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.

Business Tenders: Tendering Process

Procurement or making purchases of goods and services in smaller organizations or for that matter where value/quantities are smaller, the purchases officer calls for quotes from three to five vendors/suppliers from the market and does a comparison to choose which vendor offers more value for money. Shortlists and up on approval from the management goes ahead and places the order with the selected vendor.

Now multiply this activity to a bigger value/quantity. It is basically the same thing but something for a bigger value/quantity.

The article, tries to explain what a tender is and what are the steps involved. The main idea is go gain, as a buyer, the highest value for money.

What is a 'Tender'

Image from Google.com

To invite bids (or offers from vendors in the market place to provide their resources) for a project, or in other cases, to accept a formal offer (i.e. a takeover bid – however, in this article, we will not be discussing any take-over bids). Tender usually refers to the process whereby governments and financial institutions invite bids for large projects that must be submitted within a finite deadline. This is done not only to facilitate procurement of goods/services but to ensure the vendor(s) pass through a competitive process prior to selection have a fair opportunity to prove their ability to deliver as required/expected.

Most institutions have a well-defined tender process, as well as processes to govern the opening, evaluation and final selection of the vendors. This ensures that the selection process is fair and transparent.

Organizations cannot do everything on their own e.g. manufacture cupboards and shelving solutions along with various other stationery products that are needed on a daily basis; therefore, it makes business sense to collect different vendors and ask them to meet with the business’ stationery requirements at prices that are better than those that supply the same stationery products. This concept, can, be expanded into bigger projects like construction of buildings, roads, labor supply, appointment of consultants etc.

Today, almost all businesses somehow or the other depend on each other for supply of different goods/services and will select an offer or tender that meets their needs and provides the best value for money and that is the key, Value For Money!

Depending highly on the nature of the work/service involved, the tenders are generally widely advertised to offer opportunities to a number of suppliers, encourage competition and provide a greater pool of offers to select from.

Then What Is ‘Tendering’?

Tendering is the process of making an offer, bid or proposal, or expressing interest in response to an invitation or request for tender.

The organization, floating the tender is called, the buyer or the client/customer whereas the organization submitting the tender is called a supplier or a service provider (where the requirement is for a service).

The tendering process is generally utilized for procurements or contracts involving substantial amounts of money and is generally floated by:

·         Government departments, offices and agencies

·         Medium to Large private sector companies

 How Does It All Happen?

The buyer will prepare a works package, also referred to as Requests for Tender (RFT), Requests for Proposal (RFP) outline what is required. The document also outlines the particular requirements, criteria, and instructions that have to be followed otherwise, the tender can be rejected by the buyer and the buyer may or may not call the tender bond. We will discuss the tender bond and calling the tender bond at a later stage in the article.

Interested suppliers will then prepare a tender clearly stating their technical expertise along with their financial strength to deliver on the project. They will outline their advantage over competitors; provide information on qualifications, competencies and experience. Further they have to demonstrate how their bid offers the best value for money. This tender will contain all technical information to show the buyer that the vendor has a clear understanding of the scope/criteria and will include all possible drawings and schedules not forgetting their pricing.

The submitted tenders are then evaluated in a manner that is free from bias or favor. The offer that best meets all of the requirements outlined should win the contract.

Most buyers prefer to pre-qualify a vendor. This constitutes a pre-audit of the possible vendors to understand their technical competence and their financial strength. This exercise is carried out to avoid any non-performance during the execution of the project or anytime after the contract has been awarded.

The Tendering Process

The main steps in the tender process are:

The organization requesting the tender will determine the type of tender that will be used, as well as what will be involved in the tender process; the value, complexity and business category determine how tenders are invited A monetary threshold generally dictates if it would be a open or a closed tender. Closed tenders are generally executed through the Request for Quotations document and the Open Tenders are executed through a Request for Proposal document.

Open Tender: A bidding process that is open to all qualified bidders and where the sealed bids are opened in public for scrutiny and are chosen on the basis of price and quality. These are generally advertised in the media.

Closed Tender: Wherein, a select group of potential vendors are invited, to provide their written offers by a specified date.

The specified date may or may not be extended. Extension of time can be for any reason, low interest in the tender or perhaps a vendor has requested more time. Ideally, time extension is not granted but then it is a subjective matter as is left to the tender committee to decide.

Buyers have pre-defined monetary thresholds for which these two documents are used depending what the tender committee decided on the specific tender. It should also important to note that open tenders are far more formal than the closed tenders and require extensive documentation vis-à-vis closed tenders.

It is also worthwhile to note, in case where interest in low and a very few/less than expected number of vendors have responded, the whole exercise of re-tendering should be carried out in order to maintain transparency, unless it is difficult to do so due to urgency, technical specifications etc.

The tender package prepared outlines what is required, the contractual requirements and how the vendors should respond, ideally.

As and when the vendors respond, the first and foremost activity is to ensure is to obtain all relevant documentation that has been requested in the tender package. Parallel, to this is to check, if there is a requirement by the control framework, for vendors to be pre-qualified. In such cases, they would send in an Expression Of Interest, which would help them get pre-qualified, after which a pre tender briefing sessions would be conducted in order to clarify any uncertainties, plan and prepare a response to any and all queries of the potential vendor(s).

Each tender will be checked for compliance, and if compliant, then evaluated against the criteria specified in the tender package documentation. The tender that offers best value for money will be awarded the contract/business. It is at this stage where the potential buyers are required to submit a tender bond. The value of the bond shall be determined by the Tender Committee and is stated in the tender invitation. The buyer shall call on the tender bond for the following cases:

•        A tenderer withdraws their tender prior to the contract award date.

•        The successful tenderer refuses to enter into a contract.

•        The successful tenderer does not provide the performance guarantee in the specified time when the Contract is awarded

Notification and debriefing: when a contract has been awarded, the successful tenderer will be advised in writing of the award. In ideal circumstances, unsuccessful tenderers are also advised and offered a debriefing interview; however, it is advisable to at least send all unsuccessful tenderers a regret letter.

There are also chances whereby, vendors may choose not to participate in the first place, this is specially the case in closed tenders, these vendor(s) then send (or at least should send) a letter to the buyer stating their inability to participate. This letter may or may not state the reason(s) for not participating in the tender.

Contracts established and managed: generally a formal agreement will be required between the successful tenderer and the buyer.

Some vendors may also request an advance as a mobilization advance. The buyer asks for an Advance Payment Guarantee.

Similar to these different guarantees, the buyer may or may not ask (depending on the value of the contract) for insurance cover. This requirement of providing appropriate insurance cover will be stated in the tender package.