Economics The Study of Choice
Definition Economics is a social science that studies how people choose amongst alternatives available to them, when wants are unlimited compared to the resources.
Ideas Central to Economics 1. ScarcitySince wants are unlimited and the resources to fulfill them are limited, this condition of scarcity forces us to choose among various alternatives. The issue of scarcity raises three most important questions in every economy a) What should be produced b) How should goods and services be produced (Labor intensive or capital intensive, production in own country or foreign country etc). c) For whom should goods and services be produced 2.Choice The problem of choice arises as resource can be put to alternative uses.3.Oppurtunity Cost It is the value of the best next alternative forgone in making the choice.
Difference between Economics and other Social Sciences
1. Emphasis on Opportunity Costs Economic thinking emphasizes on the value of alternatives in each problem involving choice. 2. Individuals maximize in pursuing Self-Interest Economists assume that individuals make choices that maximize value of some objective like firms maximize profit objective and consumers aim at maximizing their level of satisfaction.3. Choices are made at margin Economists argue that individuals pay attention to the consequences of small changes i.e. a little more or little less of the activities they pursue.
Branches of Economics a) Microeconomics is the branch of economics that studies individual decision making i.e. consumers and firms. Issues such as the price determination of a firm, price of the tickets of the concerts etc are part of microeconomics study b) Macroeconomics is the branch of economics that studies the decision-making at the macro level i.e. for the economy as a whole. Issues such as rate of inflation, unemployment rate etc are part of macroeconomics study.
Careers in Economics
1. Majorly economists work in three types of organizations a) Business firms b) Government agencies c) Colleges and Universities
2. Other Jobs The undergraduate degree in economics helps to make a career as financial managers, financial analysts, underwriters, actuaries, securities and financial sales workers, credit analysts, loan and budget officers, and urban and regional planners.
Similarities between Economics and Other Social Sciences
Unlike other social sciences, economics also uses scientific method to conduct research. To study the complex real world, economists use model i.e. set of assumptions about the real world. Hypothesis are suggested and tested (commonly uses ceteris paribus assumption for tests), if true - further tested and become theory after general acceptance. Generally two kinds of assertions are tested. a) Positive statements- statements of facts. b) Normative statements-statement of value judgment.
And finally become law after universal acceptance.
Chapter 2
Confronting Scarcity Choices in Production
Factors of production in the economy help to produce goods and services, which in turn creates utility for the consumers. 1. Labor It is the human effort applied to production. 2. Capital It includes physical goods and intellectual discoveries.3.Natural Resources It is the resources that are found in nature and help in the production process. The knowledge to be applied to the factor of production (technology) and entrepreneur who uses technology with other factor of production play an important role in the production process.
Production Possibility Curve
Definition A production possibility curve is a graphical representation of the alternative combinations of goods and services that an economy can produce with factors of production and technology fixed.
Example Suppose there are three plants of one firm that can produce skis and snowboards. The table below shows the various combinations that plant 1 can produce. The PPC curve is downward sloping reflecting the scarcity of capital and labor (as producing more skis means shifting the resources from snowboards). The slope of the curve measures the opportunity costs forgone in producing more of the good on the horizontal axis for the quantity of the good on the vertical axis forgone.
The slopes of all the three plants differ with lowest opportunity cost at Plant3. Thus if firm decides to produce more snowboards, it will use Plant 3. Economists state that an economy with the lowest opportunity cost of producing the good has comparative advantage over the other economies. But if we combine all the three we get a concave curve reflecting law of increasing opportunity cost (i.e. if we produce more of one good opportunity cost of that good increases). And the more we add the production facilities the smoother the curve becomes.
Movements along the PPC curve Suppose the economy is at Pt. B (producing security and all other goods), and movement along the curve to pt. C requires shifting the resources from good to the other (Fig3).
Movement toward the PPC curve (i.e. from point inside to the point on the PPC) An economy operates inside the PPC when there is underutilization or misallocation of the resources (not allocated on the basis of comparative advantage). The economy does not operate at full employment at pt. B. When the idle factors of production are utilized fully the production of both goods rises and economy operates at Pt. A(Figure4).
Moreover, factors of production when not allocated according to comparative advantage result in inefficient production (Figure5). Thus the economy flourishes and specializes when operates on the PPC curve.
Application of PPC
1.International trade An efficient world production i.e. resource allocation on comparative advantage allows the economy to operate on the PPC curve. If the nations specialize, they rely on each other and trade. The implications of the PPC model are powerful for international trade as it helps in more production of goods and services and helps in achieving full employment too.
