BASIC CONCEPTS

Annu S Pant
Visiting Faculty of Economics
Kathmandu University
2011
 In This Unit
 Introduction
 Basic Economic Problem
Issues : Resource Scarcity
and Efficiency
 Macro Economics’ Objectives:
Growth, Employment and
Price Stability
 Opportunity Cost
 Stock and Flows
 Society’s Technological Possibility
 In This Unit
 Economic Organization : Market, Command,
Mixed
 Black or Underground
Economy
 Economic Models
 Equilibrium and
Disequilibrium
 Resource/ Inputs and Outputs/
Value Added
 Business Cycle
 MACROECONOMICS - defined

Looking at a forest not at individual trees is

the simplest way of defining
Macroeconomics.
 Introduction
 Meaning of Macroeconomics
- The term macro is derived from Greek
word macros – meaning large.
- Macroeconomics is defined as that branch
of economics which deals with the
aggregate economic variables.
- Macroeconomic variables are economic
variables at the level of economy as a
whole. For eg. Aggregate supply, general
price level, national income etc.
 Introduction
 Scope of Macroeconomics
- Concept of measurement of national
income
- Determination of income and employment
- Money and Banking
- Government Budget and the economy
- Determination of foreign exchange rate
and balance of payments.
 Introduction
 Emergence of Macroeconomics
- In 1936, with the publication of The
General Theory of Employment, Interest
and Money by J. M. Keynes –
macroeconomics emerged as a separate
branch of economics.
 Two School of Thoughts in Macroeconomics
- Classical School of Thought
- Keynesian School of Thought
 Introduction
 Classical School of Thought
Classical economists like J. B. Say, J. S. Mill,
Thomas Malthus, A. C. Pigou, David Recardo
believed that
- Free economy achieves efficiency
- Full employment exists
- Maximum level of income exists
 Introduction
 Great Depression of 1930s
The time period of 1930s – started with the
stock market crash in New York in 1929 –
affected the developed economies of Europe
and North America. The adverse effects
continued for 10 years. This led to fall in
output in the developed countries and rise in
unemployment by huge amounts. In USA,
from 1929 to 1933, unemployment rate rose
from 3% to 25% and aggregate
output fell by about 33% contd.
 Introduction
Vicious circle of poverty took a toll in these
countries.
Low Income

Low Output
Low Demand
Level

Low Low
Employment Investment
 Introduction
 Keynesian School of Thought
Lord Keynes observed the phenomenon of
Great Depression and maintained that:
- Unemployment will exist. Full
employment is not possible.
- Government must intervene
and generate employment
opportunities.
 Basic Economic Problems and Issues
 Resource Scarcity and Efficiency
Since resources are scarce and have
alternative uses, we are faced with the
economic problem of resource allocation in
the most efficient way.
 Productive Efficiency
The condition where the maximum output is
produced with given resources and
technology . Productive efficiency implies
that more of one good can be produced
without any less of another good being
produced.
 Choice and Opportunity Cost
 Because of limited means and unlimited
human wants – problem of choice arises –
leading to opportunity cost.
 Opportunity cost is the most highly valued
opportunity or alternative forfeited when a
choice is made.
Study or ??????

Costs

Benefits
 Economic Organizations
 Economic organizations or institutions,
including laws and customs, define a
society’s procedures for allocating resources –
WHAT TO PRODUCE, HOW TO
PRODUCE, FOR WHOM TO PRODUCE.
 Market/ Capitalist Economy
 In a market or 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
 Market/ Capitalist 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
 Command/ Centrally Planned/
Communist Economy
 In such an economy:
 Economic decisions are highly centralized
 The state owns and controls the means of
production and distribution
 Command 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
 Mixed Economy
* 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
 Society’s Technological Possibility
 If all the nation’s resources are fully and
efficiently employed with the prevailing
technology – it represents the possible
combinations of public and private goods
that can be produced.
Points outside the
boundary are
unattainable while inside
shows under utilization of
resources.
 Physical and Institutional Possibility
The physical PPF illustrates
different combinations of
goods the economy can produce
given the physical constraints of
(1) finite resources and (2) the
current state of technology.
The institutional PPF illustrates
,

