Transcript 1_1-basic economic concepts

BASIC ECONOMIC CONCEPTS
Samir K Mahajan
WHAT IS ECONOMICS???
The fact is that economics affects our daily lives. Virtually
everyone agrees on the importance of economics but there is far
less agreement on just what economics is.
To know what economics is, we must first know what an economy is.
WHAT IS ECONOMICS contd.
Some Definitions of Economy
An economy is the system of earning livelihood (Brown).
An economy is just a group of people dealing with one another as they go about their lives.
Another more common definition: Economy is a system of four basic economic activities such as: production,
distribution, consumption and investment of goods and services.
In nutshell,
An economy is the sum total of all economic (activities which are rewarded/paid) of the society. These activities
create utilities i.e. produce goods and services. Thus economy consists of cultivation, manufacturing, construction,
mining, trade and business, transportation and all other productive activities.
WHAT IS ECONOMICS contd.
BASIC ECONOMIC ACTIVITIES
Basic economic activities
investment.
are production, distribution, consumption and
Production is transformation of inputs into output/finished products. It is creation or addition of
utilities. We can not produce matter. Matters are free gift of nature. We make them more useful by
transforming them into finished goods.
Consumption is use of goods and services. It is destruction or decrease in utility in a particular
commodity.
Investment also called captain formation is surplus of current year’s production over its
consumption which is used for further production of goods and services. It is the production of new
capital goods.
Distribution is the sharing of produced goods and services among the various individuals that
comprises a society.
WHAT IS ECONOMICS contd.
NEED, WANT AND UTILITY
Need is something one have to have . Something one can't do without say food and water, shelter,
clothing, basic health.
Want is something one would like to have/a specific feeling of desire
Everything that goes beyond this –say a big house, name-brand clothes, fancy foods and drinks, a new
car – is a want.
Utility is the capacity of a commodity to satisfy a want . In other words, utility is the want satisfying
power of commodity.
WHAT IS ECONOMICS contd.
RESOURCES / MEANS OF PRODUCTION/ FACTORS OF PRODUCTION / INPUTS OF
PRODUCTION
Resources are the inputs into the production of goods and services which includes the followings:
Human Resources: Labour. It All forms of human input, both physical and mental, into current
production. The labour force is limited both in number and in skills.
 Natural Resources: Land, mineral resources and Raw Materials. These are inputs into production that
are provided by nature: e.g. unimproved land and mineral deposits in the ground. The world’s land area
is limited, as are its raw materials.
 Manufactured Resources: Capital. Capital consists of all those inputs in production that have
themselves been produced: e.g. factories, machines, transport equipments and tools. The world has a
limited stock/supply of capital: The productivity of capital is limited by the state of technology.
WHAT IS ECONOMICS contd.
A WIDELY ACCEPTED DEFINITION OF ECONOMICS
Economics is the study of the use of scarce resources which have alternative uses.
An economy exists because two basic facts, such as:


Multiplicity of wants (Human wants for goods and services are unlimited).
Scarcity of means of production (Productive resources which produce goods and services are limited).
With our wants being virtually unlimited and resources scare, we cannot satisfy all our wants and desires by
producing everything we want. At any one time the society can produce only a limited amount of goods and services.
Goods are scarce because productive resources are scarce. Economics studies how society manages its scarce resources
to satisfy unlimited human wants having different priorities.
SCARCITY
 The reasons for scarcity are: human wants are unlimited, and means (resources)
available to satisfy these want are limited.
 Scarcity, thus, is the excess of human wants over what can actually be produced.
Scarcity is the mother of all economic problems.
 Had resources been unlimited, economic problems would not have arrived.
 Economics thus studies how people deal with scarcity
CHOICE, TRADE-OFF AND OPPORTUNITY COST
Choice involves sacrifice. “There is no such thing as a free lunch.” To get one thing that we like, we
usually have to give up another thing that we like.
ALL decisions thus (whether or production or consumption) involve trade-offs. Trade-offs are all the
alternatives that we give up / sacrifice whenever we choose one course of action over others.
The most desirable alternative given up (sacrifice) as a result of a decision is known as opportunity
cost. In other words, the sacrifice of best alternative in the production or consumption of a good is
known as its opportunity cost.
ECONOMIC PROBLEMS : THE PROBLEM OF CHOICE
The economic problems are the problems of choice. Problem of choice arise due to the flowing
facts of life.
 Though human wants are unlimited, all wants are not equality important, and thus have different
priorities.
