Economic Analysis for Managers (MBA 679)

Chapter 1: Basic Concepts

Learning Objectives
1. Define economics.
2. Explain the concepts of scarcity and opportunity cost and how they
relate to the definition of economics.

3. Understand the three fundamental economic questions: What should

be produced and in what quantities? How should goods and services be
produced? For whom should goods and services be produced? When to
produce – now or in the future?

1.1 What is Economics?

Economics is a social science that deals with human behavior as a relationship

between ends (objectives) and scarce (limited) means (resources) which have
alternative uses.

Let’s analyze the above definition.

First, economics is a social science. It concerns the behaviors of individuals in

isolation or groups of individuals or the society as a whole when they confront
limited resources while pursuing certain economic goals or objectives. Human
beings do not act and respond uniformly under the same circumstances, although
striking similarities can be observed. Economic theories thus apply only on an
overall basis. Therefore, laboratory-type experiments cannot be carried out for
economics unlike physical or exact sciences such as chemistry or physics.

Second, economics does not deal with all types of human behavior. Only those
activities or decisions which concern the use of economic resources come within the
purview of economics.

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Third, resources are scarce or limited. It does not mean that resources are not
available. The word ‘scarce’ or ‘limited’ is used in a relative sense. It means that
people do not have resources in quantities that they would like to have. Thus
‘scarcity’ refers to the shortages of resources relative to people’s requirement. In
other words, scarcity denotes the fact that resources are short in supply compared
to demand. Some resources are more scarce (more limited) than others and,
therefore, command higher prices.

Fourth, a resource can be used for more than one purpose. Since a resource is
limited, if it is used to meet one requirement, it may not be used to fulfill another
requirement. Alternatively, if one transfers part of a resource from one activity to
another, one has to sacrifice an amount of the first activity in favor of the second.
Thus, people have to make a ‘choice’ as to which activity to take up and which
activity to give up. One thus has to prioritize.

1.2 Ten Selected Principles of Economics

Principle #1: People face tradeoffs

The first lesson about making decisions is summarized in the adage: “There is no
such thing as free lunch”. To get one thing we like, we generally have to give up
another thing that we like. Making decisions requires trading off one thing against
another.

Principle #2: The cost of something is what we give up to get it

Because people face tradeoffs, making decisions requires comparing the costs and
benefits of alternative courses of action. In many cases, however, the costs of some
action are not as obvious as it might first appear.

Principle #3: Rational people think at the margin

Economists use the term marginal changes to describe small incremental

adjustments to an existing plan of action. “Margin” means “edge”, so marginal
changes are adjustments around the edges of what you are doing. It can be argued
that individuals and firms can take better decisions by thinking at the margin. A

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rational decision-maker takes an action if and only if the marginal benefit of the
action exceeds the marginal cost.

Principle #4: People respond to incentives

Because people make decisions by comparing costs and benefits, their behavior
may change when costs or benefits change. That is, people respond to incentives.

The above four principles describe how people make decisions. The following three
principles describe how people interact, while the last three principles describe how
the economy as a whole works.

Principle #5: Trade can make everyone better off

Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater
variety of goods and services.

Principle #6: Markets are usually a good way to organize economic activity

Markets send signals to both buyers and sellers as to the profitable transactions to
occur. For example, a rise in the price of a commodity may mean that there is a
shortage of supply compared to demand.

Principle #7: Government can sometimes improve market outcomes

While markets are a good way to allocate resources, market may fail to achieve
efficiency (market failure) and equity. Government intervention may be necessary
to promote efficiency as well as equity.

Principle #8: A country’s standard of living depends on its ability to

produce goods and services

Large differences in living standards exist among nations, and that the differences
widen over time. Almost all variations in living standards can be explained by the
differences in productivity. Countries with high labor productivity enjoy high living
standards and vice versa.

Principle #9: Prices rise when money supply rises

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In almost all cases of large or persistent rises in prices, it was excessive quantity of
money that appeared to be the main culprit.

Principle #10: Society faces short-Run tradeoff between inflation and

unemployment

Inflation and unemployment are both harmful to the economy. But controlling
inflation may result in higher unemployment, at least temporarily. On the other
hand, checking unemployment may trigger inflation.

