1 Economics the Core Issues

7/30/2019 1 Economics the Core Issues

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Economics: The Core Issues


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Scarcity : The core problem

Scarcity- Lack of enough resources to satisfy all

desired uses of those resources. Factors of Production: resources used to produce

goods and services.

1. Land- all natural resources

2. Labor- skills and abilities to produce goods

3. Capital-final goods produced for use in further

production

4. Entrepreneurship-assembling of resources toproduce new or improved products and technologies


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Core Issues

What to produce

how much of each commodity should be produced.should the emphasis be on agriculture,

manufacturing or services. Should it be on health,

education, defence, infrastructure or housing?

How to produce

different ways to produce goods but which

production method to use. labour intensive, land

intensive, capital intensive? ; Efficiency. For whom to produce

who is going to get the output produced? Should

everyone get an equal share?


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Opportunity Cost

- Cost of the next best alternative forgone.

- Helps us to understand the true cost of decisionmaking and in valuing different choices.

Suppose a machine can produce either X or Y .Theopportunity cost for producing a given quantity of X

is the quantity of Y, which the resource would have

produced.

If the machine can produce 10units of X and 20units of Y, then the opportunity cost of 1x is 2Y.


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Capital Goods

Consumer Goods

Yo

Xo

A

BY1

X1

Ym

Xm

Production Possibility Curve

- Alternative combinations of final goods and services

that could be produced in a given time period, with

all available resources and technology.

O

C

D


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Production possibility curve illustrates two essential

principles: scarce resources and opportunity cost.

All points on production possibility curve areefficient points of production.

Points inside the production possibility curve shows

inefficient utilisation of resources.

Points outside the production possibility curve are not

attainable with the current level of resources.


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Capital Goods

Consumer Goods

Yo

Xo

E

E1Y1

X1

Growth: Increasing Production Possibilities-if more resources or better technology becomes available. Theeconomic growth is shown by the outward shift of productionpossibility curve.

O

A

A1 B1

B


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Circular Flow of Income: Two Sector Model

- Flow of goods and services between households

(consumers) and firms (producers).

Assumptions

Only two sectors - households and firms

Households supply factor services to firms Firms hire factor services from households

Firms sell all the goods and services to households

Households spend all their income on goods an services

No government intervention and no foreign trade

Households are the owners of productive resource - land,

labour, capital and enterprise


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Product market and Factor market.

Real flow-involves flow of goods and services.

Monetary flow-flow of money payments and expenditure.

It can be derived from the two sector model that:

Total production of goods and services by firms = Total

consumption of goods and services by household sector.

Factor payments by firms = Factor incomes of householdsector.

Consumption expenditure of household sector = Income

of firm sector.

Hence, real flows of production and consumption of firms

and households = Monetary flows of income and

expenditure of firms and households.


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Circular Flow of Income with Financial System

Brings about the role of saving and investment.

Financial institutions are primarily intermediaries

between savers and investors, or lenders and

borrowers.

Financial institutions pay interest to the savers astheir funds are placed with them for a period of time

under a contract.

Firms pay dividend and interest for the sums they

have borrowed from the financial markets in the form

of shares, bonds and public deposits.


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Circular Flow of Income In a Three Sector Economy

Government purchases goods and services from firms

and labour services from households. Governmentcollects taxes from households and firms in order to

finance its expenditure.

The government makes transfer payments to thehouseholds in the form of social security,

scholarships, etc. It also gives subsidies to the firms

for various purposes.


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Circular Flow of Income In a Four Sector Economy

The domestic economy and the rest of the

world(foreign sector) are connected through inter

import and export of goods and services ultimately

decide what the domestic economy gains or loses in

the international trade. trade surplus- when there is excess of exports over

imports.

trade deficit- when there is excess of imports over

exports.


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The four-sector model of the economy demonstratesthe overall macro economic condition of income andoutput in the following identity:

Y C + I + G + (X M)

wherein,

Y = Income or outputC = Private consumption expenditure on consumer

goods

I= Investment expenditure by producing sectorsG = Government purchases

XM = Net exports (X = Exports, M = Imports)


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Definitions

Marginalism

Incrementalism

Opportunity principle

Discounting

Time perspective


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Marginalism

Marginal analysis is related to a unit change in

independent variable, say increase in costs as a result

of a unit change in output.

Marginal output of labour: output produced by the

last unit of labour Marginal cost of production: cost incurred for

producing an additional unit of output


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Profit of a firm using principle of

marginalism

Unitsofoutput(1)

TotalRevenue

(Rs)

(2)

Marginalrevenue (Rs)

(3)

Total

costs(Rs)

(4)

Marginalcost (Rs)

(5)

Totalprofits

(Rs)(6)=(2)-(4)

Averageprofit (Rs)(7)=(6) / (1)

Marginalprofits

(Rs)

(8)

1 20 - 15 5 5.0 -

2 40 20 29 14 11 5.5 6

3 60 20 42 13 18 6.0 7

4 80 20 52 10 28 7.0 10

5 100 20 65 13 35 7.0 7

6 120 20 81 16 39 6.5 4

7 140 20 101 20 39 5.6 0

8 160 20 125 24 35 4.4 -4


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Incrementalism

Incremental reasoning involves estimating the impact of

decision alternatives. Usually, changes occur in chunk rather than unit

changes.

Incrementalism is more general whereas marginalism is

more specific. Incremental costs :change in total costs as a result of

change in the level of output, investment etc.

Incremental revenue is a change in total revenue resultingfrom a change in the level of output, price etc.

While taking a decision, always incremental revenueshould always be greater than incremental costs


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Opportunity Principle

Cost of next best alternative foregone or the costexpressed in terms of the next best alternative

sacrificed.

Helps us view the true cost of decision making

Implies valuing different choices

Highest valued benefit that must be sacrificed as a

result of choosing an alternative.


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Discounting

The concept of discounting is based on the fact that arupee now is worth more than a rupee earned a yearafter.

Even if one is sure about future income, yet it has tobe discounted because to wait for future implies a

sacrifice for the present Suppose a sum of Rs 100 is due after one year. Let

the rate of interest be 10 percent. Then we candetermine the sum to be invested now so as to

produce the return (R) of Rs 100 at the end of theyear. The present value or the discounted values ofRs100 will then be V1= R

(1+i)n


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V1 = 100

1+0.10

= Rs.90.90 A present value of Rs100 due two years later would

be V1 = 100

(1+.10)2

= Rs.82.64


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Time perspective

Short run versus long run

Short run- at least one factor of production will be

kept constant

Long run- all factors are varied

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1 Economics the Core Issues