Economics: The Core Issues

Ten principles of economics

• How people make decisions

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
 Ten principles of economics

• How people interact

4. Trade can make everyone better off
5. Markets are usually a good way to organise
economic activity
6. Governments can sometimes improve
outcomes
 Ten principles of economics

• How the economy as a whole works

8. Standard of living, productivity
9. Inflation
10. Inflation and unemployment
 Scarcity : The core problem
Scarcity- lack of enough resources to satisfy all
desired uses of those resources.
• Factors of production: resources used to produce
goods and services.
1. Land- all natural resources
2. Labor- skills and abilities to produce goods
3. Capital-final goods produced for use in further
production
4. Entrepreneurship-assembling of resources to
produce new or improved products and technologies
Core Issues
• What to produce
how much of each commodity should be produced.
should the emphasis be on agriculture,
manufacturing or services. Should it be on health,
education, defence, infrastructure or housing?
• How to produce
different ways to produce goods but which
production method to use. labour intensive, land
intensive, capital intensive? ; Efficiency.
• For whom to produce
who is going to get the output produced? Should
everyone get an equal share?
• Trade off- Guns and butter, efficiency and equity
• Opportunity Cost
- Cost of the next best alternative forgone.
- Helps us to understand the true cost of decision
making and in valuing different choices.

Suppose a machine can produce either X or Y. The

opportunity cost for producing a given quantity of X
is the quantity of Y, which the resource would have
produced.
If the machine can produce 10units of X and or 20
units of Y, then the opportunity cost of 1x is 2Y.
 Production Possibility Curve
- Alternative combinations of final goods and services
that could be produced in a given time period, with
all available resources and technology.
Capital Goods
Ym
•D

Yo A

•C
Y1 B

O Xo X1 Xm Consumer Goods
• Production possibility curve illustrates two essential
principles: scarce resources and opportunity cost.
• All points on production possibility curve are
efficient points of production.
• Points inside the production possibility curve shows
inefficient utilisation of resources.
• Points outside the production possibility curve are not
attainable with the current level of resources and
current technology.
Growth: Increasing Production Possibilities
-if more resources or better technology becomes available. The
economic growth is shown by the outward shift of production
possibility curve.

Capital Goods B
A
Y1 E1
Yo E

O Xo X1 A1 B1
Consumer Goods
 Circular Flow of Income: Two Sector Model
- Flow of goods and services between households
(consumers) and firms (producers).
Assumptions
• Only two sectors - households and firms
• Households supply factor services to firms
• Firms hire factor services from households
• Firms sell all the goods and services to households
• Households spend all their income on goods an services
• No government intervention and no foreign trade
• Households are the owners of productive resource - land,
labour, capital and enterprise
• Product market and Factor market.
• Real flow-involves flow of goods and services.
• Monetary flow-flow of money payments and expenditure.
It can be derived from the two sector model that:
• Total production of goods and services by firms = Total
consumption of goods and services by household sector.
• Factor payments by firms = Factor incomes of household
sector.
• Consumption expenditure of household sector = Income
of firm sector.
• Hence, real flows of production and consumption of firms
and households = Monetary flows of income and
expenditure of firms and households.
 Circular Flow of Income with Financial System
• Brings about the role of saving and investment.
• Financial institutions are primarily intermediaries
between savers and investors, or lenders and
borrowers.
• Financial institutions pay interest to the savers as
their funds are placed with them for a period of time
under a contract.
• Firms pay dividend and interest for the sums they
have borrowed from the financial markets in the form
of shares, bonds and public deposits.
Circular Flow of Income In a Three Sector Economy
• Government purchases goods and services from firms
and labour services from households. Government
collects taxes from households and firms in order to
finance its expenditure.
• The government makes transfer payments to the
households in the form of social security,
scholarships, etc. It also gives subsidies to the firms
for various purposes.
Circular Flow of Income In a Four Sector Economy
• The domestic economy and the rest of the
world(foreign sector) are connected through import
and export
• import and export of goods and services ultimately
decide what the domestic economy gains or loses in
the international trade.
• trade surplus- when there is excess of exports over
imports.
• trade deficit- when there is excess of imports over
exports.
Complete the four sector model by adding the external/foreign sector
 Buzz words

• Marginalism
• Incrementalism
• Opportunity principle
• Discounting
• Time perspective
 Marginalism
• Marginal analysis is related to a unit change in
independent variable, say increase in costs as a result
of a unit change in output.
– Marginal output of labour: output produced by the
last unit of labour
– Marginal cost of production: cost incurred for
producing an additional unit of output
 Profit of a firm using principle of
marginalism
Units Total Marginal Total Marginal Total Average Marginal
of Revenue revenue (Rs) cost (Rs) profits profit (Rs) profits
costs
output (3) (5) (7)=(6) / (1)
(Rs) (Rs) (Rs) (Rs)
(1) (6)=(2)-
(2) (8)
(4) (4)

1 20 - 15 5 5.0 -

2 40 20 29 14 11 5.5 6

3 60 20 42 13 18 6.0 7

4 80 20 52 10 28 7.0 10

5 100 20 65 13 35 7.0 7

6 120 20 81 16 39 6.5 4

7 140 20 101 20 39 5.6 0

8 160 20 125 24 35 4.4 -4

 Incrementalism
• Incremental reasoning involves estimating the impact of
decision alternatives.
• Usually, changes occur in “chunk” rather than unit
changes.
• Incrementalism is more general whereas marginalism is
more specific.
• Incremental costs :change in total costs as a result of
change in the level of output, investment etc.
• Incremental revenue is a change in total revenue resulting
from a change in the level of output, price etc.

While taking a decision, always incremental revenue

should always be greater than incremental costs
 Opportunity Principle

• Cost of next best alternative foregone or the cost

expressed in terms of the next best alternative
sacrificed.
• Helps us view the true cost of decision making
• Implies valuing different choices
• Highest valued benefit that must be sacrificed as a
result of choosing an alternative.
 Discounting
• The concept of discounting is based on the fact that a
rupee now is worth more than a rupee earned a year
after.
• Even if one is sure about future income, yet it has to
be discounted because to wait for future implies a
sacrifice for the present
• Suppose a sum of Rs 100 is due after one year. Let
the rate of interest be 10 percent. Then we can
determine the sum to be invested now so as to
produce the return (R) of Rs 100 at the end of the
year. The present value or the discounted values of
Rs100 will then be V1 = R
(1+i)n
• V1 = 100
1+0.10
= Rs.90.90
• A present value of Rs100 due two years later would
be V1 = 100
(1+.10)2
= Rs.82.64
 Time perspective

• Short run versus long run

– Very short run
– Short run
– Long run