Inflation: Persistent rise in the price level

Unemployment:

1.3 Resource

A resource has the following characteristics:

(1) Usefulness: A resource must satisfy human needs. In other words, people
benefit from the possession or use of a resource. Textbooks, mobile phone
sets, classroom facilities, pizza, a cricket stadium etc.

(2) Scarcity: A resource is short in supply relative to its demand. Oil and gases,
machines and equipment, time and space, arable land, and motor cars are
some of the examples of economic resources. Usefulness and scarcity
together ensure that people are ready to pay for a resource. Thus, an
economic resource necessarily commands a price. Anything that does not
command a price is not an economic resource, no matter how useful it may
be. Such resources are known as ‘free goods’. Ocean water and natural air
are such examples.

(3) Transferability: Resources are transferable or tradable at the market prices.

This means, certain types of property rights are attached to resources.

(4) Externality: A resource must be visible or perceptible. In other words,

resources may include both tangible and intangible products. The poems of
Milton, the prudence of Tagore etc.
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1.4 Economic Unit or Agent/Economic Activity

An economic unit or agent refers to an individual or a group of individuals or groups

of individuals that separately or institutionally involve themselves in economic
activities. An economic activity refers to the use of economic resources in creating
new products or commodities (that is, goods and services). Three fundamental
phases of economic activities include: production, consumption, and distribution.

1.5 Factors of Production

A ‘factor’ means a ‘determinant’ – something that causes some other thing(s) to

happen. In other words, a factor is an explanatory or independent variable that
explains the variations in other variables. Factors of production thus explain the
changes in production. The four broad categories of factors of production are as
follows:

Land: Land is defined as the amounts of known natural resources that can be
applied for the creation of new goods and services. The surface of the earth, the
quality of the soil, forest resources, oil and gas, mineral resources, water resources,
and weather and climate are considered as elements of ‘land’.

Labor: Labor refers to the physical and mental efforts on the part of human beings.
Efficiency of labor can be raised through ‘training’ and ‘education’ which is known
as human capital.

Capital: Capital is the produced means of production. Machines, equipment and

factory spaces are examples of capital. We first produce them and then directly use
them in the production process. They are also referred to as direct or physical
capital. Roads and highways, transports and communications, education, and
healthcare also indirectly contribute to production. These are known as social
capital. Caution: money is not capital.

Entrepreneurship: Entrepreneurship refers to the managerial functions of an

institution. The primary role of entrepreneurship is to combine the other factors of
production in a manner that provides the best possible outcomes to the firm.

1.6: Opportunity Cost

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Resources are limited and that resources have competing or alternative uses. If a
resource is used for one purpose, it may not be used for other purposes. Suppose
you have a savings of Tk. 2 million. You have the following options: (a) keep the
money in a safe with no returns at all; (b) put the money in a checking account with
6% annual returns; (c) put the money in a fixed deposit option with a possible
annual return of 12.5%; and (d) invest the money in a business with a possible
annual return of 30%. Obviously, as a rational decision-maker, you would choose
the best option, that is, to invest in the business. If this option was not available,
you would have put the money in fixed deposit, which is the second best option
under the present scenario. Therefore, you have sacrificed the second best option
for the first best. Opportunity cost is defined as the second best alternative forgone
or sacrificed.

Consider a second example. A family has a limited amount of income. It has fixed
amounts of expenditure on house rent and children’s education. The rest of the
income goes to food and outdoor entertainment. An extra amount of food will
certainly reduce the amount of outdoor entertainment and vice versa. Opportunity
cost is thus defined as the rate by which one commodity has to be sacrificed for an
additional unit of the other commodity.

