Economics Placement Preparation Material

Economics
Economics is the study of the principles of money, business and industry (as whole), how they
are organised and how people interact with value. It is best identified as a social science
concerned with the production, distribution, and consumption of goods and services.

The Fundamental Principles of Economics Explained:

Gregory Mankiw in his Principles of Economics outlines Ten Principles of Economics

that we will replicate here, they are:

1. People face trade-offs

2. The cost of something is what you give up to get it
3. Rational people think at the margin
4. People respond to incentives
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
8. A country's standard of living depends on its ability to produce goods and services
9. Prices rise when the government prints too much money
10. Society faces a short-run tradeoff between Inflation and unemployment

1. People face trade-offs

“There is no such thing as a free lunch .” Making decisions requires trading one goal for
another.

One of the example can be that of the trade-off between efficiency and equality.
While efficiency would mean extracting maximum benefits from society’s scarce resources,
equality involves focus on distributing economic prosperity fairly among the members of society.
Often, Seeking one means compromising on the other.
For example, tax paid by wealthy people and then distributed to poor may improve equality but
lower the incentive for hard work and therefore reduce the level of output produced by our
resources.
This implies that the cost of this increased equality is a reduction in the efficient use of our
resources.
Another Example is “guns and butter”: The more we spend on national defense(guns) to protect
our borders, the less we can spend on consumer goods (butter) to raise our standard of living at
home.

2. Significance of opportunity cost in decision making

Because people face tradeoffs, making decisions requires comparing the costs and benefits of
alternative courses of action.
For example: The cost of going to college for a year is not just the tuition, books, and fees, but
also the wages/salary foregone by choosing to not work during this period
This is called opportunity cost of resource

Opportunity cost is the cost of next best alternative foregone

When making any decision, decision makers should consider the opportunity costs of each
possible

3. Rational people think at the margin

Economists generally assume that people are rational ie they systematically and purposefully
do the best they can to achieve their objectives.
Consumers want to purchase the bundle of goods and services that allow them the greatest
level of satisfaction given their incomes and the prices they face.
Firms want to produce the level of output that maximizes the profits.

Rational people often make decisions by comparing marginal benefits and marginal costs.
For example: Why is water so cheap while diamonds are expensive? Because water is
plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare, the
marginal benefit of an extra diamond is high.

4. People respond to incentives

Incentive is something that induces a person to act. Because rational people make decisions by
comparing costs and benefits, they respond to incentives.
Incentives may possess a negative or a positive intention.
For example, by offering a raise in the salary of whosoever works harder, employer can induce
people to work hard which is a positive incentive. Whereas putting a tax on a good, say fuel, can
induce people to consume it less which is a negative incentive.

5. Trade Can Make Everyone Better Off

Trade allows countries to specialize according to their comparative advantages and to enjoy a
greater variety of goods and services

6. Markets Are Usually a Good Way to Organize Economic Activity

Many countries that once had centrally planned economies have abandoned this system and
are trying to develop market economies.
Adam Smith made the observation that when households and firms interact in markets guided
by the invisible hand, they will produce the most surpluses for the economy

7. Governments Can Sometimes Improve Economic Outcomes

Market failures occur when the market fails to allocate resources efficiently. Governments can
step in and intervene in order to promote efficiency and equity.

8. A country's standard of living depends on country production

Standard of living may vary largely from one country to another. The explanation for differences
in living standards lies in differences in the level of each economy’s productivity. High
productivity implies a high standard of living.
Thus, policymakers must understand the impact of any policy on working population’s ability to
produce goods and services and work towards enhancing productivity by ensuring that workers
are well educated, have latest inputs access to the best available technology.

9. Prices rise when the government prints too much money

When the government prints too much money, it inevitably increases the demand. When
suppliers fail to raise the production with respect to the demand, they have to raise the prices,
resulting in inflation.

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment

In the short run, when prices rise as a result of excess demand, suppliers will want to increase
their production of goods and services. In order to achieve higher production, they need to hire
more workers to produce those goods and services which lowers the unemployment while
there is still inflation.

Types of Economic Systems

Societies have organized their resources in many different ways through history, deciding how
to use available means to achieve individual and common ends. Some of the most popular
economic models, which have emerged are:

A free-market economy (or the Capitalist economy) is an economic system characterized by

private ownership of factors of production such as capital goods, labor, natural resources, and
entrepreneurship.

