Principles of Economics

Shon P. John

Why do you need to study economics?

What does the term Economics mean to you?

Lets get things straightened up!

You need to develop economic way of thinking.
Economic thinking helps you arrive at informed conclusions about what is happening in the world.

Lets take three levels

Personal level- better decisions in life. (education and career) Professional level- business performance of the firm. Public level- how economy functions. Parameters to judge its performance.

Economics- a social science

Analyze human behavior. Working definition:
Economics is the study of how people allocate their limited resources in an attempt to satisfy their unlimited wants. As such, economics is the study of how people make choices
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Limited Resources?
Resources- things/ inputs used to produce other things to satisfy peoples wants. They have value. They can be put to alternative uses. Limited- a relative term, resources are limited in terms of unlimited wants. Wants- all items people would want to buy if they had unlimited income.
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Sadly, we cannot satisfy all our wants Since resources can be put into alternative uses, we can choose how to utilize our limited resources.

For instance, resources like time, income.

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Aaron & Michelle- example

Aaron has $100 with him. Limited income, $0- $100 Aaron can use $100 in the following ways: $50 to buy a gift for his girl friend, Michelle. $10 for movies $20 to buy economics text book $10 to buy the ticket for the music concert in the city. $10 for bus tickets.

In economics
We explain choices by examining situations in which how people choose How to do things ( how to spend 8 hrs in a day, how to cut down the cost of production) When to do things (when to book your air tickets, when to invest in stocks) With whom to do things (which hospital should I go for treatment, which shop should I buy provisions from, Reliance, Big bazaar, Spencers

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Two categories of economics:

MICROECONOMICS Studies small parts of the economy. It deals with the behavior of individual economic units. Consumers, workers, investors, owners of land, business firms. MACROECONOMICS Studies economy as a whole It deals with aggregate economic quantities Level and growth rate of national output, interest rates, unemployment, and inflation.
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Ideal Economic Person is rational

she behaves as if she is motivated by self-interest. responds predictably to opportunities for gain. first articulated by Adam Smith in 1776. (An Inquiry into the Nature and
Causes of the Wealth of Nations)
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It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest (Adam Smith)

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We assume that
An ideal economic person is rational But what does being rational mean?

It means that she doesnt intentionally make decisions that would make her worse-off.
a generalized observation made on what people actually do in life with their limited resources
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Logically this would mean that

A rational economic person responds to changes in incentives. Incentives? Rewards for engaging in a particular activity. incentives are used to encourage people to make certain choices. (Attendance in SBSto bunk the class or attend the class) Positive incentives (Carrot) and Negative incentives (Stick).
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Positive Incentive- CARROT

Positive incentives make people better off and are called "rewards." Teacher says submit your assignments in time and you will get 2 marks extra.

Mom says You can watch T.V, if you clean your room .

Negative Incentives- STICK

Negative incentives make people worse off and are called penalties. Teacher says no attendance for late comers. Dad says no swimming today, if your homework isnt done.

Economics- a science
It uses models/ theories What is a model (theory)? - A simplified representation of the real world that economists use to understand, explain, and predict economic phenomena in the real world. - Economists test models by examining what has already happened in the real world.
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Thus, a model is an abstraction from reality

No economic model captures every detail or interrelationship that exists. Key to model building: capture only the essential relationships that are sufficient to analyze the particular problem or answer the particular question with which we are concerned.

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Every model or theory is based on a set of assumptions.

Assumptions define a circumstance in which the model is most likely to be applicable. For instance, falling ships and earth being flat, Columbus refuted this, earth being round.
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Ceteris- Paribus (KAY-ter-us PEAR-uh-bus) Assumption?

Other things equal (constant) Everything in the world is interrelated To avoid complexity, we must isolate the effects of changes in one variable on another variable, by keeping many other variables, that would have entered in the analysis otherwise, constant.
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Remember :
We must not shun a model for its unrealistic assumptions. We determine the usefulness of a model by checking whether it yields usable predictions and implications for the real world. How do we check? Gathering evidence/data.
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So economics
is an empirical science Evidence is looked at to see whether we are right.