Let’s now apply the concept of the opportunity to production. Suppose a farmer has
a fixed amount of cultivable land where he can grow either paddy (Y) or potato (X)
or both. If he decides to produce paddy only, the production of paddy will be the
maximum (say, 100 tons) while the production of potato will be zero. Thus, (100Y,
0X) constitutes a possible combination. On the other extreme, if he produces only
potato, suppose he can produce a maximum of 100 tons of potato. Obviously, the
production of paddy will be zero. (0Y, 100X) represents another possible
combination. Now assume that the farmer decides to produce 20 tons of potato.
How much paddy can he produce? It has to be less than 100 tons. Suppose the
amount of paddy is 90 tons. This means, the farmer has to sacrifice 10 tons of
paddy for additional 20 tons of potato. The opportunity cost of 20X is therefore
equal to 10Y. Equivalently, the opportunity cost of an extra unit (ton) of X is 0.5
units (tons) of Y. If the opportunity cost is constant, every time the farmer goes to
increase X by 20 tons, every time he will have to sacrifice 0.5 tons of X. This will be
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a case whereby the resource (land) happens to be equally productive for both
paddy and potato such that the farmer does not have to worry as to which parts
(plots) of the land to allocate to paddy and which parts to potato.

In reality, not all lands are equally productive for all types of crops. Thus, when the
farmer first decided to produce potato alongside paddy, he allocated that part of
the land to potato which is best suited to the production of potato (least suited for
growing paddy). As he opts for more potato, he has to transfer parts or plots of land
from paddy to potato production that are progressively better and better suited for
paddy production (and progressively less and less suited for potato production).
Therefore, the farmer has to sacrifice progressively more and more paddy for a
given additional amount of potato. In other word, opportunity cost is rising. (Try
yourself: paddy vs. tea production, university teaching vs. research). Increasing
opportunity cost along with production possibilities is further explained in Table 1.1.

Table 1.1: Production Possibilities and Opportunity Cost

Paddy (Y) Potato (X) Opportunity Cost Opportunity
of X in terms of Y Cost
of Y in terms of
X

100 0 -- 20X:10Y = 2.00

90 20 10:20=0.50:1 20X:15Y = 1.33

75 40 15:20=0.75:1 20X:20Y = 1

55 60 20:20 = 1:1 20X:25Y =0.80

30 80 1.25:1 20X:30Y= 0.67

0 100 1.50:1 ---

1.7 Production Possibility Frontier (PPF)

Table 1.1 shows six possible combinations of X and Y. Indeed, we could show many
more such combinations. One thing is common with each of combinations, which is:

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in each case, the resource (in this case, land) is fully utilized. When these
combinations are joined by a curve, we call it the production possibility frontier
(PPF). The PPF thus shows all possible combinations of two goods when resources
are fully utilized. Full utilization of the resources means that the production process
is efficient. In other words, the firm brings about the best possible outcome in terms
of production given the (fixed) amounts of the resources. Figure 1 depicts a
representative PPF, which is based on the six combinations of X and Y as outlined in
Table 1.1. Any point on the PPF shows efficiency.

Any point inside the PPF shows inefficiency. This will mean that all resources are not
fully utilized. In other words, the firm could produce more of at least one
commodity. Instead, it chose to produce less. For instance, a movement from point
E to D will suggest that more of X could be produced keeping the amount of Y the
same. Similarly, a comparison of point E with point B should indicate that more of Y
could be produced keeping the amount of X the same. Last of all, a movement from
E to C indicates that more of both goods. Thus, any point on the PPF is superior to
any point inside the PPF.

Alternative Definition of PPF: Suppose the farmer decides to produce exactly 20

units of potato. The maximum amount of Y will then be 90 units. Similarly, if the
farmer decides to produce 30 units of Y, the maximum amount of X that can be
produced is 80 units. The PPF, therefore, shows the maximum amount of one
commodity given the amount of the other.

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Slope= the rate of change in Y due to 1 unit change in X

The PPF is known as the frontier because any point outside the curve is not feasible
given the amounts of the resources. This means, a point like F is not feasible during
the present period. However, the PPF can shift to the right in the future for the
following reasons:

(1) by amassing more productive resources (land, labor, capital and

entrepreneurship) through extra investment or allocation of money;

(2) by acquiring new (better) technology; and

(3) through enhanced efficiency of the existing workers (by way of learning-
by-doing, or training and education).

