Basics of micro and macro Economics, Lecture notes of Economics

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ECONOMICS

What is Economics?

• Human needs and wants are unlimited, while the resources available to satisfy them are not; this leads to scarcity (as factors of production are finite).
• Scarcity exists when there is not enough of something (product/service/resource) to satisfy everyone’s wants, at a zero price.
• Faced with scarcity, people must make choices.
• Choosing one alternative means foregoing another.
• The choices we make depend on the incentives we face.
• The value of best alternative foregone is the opportunity cost of that choice. Economics is the study of the choices people (consumers, business managers, governments and so on) make to cope with scarcity.

Useful Concepts

Microeconomics : The study of decisions of single entities for themselves (like consumers or firms) and their interactions in markets. From this interaction results allocation of scarce resources amongst all the entities – i.e. what quantity of various goods is produced/consumed and at what price. Macroeconomics : The study of the economic entities composed of several individual entities (like a country or a state) and the resulting collective decision-making. Macroeconomics explains issues related to average prices and other issues like total employment, national income, and taxation. Economy : A mechanism that allocates scarce resources among alternative uses. This mechanism achieves five things: What, How, When, Where, Who.

• Factors of production are classified into one of four broad categories – - Land – includes all natural resources (crude oil, water, air, minerals, etc.) - Labour – encompasses both quantity and quality of human resources - Capital – refers to final goods produced for use in further production (fishing nets; blast furnaces, etc.) - Entrepreneurship – organize resources for new or better products; agent of innovation and change Only factors of production can do value addition.

Some Definitions

Decision makers : Households/consumers, Firms/producers, Governments Household : It refers to the all-encompassing group of consumers, any group of people living together as a decision-making unit. A household may be composed of multiple individuals but the decision-making must be as a single entity. Firm : A firm is an all-encompassing group of producers, which use productive resources to produce goods and services. All producers are called firms, no matter how big they are or what they produce. Car makers, farmers, banks, and insurance companies are all firms. Government : A many-layered organization that sets laws and rules, operates a law- enforcement mechanism, taxes households and firms, and provides public goods and services such as national defense, public health, transportation, and education. This is the medium through which macro-economic decisions are made. Market : Any place or medium where consumers and producers (i.e. households and firms) interact with each other.

Inside PPF = Not using all resources = Can produce more of both Outside PPF = Production is not possible Production efficiency: It is not possible to produce more of one good without producing less of some other good. On PPF, all resources are fully utilized; below PPF some resources are under-utilized and it is possible to produce more of one good without reducing the other (inefficiency). Economic growth: This means pushing out the PPF. It can be achieved either by increasing available resources, or by increasing the efficiency of utilizing those resources (upgraded technology). Million Computers Million Televisions C D

Production Possibility Frontier

Prices and Markets

In a centrally planned economy, prices are set by the government. In a market economy, prices are determined by the interaction between consumers and firms. These interactions occur in markets. Market: Collection of buyers and sellers that, through their actual or potential interactions, determines the price of a product or set of products. Market definition: Determination of the buyers and sellers (geography and the range of products) that should be included in a particular market. Arbitrage: Practice of buying at a low price at one location and selling at a higher price in another.

Demand Side of the Market (Law of Demand)

Demand Curve: Shows how much buyers are ‘willing’ and ‘able’ to pay for a given quantity of a good. Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded (inverse relationship). On a graph: vertical axis shows price (in relevant currency) per unit of the good, horizontal axis shows quantity demanded per unit of time. Traditionally, price (P) is plotted on the vertical axis and quantity demanded (Qd) is plotted on the horizontal axis. Various other factors affect demand for a good ( shift of demand curve ): o (^) Income: For most goods, higher income leads to a higher demand o (^) Normal goods - Goods for which demand increases as income increases o (^) Inferior goods - Goods for which demand decreases as income increases (Tata Nano) o (^) Prices of related goods: o (^) Substitute goods are goods that can be used in place of another good. Demand for good is directly related to the price of a substitute good (soft drinks and juices). o (^) Complementary goods are goods that are used in conjunction with another good. Demand for a good is inversely related to the price of a complimentary good (milk and Bournvita).

The demand curve, labeled D, shows how the Shifts in Demand Curve

quantity of a good demanded by consumers depends on its price. The demand curve is downward sloping; holding other things equal, consumers will want to purchase more of a good as its price goes down. The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods. For most products, the quantity demanded increases when income rises. For a single consumer, a higher income level shifts the demand curve to the right (from D to D’ ).

Variables that shift Market Demand

Complements: increase in price à demand for complement shifts down The dramatic fall in the price of computers over the past twenty years has significantly increased the demand for printers, monitors, and internet access.

▪ Even if price remains the same, supply of a good also depends on: o (^) Prices of factors of production ( inverse relationship ) o (^) There are four factors of production: Land, Labor, Capital, and Entrepreneurship (already mentioned) o (^) Prices of these factors of production are: Rent, Wages, Interest, and Profit o (^) Expected future prices ( inverse relationship) o (^) Expected price hike can lead to hoarding (low supply) and expected price fall can lead to dumping o (^) The number of suppliers ( inverse relationship) o (^) Technology (better technology leads to higher supply) ▪ If the price of a good changes but everything else influencing suppliers’ planned sales remains constant, there is a movement along the supply curve. ▪ If the price of a good remains the same but another influence on suppliers’ planned sales changes, supply changes and there is a shift of the supply curve.

Variables that shift Market Supply

Where the Demand Curve crosses the Supply Curve determines the market equilibrium

• At the point of intersection,^ Qd = Qs
• Consumers can purchase all they want and producers can sell all they want at the “market- clearing” price. - The^ market^ clears^ at^ price^ P 0 and quantity Q 0. - At^ the^ higher^ price^ P 1 ,^ a^ surplus develops, so price falls. - At^ the^ lower^ price^ P 2 ,^ there^ is^ a shortage, so price is bid up. ▪ When^ both^ demand^ and^ supply^ increase,^ the quantity increases. The price may increase, decrease, or remain constant. ▪ When^ both^ demand^ and^ supply^ decrease,^ the quantity decreases. The price may increase, decrease, or remain constant. ▪ When demand decreases and supply increases, the price falls. The quantity may increase, decrease, or remain constant. ▪ When demand increases and supply decreases, the price rises and the quantity increases, decreases, or remains constant.

Changes in Market Equilibrium - Example

Market for College Education (b) The supply curve for a college education shifted up as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. As a result, both price and enrollments rose sharply. If we consider the case of colleges, over the years, increases in the costs of equipping and maintaining modern classrooms, laboratories, and libraries, along with increases in faculty salaries, pushed the supply curve up. The demand curve shifted to the right as a larger percentage of a growing number of high school graduates decided that a college education was essential.