Economic Analysis for Business Decisions

What is
ECONOMICS about?

T.J. Joseph
Alliance Business School, Bangalore
 Why Study Economics?
 Understanding the behavior of economic agents
in a better way
 To understand how business work and how business
can be made more efficient and profitable
 Illustration – take any business concern
(Example: Tata Motors)
 Adam Smith – Father of Economics
(‘Wealth of Nations’)

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 Why Study Economics?
 Economics helps to solve complex problems that are
great importance to society

 Economists are concerned with ‘WHY THE WORLD

IS WHAT IT IS ?’
 Examine how individuals and firms make decisions
about consumption, investment, pricing, etc.

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 The Economic Problem
 Two general observation:
– (1) Resources are limited.
• What are resources?
– (2) Human wants are abound/unlimited

Scarcity – ‘We cannot have everything we want all

the time’
 Scarce Resources - not enough to satisfy all wants
 So choices have to be made
 Any choice involves an opportunity cost - the value of
the best alternative foregone
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 Scarcity and Choice
Unlimited Wants (Scarce goods) Limited Resources
Food (bread, milk, meat, eggs, Land (various degrees of fertility)
vegetables, coffee, etc.)
Clothing (shirts, pants, sarees, shoes, Natural (rivers, trees, minerals,
socks, coats, sweaters, etc.) Resources oceans, etc.)
Household (tables, chairs, sofas, beds, Non-human animal resources
goods dressers, television sets, etc.)
Space exploration Human (the knowledge, skill,
resources and talent of individuals)
Education
Machines and other
National defense human-made physical resources
Recreation
Technology
Leisure time
Entertainment
Clean air
Pleasant (trees, lakes, rivers,
environment open spaces, etc.)
Pleasant working conditions
Fundamental Economic Questions
 Scarcity and choice raises several unavoidable
questions to the society
 What to produce?
– More guns or more breads? More books or more
movies?
 How to produce? (optimization)
– Use more labour and less machines?
 For whom to produce (distribution)
– Distribute equally? Then on what basis?

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 Economics Defined
 Economics is the study of how people cope with
scarcity

Economics deals with the problem of how to allocate

the limited resources among competing wants in order
to satisfy as many of those wants as possible

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 Scarcity Necessitates Rationing
 Every society must have a means to ration scarce
resources among competing uses.

In a market setting, price is used to ration goods

and resources.
When price is used, the good or resource is
allocated to those willing to give up “other things”
in order to obtain ownership rights.

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 Emergence of Markets
Markets (and its components) emerge in direct
response to scarcity.
 In a market, people exchange things that they like less
or have more, for things they like more or have less
 Reallocation of their resources and enhance their
individual welfare

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 Fundamental Economic
Questions
 How shall we answer the three basic economic
questions?
 Shall we allow for individual freedom of choice? Or
shall we make all these decisions collectively?

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Economic Systems

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 Alternative Economic Systems
 The nature of economic system depends on

 how the fundamental economic questions are resolved and

 who coordinates the decisions
 Two extremes are Market and Command Economies

 In between lies the widely prevalent Mixed Economy –

a mix of command and market economies

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 Market Economy
 Market mechanism or Price mechanism
coordinates the decision making of various economic
agents
 Also known as Free-enterprise economy – one in which
government does not control economic activity
 The three fundamental economic questions are solved
by the price mechanism (through demand and supply)
 Adam Smith and ‘Invisible Hand’

 Perfectly competitive market

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 Command Economy
 Also known as Centralized economy

 The determination of What, How, For Whom goods &

services are produced is done by
 a dictator or
 a planning committee appointed by the dictator or
 using a hierarchical organizational structure

 State owns all the productive resources like land,

factories, financial institutions, etc
 Authoritarian methods are used to determine resource
use and prices
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 Mixed Economy
 Most of the world economies use a mix of both
market and command systems
 The government modifies (through taxes, subsidies,
etc.) and in some cases replaces (through direct control
of resources) the operation of price mechanism

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Economics – A Social
Science

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 Economics as a Social Science
 What differentiate economists from other social
scientists?
 Economic analysis is based on certain presupposition
about human behavior
 Tries to understand why the world is what it is
 Example (propositions enabling ‘Law of Demand’):
 People prefer more to fewer;
 people seek to maximize welfare by making reasonable and
consistent choices

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 Developing Economic Theories
 The real world of economic is very complex, therefore,
economists turn to theory
 A theory is a set of abstractions about the real world
 Economic theories are simplified models abstracted
from the complexity of the real world
 Tries to explain observed behavior and make
predictions about the future
 Assumption of Ceteris paribus (other things remain the
same)

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 Positive and
Normative Economics

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 Positive Economics
 The scientific study of “what is, what was and what
will be” the economic relationships
 Explanation and prediction (deals with actual
observed phenomena); can be proven right or wrong.
Example:
 The inflation rate rises when the money supply is increased
 What will be the impact of an import quota on foreign cars?
 What will be the impact of an increase in the gasoline excise
tax?

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 Normative Economics
 What ought to be (deals with opinions and
recommendations); reflects value judgments.
 Normative statements reflect subjective values. They
cannot be proved true or false.
– Example:
The inflation rate should be lower.
 The two can be hard to disentangle.

