one. 

It doesn’t make sense unless you look at the big picture. The thing is, the Porter’s model is a tool, a practical tool and not merely a management concept. For anything that is practical and is a tool, cannot be taken out of its environment to be understood. This is a business world tool, not a science lab experiment.

I am going to make it as realistic as possible. 

The idea of the Porter’s model is the same what the same as the SWOT analysis; understanding your organization viz-a-viz the business environment. The Competitive Business Environment and then, based on that analysis, how to devise a business strategy that ensures entry, survival and finally profits to holding substantial market share.

The Porter’s model is based on the idea of understanding own position, understanding competition and using the tools built on these five forces to determine the competitive market of a particular product in specific and an organization in general.

Threat of Substitutes

Well, there are two sides to it, affordability and availability. When users cannot afford commodities being offered by vendor A, the natural and perhaps the rational decision is to look for the same or at least almost the same. We all know, not everyone has the purchasing power to a German car, this is why we have so many Japanese and Korean cars on our roads.

Secondly, it’s the availability of a substitute. If there is a choice to buy something that is the same if not better, that too, owing to our desires, seems attractive. The world saw an iPhone 4. Nothing like it ever before. Sometime later, the Android came into existence. Today phones that may or may not be better than the iPhone, yet offer a good deal, good competition and at the same time are equally well priced for those that cannot buy the iPhone in markets where it is still sold is a luxury item than a utility.

The Rivalry between Existing Businesses

Rivalry between existing businesses creates downward pressure on prices, just like the Kinky Demand Curve concept in laid down in Economics. There is an increased competition for the same customers and product resources. There is greater competition for market dominance.

Threats of New Entrants

Now where we do not experience any sort of market concentration and the substitutes can be brought into the market with a lesser degree/chance of failure, new entrants are inevitable. These new entrants not only create a downward pressure on the existing prices and profit margins but they, now, themselves become a part of that rivalry between businesses.

Bargaining Power of Suppliers

The same concept of a perfect and imperfect market but with a twist. The twist in here is the supplier, if alone or maybe a couple, can and will control the supply of the raw materials, both, in terms of quantity as well as prices.

Bargaining Power of Customers

If you recall the Law of Demand; you will remember that the demand is affected by change in income as well as a change tastes of consumers. Likewise, in here, if the consumers choose to change their choices, tastes it creates pressure on the businesses to match the changes of their sources of income. Further, if the business is not delivering to the consumer’s satisfaction, these consumers will eventually be customers to another.