 Limited means available to satisfy unlimited wants have alternative uses.
Thus the mismatch between multiplicity wants having different priorities and limited means having
alternative uses gives rise to the problem of choice.
RATIONAL CHOICES
rational decision making, as far as consumers are concerned, involves choosing
those items that give you the best value for money – i.e. the greatest benefit
relative to cost/expenses.
The same principles apply to firms when deciding what to produce. The firm
takes rational decision when sale proceeds/revenues earned exceed the costs
entailed i.e. if it adds to profit.
DIVIDING UP
ECONOMICS
THE
SUBJECT:
MACRO
ECONOMICS
VS
MICRO
 Subject matter of Economics is traditionally divided into two main branches – macroeconomics
and microeconomics,
where ‘macro’ means big, and ‘micro’ means small.
 These terms were firs coined by Ragner Frisch.
DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.
MICROECONOMICS
Microeconomics looks at the individual parts of the economy. Microeconomics studies the behavior of
individual economic entities and small group of economic entities such as: households, business
firms, markets and governments.
It looks at the choices these individual economic entities make and how they interact with each other. It
seeks to determine the mechanism by which the different economic units attain the position of
equilibrium/make rational choice, proceeding from the individual units to a narrowly defined group.
The study of economy as a whole remains outside the domain of micro economics.
Micro economic theory studies allocation of resources, product and factor pricing, theory of economic
welfare/theory of economic efficiency.
Theory of Demand
Product
Pricing
Theory of Production and Cost
Theory of Market
Wages
Micro Economic
Theory
Factor Pricing
Rent
(Functional
Theory of
Distribution)
Interest
Profits
Theory of Economic Welfare/ Theory of
Economic Efficiency
DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.
MACROECONOMICS
Macroeconomics looks at the economy as an organic whole. Macro economics studies economic
aggregates such as: total output, total demand, aggregate income, total savings, total investment, total
employment, rise and fall in general price level, interest rates.
Study of economic growth or how governments use monetary and fiscal policy to seek growth with
economic stability etc. also falls under the domain of macroeconomics.
Macroeconomics focuses on the big picture and ignores the fine details.
Macro economic theory studies theory of employment, theory of general price level,
economic growth, macro/aggregate theory of distribution.
theory of
DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.
Theory of
Consumption
Macro Economic
Theory
Theory of Income
and Employment
Theory of
Investment
Theory of General
Price Level and
Inflation
Theory of Trade
or Business Cycles
Theory of
Econmic Growth
Macro Theory of Distribution (Relative
Share of Wages and Profits)
ECONOMIC EFFICIENCY
Theory of economic efficiency involves efficiency in production, efficiency in distribution of goods
among people (efficiency in consumption), efficiency in allocation of resources.
Efficiency in production involves minimization of cost for producing a given level of output or
producing maximum possible from output of various goods from form the given cost incurred on
the productive resources.
Efficiency in distribution consists of distributing the given amount of produced goods and services
among the individuals of the society such that total satisfaction of the society is maximized.
Efficiency in allocation of resources consists of producing those goods which are most desired most
desired by the people.
PRODUCTION POSSIBILITY CURVE
A production possibility curve (PPC)/production possibility frontier (PPF)/ production possibility boundary/product
transformation curve is a graph that shows the different combinations of amounts of two commodities that could be
produced (alternative production possibilities) by using a given amount of resources and given technology.
The model od PPC is based on 4 key assumptions :
o
o
o
o
Only two goods can be produced
Productive Resources are given
Technology is given
There is fuller /efficient utilization(employment) of resources
PRODUCTION POSSIBILITIES TABLE
With given amount of resources and given
technology, the following table showing
production possibilities (A, B, C, D, E) between
capital goods and consumer goods
is
constructed. A PPC is drawn from production
possibilities table.
Production
Possibilities
Capital Goods
Consumer
Goods
A
14
0
B
12
2
C
9
4
D
5
6
E
0
8
Each production possibility (point) represents a specific combination of goods that can be produced given full
employment of resources and given technology.
Production Possibilities Curve contd.
The PPC here shows the trade-offs between two goods such as: capital goods and consumer goods.
o Consumer Goods: are goods for present/immediate Consumption. They satisfy our wants DIRECTLY.
e.g. . Food, clothes, consumer electronics, etc.
o Capital Goods (Investment Goods): are goods that are used to /produce make other goods. These are
goods for future consumption. They satisfy our wants INDIRECTLY and promote future growth or
“happiness”.
e.g. Tools, equipment, factories, other infrastructure.