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Common Mistakes –
Pitfalls to Avoid
in Economic Thinking

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 Three Pitfalls
Violation of the ceteris paribus condition.
– Ceteris paribus is a Latin term meaning “other things
constant.”
– When describing the effect of a change, the outcome
may be influenced by changes in other things.

Association is not causation.

– Statistical association alone cannot establish
causation.

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 Three Pitfalls
Fallacy of composition
– The fallacy of composition is the erroneous view
that what is true for the individual (or the part) is
also be true for the group (or the whole).
– Microeconomics focuses on narrowly defined units,
while macroeconomics is focused on highly
aggregated units.
• One must beware of the fallacy of composition when
shifting from micro-to macro-units.

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Microeconomics
and
Macroeconomics

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Microeconomics and Macroeconomics
 Microeconomics is the study of economics at the level
of the individual economic entity
Examples: the behavior of individual consumer,
individual firm, etc.
 Macroeconomics deals with the sum of the behaviour
of all economic entities together (the economy as a
whole or about economic aggregates)
Examples: Study of national income (GDP),
employment, Inflation (price level), etc.

T.J. Joseph 26
 Micro Vs. Macro
 Microeconomics
– Studies the economy at the level of individual
consumers, workers, firms, goods, and markets
 Macroeconomics
– Studies the economy at the aggregate level, at the
level of the economy as a whole.
– Examines total consumer behavior, total
employment, total production, total sales, etc.

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 The Production
Possibilities Curve

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 Basic Concepts
 Opportunity cost: the value of the highest-valued
alternative that must be forgone when a choice is
made. It is the evaluation of a trade-off.

 Marginal benefits and costs: the benefits and

(opportunity) costs associated with one additional
unit of the good.
 Decision Making
 Decision-making is the main job of management

 It involves evaluating various alternatives and

choosing the best among them
 Decision making is done at the margin
– Decision makers evaluate a fixed array of
alternatives.
– Decision makers compare the marginal costs to
marginal benefits to determine the best alternative
– This is economic decision making.
 Production Possibilities Curve
 Production Possibilities Curve (PPC) is used to
illustrate the tradeoffs facing a society
 PPC shows the maximum quantity of goods and
services that can be produced using limited resources
to the fullest extent possible
 PPC shows that more of one type of good can be
produced only by reducing the quantity of other types
of goods that are produced
 Defense Non-defense
Production Possibilities A1 200 0
B1 175 75
Only defense
goods produced
C1 130 125
Defense Goods
D1 70 150

Im
A1

po
200 G1 E1 0 160

ssi
ble
B1 F1 130 25
175
G1 200 75
150 C1 Efficient
F1 Combinations
125
Underutilized 100
(Inefficient)
Only nondefense
75 D1 goods produced

E1
0
25 50 75 100 125 150 Nondefense Goods
 Growth
The PPC moves outward (growth occurs) as the result of:
– Increased labur resources
• Larger labor force
• Change in labor force participation
• Chance in labor-leisure decision
– Improved technology (innovation)
– Expansion of capital stock
– An improvement in the rules (laws, institutions, and
policies) of the economy
 A Shift of the PPC
Defense Non-defense
225 A2 A2 225 0
B2 200 75
Defense Goods A1 B2
200 C2 175 120
B1 C2 D2 130 150
175
E2 70 160
150 F2 0 165
C1 D2
125
100
D1 E2
75
E1 F2
0
25 50 75 100 125 150 Nondefense Goods
 Marginal Opportunity Cost
 The shape of the PPC illustrates the relative cost of
moving productive resources from one activity to
another.
 The marginal opportunity cost is the amount of one
good or service that must be given up to obtain one
additional unit of another good or service.
 The PPC bows outward because there are ever-
increasing marginal opportunity costs to the
production of any good.
Marginal Costs

To increase its
production of
nondefense
goods, society is
must give up
ever-increasing
amounts of
defense goods..

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 Questions for Thought

“The government should provide goods such

as health care, education, and highways
because it can provide them free.”
-- Is this true or false?
 Questions for Thought
1. Which of the following are positive economic
statements and which are normative?
(a) The speed limit should be lowered to 55 miles per
hour on interstate highways to reduce the number
of deaths and accidents
(b) Higher gasoline prices cause the quantity of
gasoline that consumers buy to increase.
(c) A comparison of costs and benefits should not
be used to assess environmental regulations.
(d) Taxes on alcohol result in less drinking and driving.
 Questions for Thought
1. Suppose Amy is a doctor who has records that need to
be entered. Doing this work herself would take 10
hours per week. She is contemplating hiring an
assistant could do the same work in 40 hours. If Amy
can make $80 per hour seeing patients, should she
hire the assistant at $10 an hour?
2. Do you make the food that you consume and the
clothing you wear for your self? Would modern living
standards be possible without trade?
 References
1. Chapter 1 in Dominic Salvatore (2009), ‘Principles of
Microeconomics’, 5th edition, Oxford Publications.
2. Chapters 1 and 2 in William Boyes and Michael Melvin
(2009), ‘Textbook of Economics’, 6th edition, Biztantra
publications.