● In a capitalist economy, the production of all the goods and services is dependent on the
demand and supply in the market (also known as a market economy).
● The main characteristic of a capitalist economy is the motive of earning profit. The
capitalist economy is also characterized by the presence of free markets and a lack of
participation by the government in regulating the business.
● Critics of capitalism argue that it concentrates power in the hands of a minority capitalist
class that exists through the exploitation of the majority working class and their labor;
prioritizes profit over social good, natural resources, and the environment; is an engine
 of inequality, corruption, and economic instabilities; and that many are not able to access
its purported benefits and freedoms, such as freely investing.
● Supporters argue that it provides better products and innovation through competition,
promotes pluralism and decentralization of power, disperses wealth to people who are
able to invest in useful enterprises based on market demands, allows for a flexible
incentive system where efficiency and sustainability are priorities to protect capital,
creates strong economic growth, and yields productivity and prosperity that greatly
benefit society.

A centrally planned economy (or a Socialist economy) is an economic system based on

public ownership of the factors of production. Those means include the machinery, tools, and
factories used to produce goods that aim to directly satisfy human needs.
1. In a purely socialist system, all legal production and distribution decisions are made by
the government, and individuals rely on the state for everything from food to healthcare.
The government determines the output and pricing levels of these goods and services.
2. Socialists contend that shared ownership of resources and central planning provides an
equal distribution of goods and services and a more equitable society.
3. Market economists generally criticize socialism for eliminating the free market and its
price signals which they consider necessary for rational economic calculation. They also
consider that it causes a lack of incentive and believe that these problems lead to a
slower rate of technological advancement and a slower rate of growth of GDP.

A mixed economic system is a system that combines aspects of both capitalism and
socialism.
● Mixed economies typically maintain private ownership and control of most of the means
of production but often under government regulation.
● Mixed economies socialize select industries that are deemed essential or that produce
public goods.

Economics Schools of thought

1. Classical economics: It is associated with economist Adam Smith whose book The
Wealth of Nations is considered to mark the beginning of classical economics. The main
idea of the Classical school was that markets work best when they are left alone, and
that there is nothing but the smallest role for government. The approach is firmly one of
laissez-faire and a strong belief in the efficiency of free markets to generate economic
development. It believes that the price mechanism acts as a powerful ‘invisible hand’ to
allocate resources to where they are best employed.
In terms of the macro-economy, the Classical economists assumed that the economy
would always return to the full-employment level of real output through an automatic self-
adjustment mechanism.

2. Keynesian economics: Also known as Keynesianism is named after John Maynard

Keynes. It comprises various macroeconomic theories and models of how aggregate
 demand strongly influences economic output and inflation and believes that aggregate
demand does not necessarily equal the productive capacity of the economy. The
Keynesian approach is interventionist, coming from a belief that the self interest which
governs micro-economic behaviour does not always lead to long run macroeconomic
development or short run macroeconomic stability. It is in direct contrast with aggregate
supply based classical economics. It extensively uses the IS-LM model to explain its
theories of equilibrium income, unemployment, inflation, liquidity etc. It believes in
interventionist theories and claims that business cycles (recession and boom) can’t be
corrected without government intervention and hence lays focus on fiscal policies.

3. Neoclassical Economics: Neoclassical economics is a broad theory that focuses on

supply and demand as the driving forces behind the production, pricing, and
consumption of goods and services.
It attempts to derive general rules or principles about the behaviour of firms and
consumers. Neo-classical economics assumes that economic agents are rational in their
behaviour, and that consumers look to maximise utility and firms look to maximise
profits. Utility is used to model the worth or value. Another important contribution of neo-
classical economics was a focus on marginal values, such as marginal cost and
marginal utility. Neoclassical economics theories underlie modern-day economics, along
with the tenets of Keynesian economics. Finally, this economic theory states that
competition leads to an efficient allocation of resources within an economy. The forces of
supply and demand create market equilibrium.In contrast to Keynesian economics, the
neoclassical school states that savings determine investment. It concludes that
equilibrium in the market and growth at full employment should be the primary economic
priorities of the government.

Branches of Economics
Economics can generally be broken down into microeconomics, which focuses on the
behavior of individual consumers and producers, and macroeconomics, which examines
overall economies on a regional, national, or international scale.

1. Microeconomics focuses on how individual consumers and firms make decisions; these
individual decision-making units can be a single person, a household, a business/organization,
or a government agency.

Microeconomics tries to explain how and why different goods are valued differently, how
individuals make financial decisions, and how individuals best trade, coordinate, and cooperate
with one another.

Microeconomics' topics range from the dynamics of supply and demand to the efficiency and
costs associated with producing goods and services; they also include how labor is divided and
allocated, how business firms are organized and function, and how people approach uncertainty
and risk and strategic game theory.
Most common Concepts used in Microeconomics are:

Demand

Demand refers to a person’s desire to purchase goods and services and the willingness to pay
for the same. It is also backed by the person’s ability to pay for the product.