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economists
Dont model the way people think, but the way they act- what they do with their limited resources Models of behavior, not thought process

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Positive Economics & Normative Economics

Positive- value-free- If A then B Statement of what is Always not possible to follow positive analysis. Value judgment / subjective feelings creep into our analysis When values are interjected into the analysis, we enter the realm of normative economics. Normative- value based. Statement of what ought to be.
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Jokes about economists

A mathematician, an accountant and an economist apply for the same job. The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly." Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four." Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says, "What do you want it to equal"?

Jokes ..
Three economists and three mathematicians were going for a trip by train. Before the journey, the mathematicians bought 3 tickets but economists only bought one. The mathematicians were glad their stupid colleagues were going to pay a fine. However, when the conductor was approaching their compartment, all three economists went to the nearest toilet. The conductor, noticing that somebody was in the toilet, knocked on the door. In reply he saw a hand with one ticket. He checked it and the economists saved 2/3 of the ticket price. The next day, the mathematicians decided to use the same strategy- they bought only one ticket, but economists did not buy tickets at all! When the mathematicians saw the conductor, they hid in the toilet, and when they heard knocking they handed in the ticket. They did not get it back. Why? The economists took it and went to the other toilet.

Jokes..
A civil engineer, a chemist and an economist are traveling in the countryside. Weary, they stop at a small country inn. "I only have two rooms, so one of you will have to sleep in the barn," the innkeeper says. The civil engineer volunteers to sleep in the barn, goes outside, and the others go to bed. In a short time they're awakened by a knock. It's the engineer, who says, "There's a cow in that barn. I'm a Hindu, and it would offend my beliefs to sleep next to a sacred animal." The chemist says that, OK, he'll sleep in the barn. The others go back to bed, but soon are awakened by another knock. It's the chemist who says, "There's a pig in that barn. I'm Jewish, and cannot sleep next to an unclean animal." So the economist is sent to the barn. It's getting late, the others are very tired and soon fall asleep. But they're awakened by an even louder knocking. They open the door and are surprised by what they see: It's the cow and the pig!

Scarcity, Choices, and Trade-offs

Scarcity- a situation in which the resources for producing the things that people desire are insufficient to satisfy all wants. To put it simply, it means that we do not ever have enough of everything, including time, to satisfy our every desire.
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Why does scarcity exist?

Human wants always exceed what can be produced with limited resources and time that nature makes available. That is, wants are unlimited, but resources are limited. Scarcity is a fact of life, like gravity.

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Scarcity and resources

Resources are insufficient to satisfy our every desire. Resources are the inputs used in the production of the things that we want. Production?- an activity that converts resources into products/goods that can be used in consumption.

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Resources (factors of production)

Land- include natural resources used in the production
process, such as rivers, minerals, and forests.

Labor- includes physical and mental activities of

individuals used to produce goods and services.

Physical Capital-includes human-made resources

used in producing consumer goods and services such as machinery, tools, and warehouse facilities.

Human Capital- economic characterization of

education and training, pool of skills, and training, Improves productivity.

Entrepreneurship- human talent that combines the

other resources to produce products, make strategic decisions and bear risks.

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Goods Vs Economic goods

Goods- all things from which individuals derive satisfaction or happiness. Eg. Air to breathe, beauty of sunset etc. Economic goods- subset of all goods, they are scarce goods about which we must constantly make decisions regarding their best use. Available at a price. Desired quantity exceeds the amount available. Eg. Cars, DVD Players, Computers. Tangible goods. Services- tasks performed for someone else. Intangible goods
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Wants & Needs

Needs cannot be objectively defined. A vague wish, a want, or a life saving necessity. People desire something that they do not currently have. Wants- wants are unlimited, given the limited resources. So we cannot satisfy all our wants.
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Unlimited wants, limited resources

Problem of scarcity Scarcity leads to choice ( we need to make choices). Whenever a choice is made to produce or buy something, something else that is also desired is not produced or not purchased. Whenever one want is satisfied, other wants remain unsatisfied.

