MODULE 1

INTRODUCTION

TO

ECONOMICS

Compiled By: Sonal Revankar

What is an Economy / Economic System?

• People and firms produce, exchange and consume

goods and services in an economy.

• An economic system is a system of production and

exchange of goods and services as well as allocation of

resources in a society.

• An economy can be of any size, with any number of

people and firms involved.

• All economies must choose which wants to satisfy and

how they allocate the resources – unlimited wants v/s

limited resources.

Basic Economic Problems

• What to Produce?

• How to Produce?

• For whom to Produce?

PPC

• The Production Possibilities Curve (PPC)

shows the different combination of two

goods that can be produced using full

employment of resources.

• Also called as production possibilities

frontier.

• Shows the concepts of scarcity,

opportunity costs, trade offs and efficiency

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Shift in PPC

• Change in Quantity or Quality of resources

• Change in Technology

• Trade and Specialization

Changes in PPC when:

• There are faster computers and better

technology

• Destruction of power plants

• High Unemployment

• Better education

Types of Economic Systems

• Market Economy

• Command Economy

• Traditional Economy

• Mixed Economy

Market Economy

• NO government involvement in economic decisions. Private firms account for all production.

• Consumers decide WHAT should be produced. They do this through the purchases they make.

• Businesses determine HOW the products will be produced. They must be competitive.

• WHO buys the products? The people with the most money are able to buy more goods and services.

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Command Economy

• All resources are government-owned.

• One person (dictator) or a group of officials

decide WHAT products are needed.

• The government runs all businesses, controls

all employment, and decides HOW goods

and services will be produced.

• The government decides WHO receives the

products that are produced.

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Traditional Economy

• Economy is shaped largely by custom or

religion.

• Customs and religion determine the WHO,

WHAT, and HOW.

• Example: India has a caste system which

restricts occupational choice. (A social class

separated from others by distinctions of

hereditary rank, profession, or wealth.)

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• South America, Asia and Africa support

some traditional economies of thriving

agricultural villages. Tradition decides

what an individual does for his living, so

industry, clothing and shelter are the same

as in previous generations.

Mixed Economy

• Most economies in the world today are

mixed.

• Classification is based on how much

government intervention there is.

• In the U.S. the government accounts for

about 1/3 of all U.S. economic activity.

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Example of Economies…

Pure Market Economy

Pure Command Economy

U.S.

Mexico

Sweden

Russia

Mainland

China

North

Korea

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Government Philosophies

• Countries also have different philosophies of government which reflect not only the laws and rules, but how individuals are treated.

• There are three political philosophies:

1. Capitalism

2. Socialism

3. Communism

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Capitalism

– Capitalism features private ownership of

businesses and marketplace competition.

– It is the same as a free enterprise

system.

– The political system most frequently

associated with capitalism is democracy.

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Socialism

• The main goal of socialism is to keep prices low for all people and to provide employment for many.

• The government runs key industries, generally in telecommunications, mining, transportation, and banking.

• Socialist countries tend to have more social services.

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Communism

– Have a totalitarian form of government; this

means that the government runs everything and

makes all decisions.

– Theoretically, there is no unemployment in

communist countries.

– The government decides the type of schooling

people will receive and also tells them where to

live.

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Economies in Transition

– Many countries are in transition from either

communism or socialism to capitalism.

– Privatization is a common aspect of transition

from a command economy to free enterprise

system. Privatization means state-owned

industries are sold to private individuals

and companies.

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What is Economics?

• The word ‘Economics’ was derived from

two Greek words, oikos (a house) and

nemein (to manage) which would mean

‘managing an household’ using the limited

funds available, in the most satisfactory

manner possible.

• Economics is a science of management of

limited resources with the unlimited wants

of human beings

• It includes production, distribution

(exchange) and consumption of goods

and services

Economics definitions

• Wealth definition by Adam Smith

• Welfare definition by Alfred Marshall

• Scarcity definition by Lionel Robbins

• Growth definition by Prof. Paul Samuelson

Nature of Economics

• Economics is a science or art?

• Economics as social science.

• Economics as positive science or

normative science.

• Methodology of economics.

• Economics as a subject matter.

Scope of Economics

• Micro economics

• Macro economics

• International economics

• Public finance

• Development economics

• Health and education

economics

• Environmental economics

• Urban and rural economics

Managerial Economics

• Managerial economics is the application of

economic theory and methodology to

decision making process within an

enterprise.

• It refers to those aspects of economic

analysis which are relevant to the practice

of management processes in a business

organisation.

• According to Spencer and Siegalman,

“ Managerial Economics is the integration of

economic theory with business practice for

the purpose of facilitating decision making

and forward planning by the

management.”

ME as micro economics

• Micro economics is a study of particular

firm, household, individual price, wage,

income, industry and particular commodity.