The slope of the PPF (ΔY/ΔX) indicates opportunity cost. As we move from left to
right, slope or opportunity cost rises. For example, the slope of the PPF is 0.5
(=10/20) at point A, 0.75 (=15/20) at B, 1.00 (20/20) at C, and so on.
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1.8 Fundamental Economic Questions

The choices we confront as a result of scarcity raise four sets of issues. Every
economy must answer the following questions:

1. What should be produced and in what quantities? Using the economy’s

scarce resources to produce one thing requires giving up another. Producing
better education, for example, may require cutting back on other services,
such as health care. A decision to preserve a wilderness area requires giving
up other uses of the land. Every society must decide what it will produce with
its scarce resources.

2. How should goods and services be produced? There are all sorts of
choices to be made in determining how goods and services should be
produced. Should a firm employ a few skilled or a lot of unskilled workers?
Should it produce in its own country or should it use foreign plants? Should
manufacturing firms use new or recycled raw materials to make their
products?

Land: Any natural resources that is not man-made

Labor: Mental or physical efforts on the part of human beings

Capital: Produced means of production/machines and equipment

Entrepreneurship: A management that arranges the production

process

More K less L: capital-intensive technology

More L less K: labor-intensive technology

3. For whom should goods and services be produced? If a good or service

is produced, a decision must be made about who will get it. A decision to
have one person or group to receive a good or service usually means it will
not be available to someone else. For example, representatives of the

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poorest nations on earth often complain that energy consumption per person
in the United States is 17 times greater than energy consumption per person
in the world’s 62 poorest countries. Critics argue that the world’s energy
should be more evenly allocated. Should it? That is a “for whom” question.

4. When to produce? A decision to produce more now may mean that lesser
amounts of resources will be available for future uses. Therefore, the
economy may not grow by the same rates in the future as it is growing now.
In other words, economic growth may not be sustainable.

More now less in future

Less now more in future

More now more in future *

1.9 Microeconomics and Macroeconomics

The field of economics is typically divided into two broad realms: microeconomics
and macroeconomics. It is important to see the distinctions between these broad
areas of study.

Microeconomics is the branch of economics that focuses on the choices made by

individual decision-making units in the economy—typically consumers and firms—
and the impacts those choices have on individual markets. Macroeconomics is the
branch of economics that focuses on the impact of choices on the total, or
aggregate, level of economic activity.

Both microeconomics and macroeconomics give attention to individual markets. But

in microeconomics that attention is an end in itself; in macroeconomics it is aimed
at explaining the movement of major economic aggregates—the level of total
output, the level of employment, and the price level.

Relative price: price of one product relative to the price of another product

Micro is abstract but less abstract than macro

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Exports: Macro

Exports of RMG: Micro

Wage rate: Macro

Wage rate of the RMG workers: Micro

1.10 Why does a Manager Need to Study Economics

A manager, or CEO, or COO in modern days has assumed the role of an

Entrepreneur. S/he is entrusted with the responsibility of maximizing the wealth of
the entrepreneur or the shareholders. As such, a manger needs to keep an eagle
eye on the changes in the economy that may affect the production and profitability
of his/her firm. In other words, the manager need to prudently observe if the
demand for his/her product(s) is likely to fall or rise during the next period due to,
for example, changes in peoples’ incomes, the emergence of a substitute product,
changes in government policies, changes in external demand if it happens to be an
export-oriented product etc. Similarly, the needs to foresee if cost conditions are
likely to change due to changes in wage rates, interest rates, exchange rates etc. A
manager also needs to know as to, for example, how much changes in the incomes
of people (economic growth) leads to how much changes in demand for the her/his
product and accordingly plan for the amount to be produced during the next period.
A study of the concept of elasticity comes handy in this regard. Besides, fiscal and
monetary policy changes have important bearings for the managerial decisions.

The Principal-Agent Problem: In reality, the objectives of the shareholders

(principals) may not coincide with those of the managers (agents). The potential
conflicts between the objectives of the principals and the agents are referred to as
the principal-agent problem. While the shareholders’ objective might be sustained
increase in wealth, the manager may be driven by short-term objectives in which
they may tend to improvise by demonstrating high short-term gains, thereby
pleasing the shareholders and eventually by ending up with high salaries and
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perquisites for themselves. A second source of conflicts could be the principles or

policies as to how to run the business.