Scarcity, Choice, and Opportunity Cost

Scarcity Choice Whenever a choice is made, some opportunity must be sacrificed. Therefore, every choice involves giving up an opportunity to produce or consume something else. Opportunity Cost the value of the next best (next-highest ranked ) alternative forgone.

Thus, opportunity cost

Is the value of what is given up. When you choose to do something, you loose something else. i.e., the cost of your chosen alternative is what you lose (the next best alternative). Remember, In economics, cost is always a foregone opportunity.

Trade-offs
Using any resource in any economic activity means youre trading-off the use of that resource for one or more alternative uses. The extent of the trade-off is represented by the opportunity cost. When you think of any alternative, you are thinking of trade-offs.

Trade-offs: Example
Trade-off between the results of spending time studying economics and mathematics We assume that additional time studying either economics or mathematics will lead to a higher grade in the subject to which more study time is allocated The student has the same ability to learn both subjects

Here, the trade-off is one-to-one

Opportunity Cost of receiving one grade higher in economics is one grade lower in mathematics. i.e., there is a constant trade-off between grades in economics and in mathematics. Trade-off ratio was constant.

Trade-offs through Production Possibilities Curve (PPC)

A curve representing all possible combinations of maximum outputs that could be produced assuming a fixed amount of productive resources of a given quality.

Trade-offs occur on PPC - tradeoff between the production of Pocket PCs and Digital Cameras PPC is bowed outward.

Why?
Trade-off between two goods is not constant.

Assumptions underlying the PPC

Resources are fully employed Production takes place over a specific time period, say, one year. Resources are fixed. Technology doesnt change. A formula or a recipe used to combine factors of production.

PPC indicates the maximum quantity of one good, given the quantity produced of the other good. Productively Efficient on PPC. Producing the maximum output with given technology and resources.

The Law of Increasing Relative Cost (LIRC)

When society takes more resources and applies them to the production of any specific good, the opportunity cost increases for each additional unit produced.

Society faces LIRC

Certain resources are better suited for producing some goods than they are for other goods. Resources are not perfectly adaptable for alternative uses. To increase the production of Pocket PCs, the optical imaging specialists at the digital camera firms have to be shifted to the Pocket PC firms. Lens crafting technicians, would be less effective in making Pocket PCs than the people who previously specialized in this task.

Economic Growth and PPC

Economic Growth allows for more of everything. But, Scarcity still exists. We will always face trade-offs. i.e., the more we have of one thing , the less we can have of others.

Trade-off between the present and the future consumption

Consumption? use of goods and services for personal satisfaction. Consumer goods like clothes, and food. Capital goods? Cannot be consumed directly. Enable us to produce larger quantities of consumer goods or to produce them less expensively than we otherwise could.

Capital goods: Example

To catch Fish (consumer good) You need fishing boats, nets, and poles (capital goods) Without these capital goods it would be expensive to obtain fish for the market. Catching fish with ones hands is not easy If you do it, the cost per fish rises.

Foregoing Current Consumption

Productive resources

Implicitly

Capital goods

Foregoing Current Consumption

Forego Current Consumption to produce Capital goods

You postpone current consumption to a later day, i.e., we do not get instant utility or satisfaction by doing so.

Trade-off between Consumption goods and Capital goods

To have more consumer goods in the future, we must accept fewer consumer goods today, because resources must be used in producing capital goods instead of consumer goods. Opportunity Cost

The moral of this story:

The more we give up (consumption) today, the more we can have tomorrow, provided, of course, that the capital goods are productive in future periods.

What is your opportunity cost of attending my lecture this morning?