Production Possibilities Curve contd.
Each point on the PPC represent an efficient combination of the two goods. Production possibilities (points ). A, B, C, D,
E represents the different possible alternates available for he society.
Point A reflects choosing capital goods only and no consumer goods.
Point E reflects consumption goods only and no capital good.
Point B is more likely to be chosen by a developed country relatively producing more capital goods that consumer
goods.
Point D is more likely to be chosen by a developing country relatively producing more capital goods that consumer
goods.
Point F is an inefficient combination. There is underemployment/underutilization of resources.
 Point G is outside our PPC. This point is desirable (more goods) but impossible/unattainable/currently unavailable
with given current resources. It requires better technology, and more/better resources.
Production Possibilities Curve contd.
IMPORTANCE OF PPC
PPC is a basic tool of modern economics to study the nature of basic economic problems. The model PPC
can be used to demonstrate the following:
 Scarcity of resources ( fundamental economic problem all societies face)
Efficiency
Productive
Allocative
Productive Capacity/Economic Growth(or Decline)
Trade-offs
Production Possibilities Curve contd.
PPC AND SCARCITY
Scarcity is represented by the PPC or frontier line. Given the resource, the economy has to operate on the
given frontier line(PPC).
If the society wants to increase the production of one commodity by moving along the PPC, it has to it has
to reduce some production of other commodity.
With given resources and technology, the society can not increase production of the commodity
represented on the two axes.
Production Possibilities Curve contd.
PPC AND PRODUCTIVE EFFICIENCY
The PPF curve shows the maximum possible/attainable output with current resources and technology which
is productive efficiency. We can’t
increase
production of
one
good
without
decreasing that of another.
Each point on PPC thus represents productive efficiency.
Whole PPC represents “full production” /productive efficiency /full-employment of resources/producing
at the lowest cost.
 A point on the PPC indicates efficient use of the available inputs, while a point beneath the curve
indicates inefficiency.
Production Possibilities Curve contd.
PPC AND ALLOCATIVE EFFICIENCY
As the productive resources are limited, the economy has to choose between different goods represented by
production possibilities. It has therefore to decide which goods to be produced more and which less. In
deciding what amounts of different goods are to be produced, the society would, in fact, decide about the
allocation of resources among different possible goods.
There are an infinite number of points(combination of two goods) on the PPC. Any combination chosen on
the PPC represents allocative efficiency (the combination most desired by the society).
Allocative efficiency is a value decision based on values/politics/ autocracy.
Production Possibilities Curve contd.
ECONOMIC GROWTH AND SHIFT IN PPC
The PPC shows all possible combinations of two goods that can be produced if all available resources (land,
labour, capital equipment) are fully employed (used) with the best technology currently available.
A shift in PPC upward and to the right (showing more of
both goods can be produced than before) indicates
economic growth. Economic growth or shift in PPC (How
do we get to point G) occurs if
Capital Goods
A
B
o Productive resources expand Technological
advancement which increases productivity
C
F
G
o Discover new resources
o Take resources (War/ colonization)
D
o Trade for Resources
E
O
Consumer Goods
Production Possibilities Curve contd.
TRADE-OFFS
The PPC reflects numerous combination of two goods that can be produced with the given resources and
technology.
If a particular combination say ‘C’ is chosen, other alternative combinations are given up. These
sacrificed alternatives say A,B, D,E are trade-offs.
Production Possibilities Curve contd.
OPPORTUNITY COST
The opportunity cost to produce one extra unit
of a commodity means the lost production
another good. Opportunity cost is illustrated in
terms of moving from one point to another
along the frontier line.
Opportunity cost can be studied with marginal
rate of transformation (MRT). MRT is the rate at
which one good must be sacrificed in order to
produce a single extra unit (or marginal unit) of
another good, resources and technology being
given. MRT of consumers good for capitals good
is given by
𝑴𝑹𝑻𝑪𝑲 =
cost
𝒅𝑲
𝒅𝑪
PPC and
Opportunity
curve
Production
Possibilitie
s
Capital
Goods
Consumer
Goods
A
14
0
----
B
12
2
1
C
9
4
1.5
D
5
6
2
E
0
8
2.5
= 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝑷𝑷𝑪 = opportunity
Where, K stands for capital goods
C stands for consumer goods
The concavity of PPC is due to increasing opportunity
cost/MRT. Opportunity cost rises or MRT as we move
down along the PPC.
𝐌𝐑𝐓𝐂𝐊 =
𝐝𝐊
𝐝𝐂