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## DISCOVERING THE SCARCITY AND STRATEGY ECONOMIC SIMULATION

### INTRODUCTION

1.  The Price System: Supply and Demand establish prices.

Economists discuss how supply and demand work together - usually done with curves on the blackboard.  The simulation calculates prices based on the quantities supplied and demanded in a given industry for a year.  Let us trace through this process by viewing the simulation while reading through these instructions.

Supply
A supply amount is available for each industry by adding the  current production of the firms to available inventories. Consider the Manufacturing industry (color coded yellow for use on graphs). Identify on the Manufacturing row of the main simulation screen how the industry has 100 firms ( each firm is given a production capacity of 100 units) and the capacity use rate is 80%.  Therefore industry output in year one is 8000 units of manufacturing goods.  When inventories are available from last year, the program adds that to output. Available inventories are colored  grey, red numbers in the inventory column are back orders that could not be filled and must be delivered next year.

Demand
Consumer income comes primarily from wages.  Notice the available quantities of  three skill levels of labor and the wages for each group. In the simulation, all consumer income is totaled and divided to buy the products of various industries on the following schedule:
Agriculture 20%    Mining 5%   Construction 10%     Manufacturing 20%   Transportation 10%    Trade 5%       Services 15%     Energy 10%    5% is savings

Business demand comes from revenues and is spent on the items needed to maintain an enterprise and production, as indicated on the input-output table.

Each industry will have a product price for the next year calculated by a formula which is based on the difference between units supplied in the industry and those demanded.  The price system is therefore market driven.

Price changes are adjusted for the elasticity of demand, so large price increases will often mean that consumers buy fewer units of that industry’s production.

The Costs of the Firm
Each firm in an industry has costs listed on the input- output table. The prices charged by supplier firms become the cost of buying firms. Push the button entitled Input-Output. Read down the column for the agriculture industry. The numbers listed are the amounts of output from other industries that are necessary to produce 100 units of agricultural output.  Notice that 10 units are bought from agriculture by agriculture - obviously farmers must eat. Check your understanding by finding that among the other requirements are 10 units from manufacturing and 20 units of unskilled labor.   Push the upper left hand button to see the input-output screen with costs to the business calculated  ( units used are multiplied by the current price of the product of each industry). When you read down the column for agriculture (or any  industry) the cost per firm of 100 units of output is totaled on the bottom line. Actual calculations for a firm’s cost multiply the percentage of capacity used by these totaled costs to establish annual costs. These costs are subtracted from the money gathered in revenues ( price times output) to determine profit or loss for the firm in a year.

The Profits of the Firm

Profits are simply revenues (output units times current price) minus costs (shown on the input-output table).  Profits and losses are calculated for an average firm in an industry on the last column of the main screen (firm P/L).

3. Profits Drive the Market Economy

Automatic adjustments occur yearly in this simulation program as indicated below:

Market systems are shaped over time by expansion in profitable industries and contraction in losing enterprises.  Wherever profits appear, new firms are opened and labor is hired.  This simulation program increases investment (adds new firms) in each industry when profits are substantial, and causes some firms to fail (subtracts firms) when financial losses occur.
Profits are also critical to capacity use decisions for firms currently producing; the simulation program increases capacity use given industry  profitability and decreases usage when firms lose money.
An accompaniment of weak profitability or outright losses for firms is the accumulation of excess products in inventories.

4.Viewing the General Equilibrium

Computer technology makes possible the visible movement of an economic system.  Economists have long referred to the intersection of supply and demand curves as an “equilibrium” point. However, changes in these points (which determine prices) are  laborious to show on the whiteboard from year to year. Computer programs expand the potential for such work.
A general equilibrium system has been constructed mathematically in economic literature to show that markets are interrelated and do in fact have the possibility for rational and efficient allocation of resources claimed by verbal argument. Moreover, all prices and quantities produced are capable of adjustment to mutually consistent levels. This simulation provides supporting evidence of the possibility of a rational outcome over time for competitively structured market economies.
However, arguments that a market economy may be efficient do not necessarily invalidate  political attempts to handle social problems  by governmental programs to aid those unable to pay
As you press the advance button to move the simulation from year to year, the movement of a general equilibrium system is being shown. Economic literature usually deals with general equilibrium analysis without consideration of changes over time, thus this simulation offers a truly advanced example of this idea.

REVIEW THE INTRODUCTION

1. Discuss how supply and demand establish prices.

2. Explain how profits shape the market economy.

3. What does the input-output table show about the prices and costs of the firm?