2. Economic Growth An increase in the quantity or quality of factor of production allows more production of goods and services in turn shifts the PPC curve outwards and raises the economic growth. Though we have assumed factor of production and technology to be fixed, but the automated production, innovation in transportation, development of modern information have changed the scenario a lot in real.
3. Choice of Economic System The world economies are somewhere operating between capitalism and socialism i.e. they are mixed economies. The global shift has tilted the world economies towards the capitalist economic system, which provides more of economic freedom and more inducement toward allocation of resources on the basis of comparative advantage. And this also raises the income per person. But governments role, though limited, remains fundamentally important.
Chapter 3.
Demand And Supply
Demand
Law of Demand The law states, the quantity demanded falls when the price rises, all other things unchanged(Ceteris paribus).
Demand Schedule Demand Curve It is the table that shows the quantities of a good demanded at different price at a particular period of time. The graphical representation of the demand schedule is the demand curve.
Figure1 Demand Schedule Demand curve
Determinants of Demand Besides price, there are various variables affecting demand a) Preferences Change in the preference that is popular shifts the demand curve to right and the less popular one shifts the curve to left. b) Prices of related goods and services The fall in the price of the complementary raises the demand while substitutes demand fall with the fall in the price. c) Income Generally, the demand for the good rises with the rise in the income but inferior goods are exception to the rule. d) Demographic Characteristics Greater the population, greater the demand. e) Buyer expectations Future expectations for price rise will shift the demand curve to the right and vice versa.
Movement along the demand curve Shift of the demand curve The change in demand due to price causes the movement along the demand curve, while changes due to other determinants causes shift (to right or left) of the demand curve.
Supply
Law of supply The law states, An increase in the price results in the increase in the quantity supplied, all other things unchanged.
Supply Schedule Supply Curve The table showing the quantities supplied at different prices during particular period. And the graphical representation of the schedule depicts the supply curve in the figure below.
Figure2 Supply Schedule Supply curve
Determinants of Supply Besides price there are other factors that affect the quantity supplied by the sellers a) Prices of factor of production An increase in the factor prices will decrease the quantity supplied and vice versa. b) Returns from the alternative activities An increase in the returns from the alternate activities decreases the supply. c) Technology An improvement in the technology (such as use of computers) increases supply while certain equipments (such as pollution control devices) reduce supply. d) Seller Expectations Future expectations of price rise decreases the current quantity supplied. e) Natural events Storms, droughts etc reduces supply while unusually good harvest increases the supply. f) No. of sellers More the number of sellers greater will be the supply.
Movement along the supply curve and shift of the supply curve This figure below sums the topic clearly
Equilibrium
Determination of the equilibrium The intersection of the demand and the supply curve at a single point determines the equilibrium price and quantity.
Any other price other than the equilibrium price puts the market in disequilibrium. Any surplus will cause the price to fall and ultimately reach the equilibrium price. Similar happens in the case of shortages too.
Movements in Demand and Supply Curves The movements can be individual or simultaneous in both the curves.
Individual shifts
Changes in the curveEffect on equilibrium price Effect on equilibrium quantityIncrease in demandPrice increasesQuantity increasesDecrease in demandPrice decreasesQuantity decreasesIncrease in supplyPrice decreasesQuantity increasesDecrease in supplyPrice increasesQuantity decreases
The simultaneous shifts If the simultaneous shifts in demand and supply cause the equilibrium price and quantity to move in same direction, then price and quantity move in same direction. If the shift in the curves is in the opposite (i.e. one falls and other rises) then shift in price and quantity is critical to find out, depending on the shift. (How far or how close).
The Circular flow Model It provides the insight how markets work and are related to each other. Firms supply goods and services to households, who in turn supply factor of production to firms. The factor payments made by the firms become the income of the household. Thus the whole process is circular and ongoing.
Chapter 5.
Elasticity A Measure of Response
Definition Elasticity is the ratio of the percentage in quantity demanded in a dependent variable to a percentage change in an independent variable.
Price Elasticity of Demand Definition - It is the percentage change in the quantity demanded of a particular good divided by the percentage change in the price of that good or service, all other things unchanged. It reflects the movement along the demand curve and is always negative.
Ways of computing price elasticity a) Percentage Method We compute the percentage changes in both the quantity demanded and the price and divide them to arrive at a value of elasticity. b) Arc Method This method is generally used when we have linear demand curve. It calculates the percentage changes relative to the average value of each variable between two points. It is an approximate method and cannot be applied to large changes. The price elasticity falls as we move down and to the right of the linear demand curve.