Law of Demand

It is one of the most fundamental concepts of economics. It states that the quantity purchased
varies inversely with the own price of the good. In other words, the higher the own price of the
product, the lower is the demand for the product, other parameters held constant.

Function: Qx = f(Px ; Y)
Px = price of good x
Qx = quantity of good x
Y = Other Parameters (held constant)

Supply

Supply is an economic concept that refers to the willingness and ability of producers to create
goods and services to take them to market.

Law of Supply

It is an economic law that states that keeping other things constant, as the price of the product
rises, the quantity of the goods or services offered by the suppliers rises and vice versa.
Elasticity

Demand Elasticity

The elasticity of demand measures the sensitivity of the quantity demanded of a product to the
own price of the product.

E(d) = (-)(% change in quantity)/(% change in Prices)

Supply Elasticity

It is a measure used to show the responsiveness of the quantity supplied of a good or service to
the change in its own prices.

E(s)= (% change in quantity) / (% change in prices)

Types of Elasticity

• Inelastic demand/supply
Elasticity is considered inelastic when its value (Ed/s) < 1. It indicates that the
proportionate change in quantity is lesser than the proportionate change in prices.

• Elastic demand/supply
When the value of elasticity (Ed/s) >1, then we call it elastic demand/supply. It shows
higher responsiveness in the product with respect to its prices. Elastic demand/supply
means that the proportionate change in quantity is greater than the proportionate change
in the prices.

• Unitary Elastic
When the proportionate change in prices is equal to the proportionate change in
quantity, then it is a case of unitary elasticity. (Ed/s = 1 in this case).

Types of Market
 ● Pure Competition

It is a market structure defined by a large number of small firms competing against each other.
A single firm doesn’t have significant marketing power, and as a result, the industry produces an
optimal level of output because firms don’t have the ability to influence market prices. The prices
and output of goods and services are determined by the forces of the market, i.e., demand and
supply.

Products are identical for all the players in the market and there are no significant barriers to
entry and exit the market.

● Monopolistic competition

It is characterized by a large no. of small firms (producers) competing against each other. The
products sold are highly differentiated among the competitors (similar line of products are sold).
The small differences in firms’ products become the basis for the firms’ advertising and
marketing—for example, Fast Food restaurants.

● Oligopoly

This type of market is characterized by a small no. of large-sized firms and hence results in
limited competition. They can collaborate with or compete against each other to use their
collective market power to drive up prices and earn more profit. Oligopoly has a lot of entry and
exit barriers and hence it is not easy to enter the market. Products are generally homogenous
but can be differentiated in some aspects. For example, Video Game Console companies

● Monopoly

A monopoly exists when there’s a single firm that controls the entire market. The firm and
industry are synonymous. This firm is the sole producer of a product, and there are no close
substitutes. Because there are no alternatives, the firm has the highest level of market power.
Hence, monopolists often reduce output, increase prices, and earn more profit. The monopolist
is a price setter.

Entry or exit is blocked in a pure monopoly. This can occur for many reasons, i.e., legal,
copyright, technical, etc. For example, the Government in the provision of public utilities.

Types of Costs

Opportunity costs- It is the cost of the next best alternative foregone.

Marginal Opportunity cost- It refers to the number of units of a commodity sacrificed to gain
one additional unit of another commodity.

Explicit cost- It is the actual money expenditure on inputs or payment made to outsiders for
hiring their factor services.
Implicit cost- It is the estimated value of the inputs supplied by the owners including normal
profit.

Cost function- It refers to the functional relationship between cost and output. It is expressed
as: C= f(q)

Short Run Costs

Short run costs are of two types-

1. Total Fixed Cost (TFC) or Fixed Costs (FC) - It refers to those costs which do not
vary directly with the level of output.

2. Total Variable costs (TVC) or Variable costs (VC)- It refers to those costs which vary
directly with the level of output

Total Costs (TC) - Total cost is the total expenditure incurred by a firm on the factors of
production required for the production of a commodity.

The relationship between TFC, TVC AND TC is as follows-

TC= TFC+TVC

● Average Fixed Cost - It refers to the per unit fixed cost of production . It is calculated by
dividing Total Fixed Costs by total output.

AFC = TFC/Q
 ● Average Variable Cost - It refers to the per unit variable cost of production. It is
calculated by dividing Total Variable Costs by total output.

AVC = TVC/Q

● Average Total Cost - It refers to the per unit total cost of production. It is calculated by
dividing total costs by the total output.

