Introduction to Economics

Limits, Alternatives & Choices

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Aims & Objectives• After studying this lesson, you would be able to

understand

• What is economics?• Concepts like scarcity & choice• Microeconomics Vs Macroeconomics• Individual’s & Society’s Economizing Problem• Society’s Production possibility frontier• Economics & managerial decision making

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What is economics?• Economic wants exceed productive capacity → scarcity →

calls for optimal choice making • Economics is a social science concerned with making

optimal choices under conditions of scarcity.

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Scarcity & Choice• Scarcity of goods refer to a situation in which goods are

limited relative to desires

⇒ Choices must be made

⇒ there is a cost of making a choice called Opportunity cost

Microeconomics & macroeconomics

Economics is divided into two major subfields –

• Microeconomics – concerned with the behaviour of individual entities such as households, firms & markets. Adam Smith (The Wealth of Nations, 1776) is considered the founder

• Macroeconomics – concerned with the overall performance of the economy i.e. aggregate behaviour of the economy. John Maynard Keynes (General Theory of Employment, Interest and Money, 1936) is considered the founder of modern macroeconomics.

Note: the present course discusses microeconomics with focus on Firms, Markets & their behaviour

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Individuals Economizing Problem• An individual has limited income but unlimited wants

→ he faces a problem of constrained optimization

i.e given his budget he has to make the best choice posssible

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Society’s Economizing Problem• A society has scarce resources – land, labour, capital &

entrepreneurial ability • It has to decide how to allocate these limited resources among

thousands of different possible commodities & services• To summarize: given resources are scarce relative to wants, an

economy must choose among different potential bundle of goods, select from different techniques of production and decide in the end who will consume the goods

• Given this problem facing the economy two concepts are very important:

Inputs – commodities or services used to produce goods & services. Also called factors of production

Outputs – various useful goods or services that result from the production process & are either consumed or used for further production

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The Production Possibility frontier (PPF)

PPF shows the maximum quantity of goods that can be efficiently produced by an economy, given its technological knowledge and quantity of available inputs.

Economic growth shifts the PPF outward

PPF & Opportunity cost

• In a world of scarcity, choosing one thing means giving up something else. The opportunity cost of a decision is the value of the good or service foregone. This is a very important concept in economics

• As we move up the PPF, good X is given up to have additional quantities of Y. The opportunity cost of producing additional Y is the amount of X foregone.

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How is economics useful in managerial decision making?

• Evaluating Choice Alternatives

Identify ways to efficiently achieve goals. Specify pricing and production strategies. Provide production and marketing rules to help

maximize net profits.

• Making the Best Decision

Economics, in particular managerial economics, can be used to efficiently meet management objectives.

Economics, in particular managerial economics, can be used to understand logic of company, consumer, and government decisions.

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The market system & Circular Flow

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Aims & Objectives• After studying this lesson, you would be able to

understand

• Economic Systems • Command Economy and Market Economy• Fundamental questions facing an economy• Circular Flow of Income

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Economic Systems• Economic systems are a set of institutional arrangements

and a coordinating mechanism to solve economic problems.

• Economic systems differ in two important ways: ▫ Who owns the factors of production and ▫ the method used to coordinate economic activity

• The two fundamentally different economic systems are:▫ Command economy▫ Market economy

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Command Economy • Known as socialism or communism• Government ownership of resources• Decisions made i.e. economic activity is coordinated by a

central planning board.▫ Libya, Myanmar, and Iran.

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Demise of Command System• Soviet Union, Eastern Europe, and China• System was a failure• The coordination problem• The incentive problem

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Market Economy• Known as capitalism• Private ownership of resources• Decisions based on markets

▫ Australia, Switzerland, and the U.K.

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Characteristic of the Market System

• Private property • Freedom of enterprise and choice• Self-Interest• Competition• Markets and prices• Technology & capital goods

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Private property

• Private individuals and firms own most of the private property (land and capital):

Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property.

Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth.

Property rights extend to intellectual property through patents, copyrights, and trademarks.

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Freedom of enterprise and choice• Freedom of enterprise means that entrepreneurs and

businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice.

• Freedom of choice means: Owners of property and money resources can use resources as they choose, workers can choose the training, occupations, and job of their choice, consumers are free to spend their income in such a way as to best satisfy their wants.

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Self-Interest• Self interest is one of the driving forces in a market

system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction. As each tries to maximize profits, income, and satisfaction, the economy will benefit if competition is present.

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Competition• Competition requires two or more independently acting

buyers and sellers. This serves to decentralize economic power. Also, it requires freedom to enter or leave the markets.

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Markets and prices• Markets and prices: this characteristic reflects that the

decisions made on each side of the market determine a set of product and resource prices that guide owners, entrepreneurs and consumers as they all make choices based on their respective self-interests.

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Technology & Capital goodsMarket systems reward individuals and businesses for development of new technologies thereby encouraging their development and implementation.•Specialization allows economies to take better advantage of their resources and their capabilities.

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Active but limited Government• Although the market system promotes efficiency, it has

certain shortcomings. • There may be over production of goods with social costs,

and an underproduction of goods with social benefits. • There are tendencies for businesses to increase monopoly

power.• Hence Government intervention is observed as and when

required

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Five fundamental questions facing an Economy• All economies whether a market system, or otherwise,

must address the following five fundamental questions:

• What goods and services will be produced?• How will the goods and services be produced?• Who will get the goods and services?• How will the system accommodate change?• How will the system promote progress?

Circular flow of income• Let us for the time being assume a simple economy

which has no government and is closed. The economy has only two sectors: Households & Firms

Households Firms

Factor services (land, labour, capital & organization)

Payments for factor services (rent, wages, interest & profits)

Payment for goods & services

Goods & services

Refer next slide for complete diagram

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28 Abroad

Government

Households

Borrowings & imports

Firms

Pay for imports & borrowings

Imports

Taxes (T)

Transfer payments

Payments for goods & services

Goods & services

Factor inputs (land, labour, cap, org)

Factor incomes (rent, wager, interest, profits)

Banks

Payment for goods & services & subsidies

Exports & pay for imports

Imports & pay for exports

Interest rate (lending rate)

Y Yd = Y - T

= C+S

Demand & time deposit

Interest rate (deposit rate)

Reserves CRR, SLR, repo rate

Securities & Gold Bond Mkt.

Payment for imports

Loans

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Thank You