2 what is economics

Goods and BadsResourcesScarcityOpportunity CostsCosts and Benefits

In This Lecture…..

In This Lecture…..

Decisions Made at the MarginEfficiencyUnintended EffectsExchange

Microeconomics & Macroeconomics

Positive & Normative Economics

In This Lecture…..

What does an Economist do?

Benefit

Cost

• Economists look at the world and ask questions.

• Their questions give us insight into the economic way of thinking.

Five Basic Questions of Economics

• What is Economics?• What do Economics study?• Is there an economic way of

thinking?• Why study Economics?• Can the study of Economics help us

understand our world?

What is Economics?

• Economics is about choices that an individual and society make.

• Why do people and society make choices?

• Why can’t a society and a person have everything they want?

• Economics is the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants.

What do Economics study?

• Everything in the world that attracts the curiosity is studied using economic analysis.

• Economic analysis : process of using economic tools and economic way of thinking to real world problems.

• However, economics cannot explain everything about the world but believe it can explain much.

Is there an economic way of thinking?

• It means how the economists view, interpret and analyze the world.

• Economists can see things that other people cannot.

• Economic way of thinking cannot be pinned down.

• It is more about watch- economists do economics, think-what economists are doing and how and identify- what is essential to economic problem solving.

Why study Economics?

• To solve the real world problems• Because of its explanatory and

predictive power – economics can explain why things are as they are and predict what is likely to happen under certain conditions.

• Because it explains certain ideas that have shaped the world – helps us to judge whether they are right or wrong.

Can the study of Economics help us understand our world?

• Economics matters in people’s everyday life.

• Global events affect and impact everyone’s life.

• The universal language for twenty first century is the language of Economics.

RECAP – What is economics?

• Economics is about choices that an individual and society make.

• Why do people and society make choices?

• Why can’t a society and a person have everything they want?

• Economics is the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants.

Scarcity

The condition in which our wants are greater than the limited resources available to satisfy those wants

Effects of Scarcity

• Need to make choice• Need for a rationing device• Competition

Need to make Choice

• Scarcity = wants > limited resources

• What is wants? * Anything that provides utility• What is utility? * The satisfaction one receives

from a good

Contd.

What is good and what is bad? Good - Anything from which individuals receive utility or satisfaction Bad - Anything from which individuals receive disutility or dissatisfactionDisutility - The dissatisfaction one receives from a bad

PEOPLE WANT GOODS NOT BADS.

Contd.

• Goods can be tangible or intangible• Goods do not appear with the snap

of your finger.• It takes factors of production or

resources to produce them.• Factors of Production : Land, Labor,

Capital, Entrepreneurship.

Factors of Production ~ Resources ~

Land - All natural resources, such as minerals, forests, water, and unimproved land

Factors of Production ~ Resources ~

Labor - The physical and mental talents people contribute to the production process

Factors of Production ~ Resources ~

Capital - Produced goods that can be used as inputs for further production, such as factories, machinery, tools, computers, and buildings

Factors of Production ~ Resources ~

Entrepreneurship - The particular talent that some people have for:organizing the resources of land, labor, and capital to produce goodsseeking new business opportunities developing new ways of doing things

Characteristics of Resources

• Resources are scarce• Resources have alternative uses

This leads to economic problem – the problem of choice.

What is the motive of making choice?- Welfare at individual, producer and

government level.

Economic Problem/Resource Allocation

• Economic problem or Problem of choice

• There are three critical issues 1. what to produce + How much

to produce2. how to produce3. for whom to produce

• Economics examines how societies address these three issues: allocation of scarce resources

What to Produce + How much to produce?

• To make a choice of wants which are important for the economy as a whole on the basis of the technology available, cost of production, demand for the commodity. It is studied under Price Theory.

• How much to produce is the problem of determining the quantity for each good to be produced on the basis of the technology available, cost of production, demand for the commodity

How to produce?

• Choice of technique of production that maximizes output or minimizes costs or by choosing the efficient technique of production

• Labor Intensive – more labor and less capital used

• Capital Intensive – more capital less labor is used

QUESTIONS!!!

• In a country like Nepal which technique of production should be used?

Labor intensive as labor is in abundance so as to raise the standard of living of the people.

• In USA which technique of production should be used?

Capital Intensive as capital is in abundance

For whom to Produce?

• It is concerned with the distribution aspect of product among various sections of the society.

• It is related to the buying capacity of the consumers in the market.

• Buying capacity is dependent on his purchasing power / income

• Production will be carried out for those consumers who can pay.