1.11 Models in Economics

All scientific thoughts involve simplifications of reality. The real world is far too
complex for the human mind—or the most powerful computer—to consider.
Scientists use models instead. A model is a set of simplifying assumptions about
some aspect of the real world. Models are always based on assumed conditions that
are simpler than those of the real world, assumptions that are necessarily false. A
model of the real world cannot be the real world. Economists often use graphs to
represent economic models. Models in economics also help us to generate
hypotheses about the real world. In the next section, we will examine some of the
problems we encounter in testing those hypotheses.

Testing Hypotheses in Economics

Here is a hypothesis suggested by the model of demand and supply: an increase in

the price of gasoline will reduce gasoline demand. How might we test such a
hypothesis?

Economists try to test hypotheses such as this one by observing actual behavior
and using empirical (that is, real-world) data. The average retail price of gasoline in
the United States rose from an average of $2.12 per gallon on May 22, 2005 to
$2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by
U.S. motorists rose by 0.3% during that period.

The small increase in the quantity of gasoline consumed by motorists as its price
rise is inconsistent with the hypothesis that an increased price will lead to a
reduction in the quantity demanded. Does that mean that we should dismiss the
original hypothesis? On the contrary, we must be cautious in assessing this
evidence. Several problems exist in interpreting any set of economic data. One
problem is that several things may be changing at once; another is that the initial
event may be unrelated to the event that follows. The next two sections examine
these problems in detail.
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The All-Other-Things-Unchanged Problem

The hypothesis that an increase in the price of gasoline produces a reduction in the
quantity demanded by consumers carries with it the assumption that there are no
other changes that might also affect consumer demand. A better statement of the
hypothesis would be: An increase in the price of gasoline will reduce the quantity
demanded, ceteris paribus. Ceteris paribus is a Latin phrase that means “all other
things unchanged.”

But things changed between May 2005 and May 2006. Economic activity and
incomes rose both in the United States and in many other countries, particularly
China, and people with higher incomes are likely to buy more gasoline. Employment
rose as well. People with jobs use more gasoline as they drive to work. Population in
the United States grew during the period. In short, many things happened during
the period, all of which tended to increase the quantity of gasoline people
purchased.

Our observation of the gasoline market between May 2005 and May 2006 did not
offer a conclusive test of the hypothesis that an increase in the price of gasoline
would lead to a reduction in the quantity demanded by consumers. Other things
changed and affected gasoline consumption. Such problems are likely to affect any
analysis of economic events. We cannot ask the world to stand still while we
conduct experiments in economic phenomena. Economists employ a variety of
statistical methods to allow them to isolate the impact of single events such as price
changes, but they can never be certain that they have accurately isolated the
impact of a single event in a world in which virtually everything is changing all the
time.

In laboratory sciences such as chemistry and biology, it is relatively easy to conduct

experiments in which only selected things change and all other factors are held
constant. The economists’ laboratory is the real world; thus, economists do not
generally have the luxury of conducting controlled experiments.

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1.12 Normative and Positive Statements

Two kinds of assertions in economics can be subjected to testing. We have already

examined one, the hypothesis. Another testable assertion is a statement of fact,
such as “It is raining outside” or “Microsoft is the largest producer of operating
systems for personal computers in the world.” Like hypotheses, such assertions can
be demonstrated to be false. Unlike hypotheses, they can also be shown to be
correct. A statement of fact or a hypothesis is a positive statement.

Although people often disagree about positive statements, such disagreements can
ultimately be resolved through investigation. There is another category of
assertions, however, for which investigation can never resolve differences. A
normative statement is one that makes a value judgment. Such a judgment is the
opinion of the speaker; no one can “prove” that the statement is or is not correct.
Here are some examples of normative statements in economics: “We ought to do
more to help the poor.” “People in the United States should save more.” “Corporate
profits are too high.” The statements are based on the values of the person who
makes them. They cannot be proven false.

Because people have different values, normative statements often provoke

disagreement. An economist whose values lead him or her to conclude that we
should provide more help for the poor will disagree with one whose values lead to a
conclusion that we should not. Because no test exists for these values, these two
economists will continue to disagree, unless one persuades the other to adopt a
different set of values. Many of the disagreements among economists are based on
such differences in values and therefore are unlikely to be resolved.

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