AC = TC/Q

Relationship between AC, AVC and AFC is as follows-

AC = AFC + AVC

Marginal Cost (MC) – It refers to the addition to total costs when one more unit of output is
produced.

It is represented as:

MC = TCN – TCN-1

Where,

N is the number of units produced

MC is the Marginal Cost

TCN is the total cost of n units

TCN-1 is the total cost of (N-1) units

The relationship between MC and average costs can be seen in the following diagram:
Production - It refers to the transformation of inputs into outputs.

Production Function - It is an expression of the technological relationship between physical

inputs and output of a good.

It can be shown symbolically as follows-

OX = f (i1, i2, i3……….in)

Where,

OX is the output of commodity x

f is the functional relationship

i1, i2, i3……in is the inputs needed for OX

Short Run and Long Run – Short run refers to a period in which output can be changed by
changing only variable factors and long run refers to a period in which output can be changed
by changing all factors of production.

Variable and Fixed Factors – Variable factors refers to the factors that can be changed in the
short run and fixed factors refers to the factors that cannot be changed in the short run.

Product – Product or Output refers to the volume of goods produced by a firm or an industry
during a specified period of time.
Total Product (TP) – It refers to the total quantity of goods produced by a firm during a given
period of time with given numbers of inputs.

Average Product – It refers to the output per unit of a variable input. It can be shown as:

AP = Total Product (TP) / Units of variable factors (n)

Marginal Product (MP) – It refers to the addition to total product, when one more unit of
variable factor is employed.

MP = TPn – TPn-1

Where,

MPN is the marginal product of the nth unit of variable factors,

TPN is the Total Product of n units of variable factors

TPN-1 is the Total Product of (n-1) units of a variable factor and

N is the number of units of variable factor

Law of Variable Proportions – It states that as we increase the quantity of only one input
keeping other input constant, total product (TP) initially increases at an increasing rate, then at a
decreasing rate and finally at a negative rate.

It can be seen by the following diagram:

Stage 1 – TP rises at an increasing rate
MP increases
Stage 2 – TP rises at a decreasing rate
MP decreases and is positive
Stage 3 – TP falls
MP becomes negative

Law of Returns to Scale – Returns to scale refers to the change in output when all the factor
inputs are changed simultaneously in the same proportions in the long run.

The are three types of Returns to Scale-

1. Increasing Returns to Scale – When proportionate increase in total output is more

than proportionate increase in inputs, it is Increasing Returns to Scale

2. Constant Returns to Scale – When proportionate increase in total output is equal to

proportionate increase in inputs, it is Constant Returns to Scale.

3. Diminishing Returns to Scale – When proportionate increase in total output is less

than proportionate increase in inputs, it is Diminishing Returns to Scale.
2. Macroeconomics studies an overall economy on both a national and international level,
using highly aggregated economic data and variables to model the economy.

Its primary areas of study are recurrent economic cycles and broad economic growth and
development. Topics studied include foreign trade, government fiscal and monetary policy,
unemployment rates, the level of inflation and interest rates, the growth of total production
output as reflected by changes in the Gross Domestic Product (GDP), and business cycles that
result in expansions, booms, recessions, and depressions.

Micro- and macroeconomics are intertwined. Aggregate macroeconomic phenomena are just
the total of microeconomic phenomena. However, these two branches of economics use very
different theories, models, and research methods, which sometimes appear to conflict with each
other.

Most common Concepts used in Macroeconomics are:

The Monetary Policy

Monetary policy is the policy laid down by the Monetary Authority of a country. It involves the
management of money supply and interest rate and is the demand side economic policy used
by the Central Bank of a country to achieve macroeconomic objectives and sustainable growth.

In India, monetary policy is managed by RBI in order to meet the requirements of different
sectors of the economy and to increase the pace of economic growth.

The Central Bank has traditionally used three tools to conduct Monetary Policy:

● reserve requirements,
● the discount rate and
● the open market operations.

Fiscal Policy

Fiscal policy refers to the use of government spending and tax policies to influence economic
conditions, which include aggregate demand for goods and services, employment, inflation, and
economic growth.

● The three tools to conduct Fiscal Policy:

● Government Spending
● Taxes
● Transfer Payments

Difference between Monetary and Fiscal Policy

In Monetary Policy, central banks take actions to achieve macroeconomic policy objectives such
as price stability, full employment, and stable economic growth. Fiscal policy refers to the tax
and spending policies of the Central government. Some of the differences could be enumerated
as follows:

1. Fiscal policy generally makes changes in Government spending and Tax rate while
Monetary Policy makes changes in Interest rates and Money supply.