Categories of price elasticity a) Price inelastic (a given percentage change in price results in smaller quantity demanded). b) Unit elastic (a given change in price does not change the quantity demanded). c) Price elastic (a given percentage change in the price leads to bigger change in the quantity demanded).
Impact of elasticity on total revenue As per the law of demand the quantity demanded is inversely related to the price but the total revenue move in the direction of the variable by the larger percentage (and remains same if variable move by the same percentage).
Determinants of price elasticity a) Availability of Substitutes - closer the substitutes available, greater the price elasticity. b) Importance of households - the goods that affect the purchasing power definitely affects the quantity demanded. c) Time - greater the elasticity when more time is allowed to the consumers.
Income Elasticity The percentage change in the quantity demanded at a specific price to the percentage change in income is called income elasticity (denoted as ey). Categories of income elasticity a) Positive income elasticity - Normal good (an increase in income increases demand and vice versa). b) Negative income elasticity Inferior good (increase in income reduces demand and vice versa).
Cross price elasticity of Demand The responsiveness of demand for a good or service to the change in the price of another good or service is called cross price elasticity of demand. Categories of cross elasticity a) Positive cross elasticity Substitutes (an increase in the price of one will lead to the increase in the demand of the other). b) Negative Cross Elasticity-Complements (an increase in the price of will lead to the reduction in the demand for other. c) Zero Elasticity- unrelated (change in the price of one will not affect the demand of the other).
Price Elasticity of Supply The ratio of the percentage change in the quantity supplied to the percentage change in its price is called price elasticity of supply (ceteris paribus).Categories of Supply elasticity a) Perfectly inelastic. b) Unit elastic. c) Perfectly elastic.
Time is an important factor, as more the time more price elastic is the supply curve.
Chapter 6
Markets, Maximizers, and Efficiency
Logic of Maximizing Behavior Economists argue that individuals maximize their objectives. Consumers seek to maximize utility and firms seek to maximize economic profit. In this model, we assume that consumers and firms maximize the net benefit (total benefit minus the opportunity costs) of each activity, with benefits and costs given. And to maximize their respective objectives, they evaluate the additional benefit and additional cost of each activity. So therefore economists apply the marginal decision rule to it. The rule says that If the additional benefit of one more unit exceeds the extra cost, do it if not, do not. But there are constraints to it, as the consumers cannot go beyond their income or budgets and firms not beyond their production capacity. And if an activity is carried out at less or more than efficient level, the loss in net benefits is called the deadweight loss.
Figure Using Marginal Benefit and Marginal Cost Curves to Determine Net Benefit
Maximizing in the Marketplace In 1776, Adam Smith argued that efforts by the individuals to maximize their own objective maximize net benefit for the economy as a whole, as it allocates the resources efficiently.
Conditions for efficient market allocation a) marketplace must be competitive. b) Allocation regarding property rights (property rights must be exclusive and transferable). When the efficiency condition is met the market demand and market supply can be interpreted as the marginal benefit and marginal cost curves.
Producer and Consumer Surplus Both buyers and the sellers want to be better off in a transaction in the marketplace. The benefit of the consumer is measured in terms of consumer surplus (difference between total benefits of consuming and the total expenditures of a given quantity) and that of the producer in terms of producer surplus (difference between total revenue received and the cost of producing a given quantity of output). The sum of consumer surplus and the producer surplus measures net benefit to society of any level of economic activity. Thus the net benefit is maximized when demand and supply curves intersect.
Efficiency and Equity When the condition of efficiency is achieved in a market the condition of equity i.e. equitable distribution of income arises. Governments step in as markets are not fair enough for equitable distribution of income (taxes for rich and welfare programs for poor).
Market Failure When market fails to achieve the efficient allocation of resources (due to failure of the abovementioned conditions) is termed as market failure. a)Non-competitive markets - It is the case where buyers and sellers are powerful to influence the market price. b) Public goods-in, which the cost of exclusion is prohibitive and marginal cost of additional user, is zero. Thus condition of efficient allocation is violated. Therefore the governments step in, and supply by direct provision or buy from private agencies on contract basis. The efficient level is Q but free riders prevent to produce the efficient level and causes deadweight loss shown by triangle ABC. Example national defense.
External costs and Government Intervention If an activity generates external costs the decision maker will not be facing it, so government intervened to achieve the efficiency level (taxes or direct regulation).
Common property Resources In these the property rights are not defined so no efforts are taken to preserve them. So the governments impose limits.