It is defined as study of economic activities

of consumers, resource owners and

business firms

• Macro economics deals not with individual

quantities but with aggregates of these

quantities, not with individual income but

with national income, not with individual

prices but with price levels, not with

individual outputs but with the national

output

Features of ME

• New discipline

• Separate branch of economics

• Micro (Internal to firm) and Macro(External) in

nature

• Pragmatic – provides solutions

• Normative science – prescriptive rather than

descriptive

• Science of decision making

• Study of allocation of resources

• Related to other subjects- Statistics, Accounts,

Mathematics etc

Scope of ME/ Applications of ME

• Demand Analysis

• Production and Cost analysis

• Pricing decisions, policies and practices

• Capital management

• Profit management

Demand Analysis

• Demand Analysis – estimate future demand by

taking into consideration income, price and

substitution elasticity, demand determinants,

demand distinctions and demand forecasting.

• Demand Theory can help in making the choice

of commodities, finding the optimum level of

production and determining the price of the

product.

Production and Cost analysis

• Production theory – explains the relationship

between inputs and outputs, maximization of

output, optimum size of the output , helps in

determining the size of a firm, size of output,

amount of capital and labor to be employed –

Physical terms of production

• Cost Theory – Cost ascertainment, cost control

and cost reduction, cost and output relation,

economies of scale- Monetary terms of

production.

Pricing decisions, policies and practices

• Pricing theory- what price to charge under

different market conditions, price discrimination,

extent of advertising.

Capital Management

• Choice of investment project

• Assessing the efficiency of capital.

• Most efficient allocation of capital.

Profit management

• Profit is the primary measure of success

• How to make profit under uncertainity

• Profit planning, profit management and

profit measurement.

Objectives of ME

• Decision Making

• Forward Planning

• Problem Solving

Decision Making

• Business decision making is essentially a

process of selecting the best out of

alternative opportunities open to the firm.

• What should be the price of a product?

• What should be the size of the firm?

• How many workers should be employed?

Process of decision making

1) Determining and defining the objective to

be achieved

2) Collection and analysis of related data-

economic, social, political, technological etc

3) Inventing, developing and analyzing the

possible courses of action

4) Selecting a particular course of action

from the available alternatives

Forward planning

• Forward planning means establishing the

plans for the future.

• Uncertainty v/s forward planning

• Forward planning is for the future

• Decision making and forward planning are

closely associated.

Problem solving process

• Identify and define the problem.

• Problem analysis

• Generating possible solutions

• Analyzing the solutions

• Selecting the best solution

Fundamental concepts of managerial

economics

• Opportunity cost

• Incremental cost / Marginal Principle

• Discounting principle

• Equi- marginal principle

• Time perspective

Opportunity cost

• The opportunity cost of availing an

opportunity is the foregone income

expected from the second best opportunity

of using the resources.(Sacrifice of

alternatives)

• Arises due to alternative use of resources

• Difference between actual earning and

opportunity cost is called economic gain or

economic profit.

Example

• Alternative 1: Expansion of size of the firm

– Rs 20 million

• Alternative 2: Setting up of a new

production unit – Rs 18 million

• Alternative 3 : Buying shares in another

firm – Rs 16 million

Incremental costs

• An increase in the total cost of production

due to business decisions.

• Example

• Incremental revenue, incremental output,

incremental reasoning

• Incremental cost includes –

Present / Explicit costs- fixed and variable

Opportunity cost

Future costs

Example

Cost Revenue Profit

Existing 100 crores 130 crores 30 crores

New 115 crores 150 crores 35 crores

Incremental 15 crores 20 crores 5 crores

Incremental principle

• A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii It reduces costs more than revenues.

• MR-MC= MP

• Incremental v/s Marginal difference

Discounting principle

• The mathematical technique for adjusting for the

time value of money and computing present

value is called ‘discounting’.

• for making a decision in regard to any

investment which will yield a return over a period

of time, it is advisable to find out its ‘net present

worth’. Unless these returns are discounted and

the present value of returns calculated, it is not

possible to judge whether or not the cost of

undertaking the investment today is worth.

Equi- marginal principle

• Equi- marginal principle is applied by the

business managers for allocation of

resources between alternative uses with a

view to maximizing profit in case a firm

carries out more than one business activity

• The marginal productivity gains (MP) from

the various activities are equalized.

Example

Time perspective

• The time perspective concept states that

the decision maker must give due

consideration both to the short run and

long run effects of his decisions.

• Variable factors of production can be

changed in the shortrun but fixed factors

can be altered only in the long run.

Example

• Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.

• The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.

(b) The other customers may also demand a similar low price.

(c) The image of the firm may be spoilt in the business community.

(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Assignment -1

• Explain the scope of Economics.

• Explain the importance of Managerial

Economics.

• What is the relationship of ME with other

disciplines?

• Give one example each and explain the

fundamental concepts of ME

• What are the applications of PPC?