2. In Fiscal Policy, there is no target set, while Monetary Policy targets inflation.

3. Fiscal policy generally has a strong political dimension, while Monetary Policy is free
from such a political process.

4. Fiscal policy might have side effect on government budget or borrowing while a
monetary policy could affect exchange rate

GDP

Gross Domestic Product is the Monetary Value of all the finished goods and services produced
in a country during a particular period of time. It can be Real and Nominal.

Real GDP- It is an inflation-adjusted measure that reflects the value of all goods and services
produced in a given year by an economy. Real GDP makes comparing GDP of different years
more meaningful because it shows comparisons for both the quantity and value of goods and
services.

Nominal GDP- Nominal GDP measures a country's gross domestic product using current prices.
It is calculated without adjusting for inflation.

Bank rate - The bank rate is the interest rate that the central bank charges on its loans and
advances to a commercial bank.

At whatever point a bank has a lack of assets, they can borrow from the Central bank
depending on the nation's monetary policy. It is a commonly utilized instrument that Central
banks use to change the degree of cash supply in the economy and fix inflationary or
deflationary gaps.

Repo rate - The repo rate refers to the rate at which commercial banks borrow money by selling
their securities to the Central bank of our country i.e Reserve Bank of India (RBI) to maintain
liquidity, in case of a shortage of funds or due to some statutory measures. It is one of the main
tools of RBI to keep inflation under control

Reverse repo rate - Reverse Repo Rate is a mechanism to absorb the liquidity in the market,
thus restricting investors' borrowing power.
Reverse Repo Rate is when the RBI borrows money from banks when there is excess liquidity
in the market. The banks benefit from it by receiving interest for their holdings with the central
bank.

During elevated levels of expansion in the economy, the RBI expands the reverse repo. It urges
the banks to park more assets with the RBI to procure more significant yields on abundance
reserves. Banks are left with lesser assets to stretch out credits and borrowings to purchasers.

CRR - Cash Reserve ratio is the minimum portion of deposits that banks have to keep with the
RBI. The higher the CRR, the lower the deposits that banks can use for lending or investing
purposes. Hence, RBI uses CRR to control liquidity in the economy.

SLR – Statutory Liquidity Ratio is the minimum percentage of deposits that banks have to
maintain as gold, cash, or any other approved security. An increase in SLR restricts a bank's
ability to pump money into the economy, thereby regulating credit growth.

Balance of Payments
The Balance of Payments (BOP) is a statement of all transactions made over a given period of
time, such as a quarter or a year, between individuals in one country and the rest of the world.

Economic Policy and the Balance of Payments

In formulating national and foreign economic policy, balance of payments and data on the
international investment role are important. Some aspects of payment balance details, such as
payment imbalances and foreign direct investment, are key issues that the policymakers of a
nation seek to address.
Economic policies are also aimed at particular targets that have an effect on the balance of
payments in turn. One nation, for example, might implement policies explicitly designed to
attract foreign investment in a particular sector, while another could try to hold its currency at an
artificially low level in order to boost exports and build up its reserves. In the balance of
payments data, the effect of these policies is eventually captured.
GST
The GST (Goods and Services Tax) is an indirect tax (or sales tax) on the production of goods
and services used in India. It is a systematic, multi-stage, destination-based tax: comprehensive
since, except for a few state taxes, it has subsumed almost all the indirect taxes. The GST,
multi-staged as it is, is implemented at any phase of the production process, but is intended to
be refunded to all parties in the process of production other than the final consumer and as a
destination-based tax, it is collected from point of consumption and not point of origin like
previous taxes.

GDP Deflator
The price deflator for GDP, also referred to as the deflator for GDP or the implied price deflator,
tests the price adjustments for all the goods and services produced in an economy.

Important Points:
• The price deflator for GDP tests the price adjustments for all the goods and services
produced in an economy.
• The use of the GDP price deflator allows economists to compare real economic activity
levels from one year to the next
• A more rigorous inflation indicator than the CPI index is the GDP price deflator, since it is
not centered on a fixed basket of goods.

FDI (Foreign Direct Investment)

A foreign direct investment (FDI) is an investment made into business interests located in
another country by a corporation or person in one country. In general, FDI takes place when an
investor in a foreign corporation develops foreign business operations or acquires foreign
business properties. FDIs, however, are distinct from portfolio investments in which an investor
merely buys foreign-based companies' equity.

Foreign institutional investors (FII)

Foreign institutional investors (FIIs) are investors or investment funds which invest in a country
outside the country in which they are registered or have their headquarters. The term foreign
institutional investor is possibly most widely used in India, where external companies investing
in the financial markets of the country are referredto.1 The term is also officially used in China.