Institutions for Allocation Resources

• Institutions, including laws and customs, define a society’s procedures for allocating resources

• In a capitalist economy:– Means of production are owned and

controlled by and for the benefit of private individuals

– Resources are allocated by voluntary trading among businesses and consumers

The Market Economy* Private Ownership of Property* Freedom of Enterprises* Profit Motive of Production* Price Mechanism guides production

decisions* Existence of competition* Consumers are supreme* Very unequal distribution of Income* Absence of role of Government

Communist/Command/Centrally Planned Economy

• In such an economy:–Economic decisions are highly centralized

–The state owns and controls the means of production and distribution

The Centrally Planned Economy

* Public ownership of property or factors

of production* No freedom of enterprise* Social welfare motive* Planning mechanism guides production* No competition* Absence of consumer’s sovereignty* Restriction of freedom of occupation* Inequalities of income greatly reduced* Complete role of government

No economy is completely centralized or decentralized; all economies are a combination of both.

Mixed Economy* Ownership of property both by

private and public sector.* Freedom of enterprise in private sector but no freedom in public sector.* Private sector – profit motivated; public sector – welfare motivated* Private Sector – Price mechanism Public Sector - Government

* Competition exists only in private sector* Consumer sovereignty exists* Freedom of occupation exists* Considerable inequality of income exists* Full role of government in public sector and limited role in private sector.* Price mechanism resolves the central problems of economy in private sector while central planning authority decides in public sector

Economics- REDIFINED

Economics is the science that studies human behavior in regards to the allocation of scarce resources so that consumers attains the maximum level of satisfaction, producers attains the maximum level of profit and the nation attains the maximum level of social welfare.

If you are willing and able to pay the price the good is yours.

A means for deciding who gets what of available resources and goods

Need for Rationing Device

Competition

• It’s the result of scarcity of resources

• Competition takes the form of people trying to get more of the rationing device.

• If dollar price is the rationing device people would compete to earn dollars.

Self Test Questions

1. What are the three effects of scarcity?

2. Define utility and disutility.3. State how economists divide utility.4. State the function of rationing device

and give an example.5. Scarcity is the condition of finite

resources. True or false? Explain your answer.

Self Test Questions

1. How does competition arise out of scarcity?

2. How does choice arise out of scarcity?

Opportunity Costs

The most highly valued opportunity or alternative forfeited when a choice is made

Study or ???

Benefit

Cost

Contd.

The higher the opportunity cost of doing something, the less likely it will be done.

• Why young rock stars, movie stars, and fashion models rarely go to college?

BECAUSEthe opportunity cost are sufficiently high for the individual that the benefits of attending college are outweighed by the cost.

Economics, the Science of Scarcity

The science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants.

Production Possibilities Frontier

Represents the possible combinationsof two goods that can be produced ina certain period of time with a given state oftechnology and fully employedresources.

• It is a hypothetical model of an economy that produces only two products.

• Since scarcity is the fact of economic life, we need to use our resources as efficiently as possible. If we succeed we are operating on full economic capacity. Usually, there are some economic slack, but every so often we do manage to operate at peak efficiency.

• When this happens, we are on our production possibilities frontier.

• When at PPF, 4-6% labor unemployment rate and 85-90% use of plant and machinery is an accepted norm.

Production Possibility Curve

Assumptions – Economy produces only two goods.

- Economic resources are constant

- Resources are not specific

- Resources are fully employed

- Technology is constant- Resources are efficiently

employed

Tabular and Graphical Presentation of PPC – when MRT

is constant• What is marginal opportunity cost or

MRT (marginal rate of transformation)?It means the sacrifices made in terms of units of Y to produce an additional unit of X.

• When MRT is constant PPC will be a downward sloping straight line.

Production Possibilities Frontier

Constant Opportunity Costs

Tabular and Graphical Presentation of PPC – when MRT

is not constant• When MRT is not constant in fact,

increasing - PPC will be a downward sloping curve concave to the origin

Production Possibilities Frontier

Increasing Opportunity Costs

Production Possibility FrontierFramework for Understanding

Scarcity and Choice

• All the points on PPC shows what to produce and how much to produce.

• All points on the curve are efficient and attainable.

• Depending on nation’s policy it can choose any point on the curve

• All points on PPC imply that most efficient technology is employed

Productive Efficiency and Inefficiency

Productive EfficiencyThe condition where the maximum output isproduced with given resources and technology

Productive InefficiencyThe condition where less than the maximumoutput is produced with given resources andtechnology. Productive inefficiency implies thatmore of one good can be produced without anyless of another good being produced.

Unemployment

• Any point inside PPC shows that resources are unemployed or underemployed or are lying idle.

• By increasing the use of resources production can be increased

Attainable and Unattainable Regions

and Productive Efficiency

Economic Growth withina PPF Framework

An increase in resources or an advance in

technology can increase the productioncapabilities of an economy, leading toeconomic growth and shift outward in

theproduction possibilities frontier.

