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.

Some Definitions of Economy 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.

BASIC ECONOMIC ACTIVITIES WHAT IS ECONOMICS contd. BASIC ECONOMIC ACTIVITIES Basic economic activities are production, distribution, consumption and investment. 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.

A WIDELY ACCEPTED DEFINITION OF ECONOMICS 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 THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS 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 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.

Micro Economic Theory Product Pricing Theory of Demand Theory of Production and Cost Theory of Market Factor Pricing (Functional Theory of Distribution) Wages Rent Interest Profits Theory of Economic Welfare/ Theory of Economic Efficiency

DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD. 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, theory of economic growth, macro/aggregate theory of distribution.

Theory of Income and Employment Theory of Consumption DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD. Macro Economic Theory Theory of Income and Employment Theory of Consumption Theory of Investment Theory of Trade or Business Cycles Theory of General Price Level and Inflation 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 : Only two goods can be produced Productive Resources are given Technology is given There is fuller /efficient utilization(employment) of resources

PRODUCTION POSSIBILITIES TABLE Production Possibilities 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 B 12 2 C 9 4 D 5 6 E 8 Each production possibility (point) represents a specific combination of goods that can be produced given full employment of resources and given technology.

e.g. . Food, clothes, consumer electronics, etc. Production Possibilities Curve contd. The PPC here shows the trade-offs between two goods such as: capital goods and consumer goods. Consumer Goods: are goods for present/immediate Consumption. They satisfy our wants DIRECTLY. e.g. . Food, clothes, consumer electronics, etc. 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.

Point A reflects choosing capital goods only and no consumer goods. 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.

PPC AND PRODUCTIVE EFFICIENCY 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.

PPC AND ALLOCATIVE EFFICIENCY 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.

ECONOMIC GROWTH AND SHIFT IN PPC 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 Productive resources expand Technological advancement which increases productivity Discover new resources Take resources (War/ colonization) Trade for Resources Capital Goods A B C G F D 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.

PPC and Opportunity curve Production Possibilitie s OPPORTUNITY COST Production Possibilities Curve contd. 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 𝑴𝑹𝑻 𝑪𝑲 = 𝒅𝑲 𝒅𝑪 = 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝑷𝑷𝑪 = opportunity cost Where, K stands for capital goods C stands for consumer goods PPC and Opportunity curve Production Possibilitie s Capital Goods Consumer Goods 𝐌𝐑𝐓 𝐂𝐊 = 𝐝𝐊 𝐝𝐂   A 14 ---- B 12 2 1 C 9 4 1.5 D 5 6 E 8 2.5 The concavity of PPC is due to increasing opportunity cost/MRT. Opportunity cost rises or MRT as we move down along the PPC.