different combinations of goods

the economy can produce given
the physical constraints (1)
finite resources, (2) the current
state of technology, and (3) any
institutional constraints.
 Physical and Institutional Possibility
 The economy is at the natural
unemployment rate if it is located on
its institutional PPF, such as at points
A, B, or C.
 An economy can never operate
beyond its physical PPF, but it is
possible for it to operate beyond its
institutional PPF because institutional
constraints are not always equally
effective.
 If the economy does operate beyond
its institutional PPF, such as at point
D, then the unemployment rate in the
economy is lower than the natural
unemployment rate.
 Objectives of Macroeconomics
 Growth : It is related with the prosperity of a
country. A growth of a nation is the central
factor in determining the growth in its real
wages and living standards.
 Employment : Every market economy show
patterns of expansion and contraction known
as business cycle. The objective of
macroeconomic policy is to reduce the
severity of business cycle down-turns and
unemployment by using monetary and fiscal
policy.
 Objectives of Macroeconomics
 Price Stability : Price stability helps avoid
the distortion of economic decisions of the
economy. High inflation means that the
purchasing power of money erodes quickly
which forces the people to scramble to spend
their money as soon as they receive it.
Slowing inflation requires contracting
economic activities and raising
unemployment. Therefore, a stable price or
gentle upward creep of prices are preferred
to let the economy function smoothly.
 Stock and Flows
 A stock is the quantity measured at a given
point in time.
 A flow is the quantity measured during a
period of time.
 A person’s wealth is a stock, his income and
expenditure are flows.
 The number of unemployed people is a stock,
the number of people losing jobs is flow.
 The amount of capital in the economy is a
stock, the amount of investment is a flow.
 Gross Domestic Product (GDP)
 It is the market value of all the final goods
and services produced in a country during
a period of one year by all production
units inclusive of net indirect taxes and
depreciation.
 Black or Underground Economy
 The underground economy is a part of
economy that people hide from the government
either because they want to evade the taxation
or because the activity is illegal.
 Income earned off the books for services such
as lawyers, physicians, domestics, tailors, baby
sitters, taxi drivers – do not get reported to
evade taxation.
 Income earned through drug trafficking,
bribery, prostitution, gambling, do not get
reported as they aren’t negotiated openly in
the market.
 Economic Models
 It illustrates, often in mathematical
terms, the relationship among
endogenous and exogenous variables.
 Endogenous variables are those
variables that a model tries to explain.
 Exogenous variables are those variables
that a model takes as given.
 Economic Models
 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.
 Economic Models
 Models are simplified theories that show the
key relationships among economic variables.
 The model shows how changes in the
exogenous variables affect the endogenous
variables.

Exogenous Endogenous
Model
Variables Variables
 Equilibrium and Disequilibrium
 Equilibrium is a state of balance.
 When forces acting in opposite directions
are exactly equal, the object on which they
are acting is said to be on a state of
equilibrium.
 Disequilibrium is a state of unbalance.
 When forces acting in opposite directions are
unequal, the object on which they are acting
is said to be on a state of equilibrium.
 Resources/ Inputs and Outputs/
Value Added
 Resources/ Inputs : Land, Labor, Capital,
Entrepreneurship, intermediate goods and
services
 Outputs/ Value Added : Final goods and
services
 Business Cycle
 Business Cycle looks like a Roller Coaster. It
begins at a peak, drops to a bottom, climbs
steeply, and then reaches another peak.
 Business Cycle
 Peak : the phase of the business cycle during
which real GDP reaches its maximum after
rising during recovery. At peaks the economy
is close to or at full employment and is
operating near its PPC.
 Recession : A downturn in the business cycle
during which real GDP declines. It is
characterized by the fall in business profits,
rise in unemployment rate and
underutilization of productive resources.
The economy is functioning inside PPC.
 Business Cycle
 Trough : The phase of the business cycle in
which real GDP reaches its minimum after
falling during a recession. It is the phase
when the real GDP “bottoms out”. The rate of
unemployment and idle productive capacity
is at highest at this phase.
 Recovery : An upturn in the business cycle
during which real GDP rises. During this
phase profits gradually improves, real GDP
increases and employment moves towards
full employment.
Recession vs. Depression

A recession is when your

neighbor loses his or her
job and depression is
when you lose your job!
 NEXT
Measuring National
Economic Activity