PPF and Economic Growth

Economic Growth and Shift in PPC

• PPC will shift to the right when

- New stock of resources are discovered

- There is an advancement in technology• PPC will shift to the left when

- Resources are destroyed because of national calamity like earthquake, fir, war etc.- There is the use of outdated technology

Advance in Technology

An advance in technology commonly refers to the ability to produce more output with a fixed amount of resources or the ability to produce the same output with fewer resources.

PPC – Technological Change

P1 P P1 P P

O O O P P1 P P1

P

Fig A Fig B Fig CAdvancement in technology Advancement in technology Advancement in

technologyOf both Good X and Good Y of Good X only of Good Y only

Positive vs. Normative Economics

Positive - The study of “what is” in economic matters.

Cause Effect• Deals with actual or realistic

situation

• eg. What determines the price rise? Govt has adopted policies to reduce unemployment. Rate of inflation is 6% in Nepal.

Normative - The study of “what should be” in economic matters

Judgment and Opinion (ethics)

• Deals with idealistic situation

• Eg – What is a fair price rise? Unemployment is worse that poverty. Rate of inflation should not be more than 6%.

Positive vs. Normative Economics

Microeconomics

Microeconomics deals with human behavior and choices as they relate to relatively small units—an individual, a business firm, an industry, a single market.

Microeconomic Questions~

• How does a market work?• What level of output does a firm

produce?• What price does a firm charge for

the good it produces?

Microeconomic Questions(continued)

• How does a consumer determine how much of a good he or she will buy?

• Can government policy affect business behavior?

• Can government policy affect consumer behavior?

Macroeconomics

Macroeconomics deals with human behavior and choices as they relate to highly aggregate markets (e.g., the goods and services market) or the entire economy.

Macroeconomic Questions

• How does the economy work?• Why is the unemployment rate

sometimes high and sometimes low?

• What causes inflation?• Why do some national economies

grow faster than other national economies?

Macroeconomic Questions(continued)

• What might cause interest rates to be low one year and high the next?

• How do changes in the money supply affect the economy?

• How do changes in government spending and taxes affect the economy?

Difference between Micro and Macro Economics

Microeconomics Macroeconomics* It studies individual economic units.

* It studies aggregate economic units.

* It deals with determination of price and output in individual markets.

* It deals with determination of general price level and national output in the economy.

* Its basic parameter is price, i.e. consumers and producers take economic decision on the basis of price.

* Its basic parameter is income, i.e. economic decision relating to consumption, saving, investment etc. are made on the basis of national income

* It uses partial equilibrium method given by Alfred Marshall.

* It uses general equilibrium method given by Walras.

* It aims at optimal allocation of resources.

* It aims at determination of aggregate output, national income, price level and employment level in the economy.

* eg. Individual demand * eg. Aggregate demand, national income

Need for integration of Micro and Macro Economics

• Why integration?

To get correct solutions of our main economic problems

Economic Theory / Model

• It is an abstract representation of the real world designed with the intent to better understand that world.

• Abstract means to omit certain variables to understand something.

• In theory only those variables are emphasized that are critical to explain/predict an activity or event.

Models and Mathematics

• Economists use models to provide an account of cause and effect, to help us understand how the world works

• Some economic models are quantitative (mathematical) so that they are more precise

Simplifying Assumptions

• All scientists build models based on assumptions, so do economists

• This allows the model to focus on the most important explanations for a particular phenomenon

• No economic model is literally true• Some assumptions are easy to

criticize• The test of a model is its usefulness

Data Analysis

• Scientific method requires models to be tested with data, e.g., from:– Records (financial accounts, customer

databases)– Surveys (Consumer Expenditure Survey, other

government or private sources)– Experiments

• Econometrics: application of statistical methods to empirical questions in economics

Judging a Theory

• On the basis of how well they predict• Common mistake – theories judged on

the basis of its assumptions• If the theory works, if the evidence

supports the theory, then it is a good and useful theory, and the assumptions of the theory, no matter what anyone might think of them, are a sufficiently good approximation for the purpose in hand.

Laws of Economics• They are set of generalizations that explain

economic activities.• They are statement of uniformities which

shows human behavior concerning the utilization of limited resources for the achievements of the ultimate ends. (Robbins)

• The nature of economic laws are indicated by the phrase “ other things being equal” (ceteris paribus)

• Some economic laws are axiomatic in character i.e. greater gain is preferred to smaller gain

• Some economic laws are of the nature of physical laws eg. Law of Diminishing Returns

Contd.• The economic laws lack definiteness found in

the laws of sciences like Physics. They are more like laws of tides (Marshall).

• Economic laws are hypothetical or conditional as their validity depends on the fulfillment of certain conditions.

• Economic laws are statements of tendencies of statistical probabilities. They can only say what is likely to happen eg. If demand increases price tends to rise. Actually it may or may not rise. It will also depend on the supply condition.

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