Fundamentals of Economics Module 1 PDF

MODULE 1 FUNDAMENTALS OF ECONOMICS PRINCIPLES OF MICROECONOMICS Definition of Economics ▪ Economics is the study of the allocation of scarce resources among competing end uses. This scarcity imposes a variety of constraints on the choices available to a society. ▪ For eg. no i...

MODULE 1 FUNDAMENTALS OF ECONOMICS PRINCIPLES OF MICROECONOMICS Definition of Economics ▪ Economics is the study of the allocation of scarce resources among competing end uses. This scarcity imposes a variety of constraints on the choices available to a society. ▪ For eg. no individual can spend more than his/her income or use more than 24 hours in one day. So how do we optimally allocate resources within an economy? Theoretical Models ▪ Economists use models to describe economic activities. ▪ While most economic models are abstractions from reality, they help understand economic behavior. ▪ For eg. there are thousands of firms producing millions of different goods which are bought in the market by consumers. These consumers in turn provide their labour to the firms and work in all sorts of occupations. ▪ Economic models try to capture in a simplified way the interaction of individuals and firms in the market: how individuals make decisions and how firms behave. ▪ Features of an economic model: Depending on the problem being addressed, economic models incorporate certain assumptions. Three common assumptions: Ceteris Paribus, Optimization assumptions and Positive – Normative Distinction Ceteris Paribus Assumption ▪ Ceteris Paribus means “other things the same” ▪ Economic models attempt to explain simple relationships - focus on the effects of only a few forces at a time - other variables are assumed to be unchanged during the period of study ▪ Eg. we may seek to explain wheat prices with only a small number of variables such as rainfall, farmers’ wages and consumer income leaving out other variables which might also impact prices. These are assumed to be unchanged. Optimization Assumption ▪ Many economic models begin with the assumption that economic actors are rationally pursuing some goal - consumers seek to maximize their utility - firms seek to maximize profits (or minimize costs) - government regulators seek to maximize public welfare Positive-Normative Distinction ▪ Positive economic theories seek to explain the economic phenomena that is observed ▪ Normative economic theories focus on what “should” be done Nature, Scope and Importance of Economics ▪ A modern society must make many decisions - what jobs will be done and who will do them e.g. growing food, making clothes, or designing computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services that they produce. ▪ A modern economy is a complicated entity. Thousands of firms engage in producing millions of different goods. Many millions of people work in all sorts of occupations and make decisions about which of these goods to buy. ▪ Economics is the study of how society manages its scarce resources. Resources are allocated through the combined actions of millions of households and firms. ▪ Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. ▪ Economists also study how people interact with one another. For instance, how buyers and sellers of a good together determine the price of the good and the quantity that is sold. Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising. ▪The management of society’s resources (which is what economics studies) is important because resources are scarce. ▪Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. ▪Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire. Example Which of these is not an economic decision? 1) Harvesting peanuts 2) Turning peanuts into peanut oil or peanut butter 3) Distributing peanut products across thousands of retail outlets 4) Throwing peanuts Some Common Terminologies in Economics ▪ Market: A place where buyers and sellers interact to determine the price of a good. ▪ Price: Prices facing individuals and firms in a market. Refers to the market price established by the interaction of buyers and sellers. ▪Demand: Amount of product or good that a consumer wants to buy (for a given price). ▪ Supply: Amount of product of good that a producer wants to sell (for a given price). ▪ Productivity: the amount of goods and services produced from each hour of a worker’s time. ▪Market economy: An economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. ▪Efficiency: the property of society getting the most it can from its scarce resources ▪Equity: the property of distributing economic prosperity fairly among the members of society. ▪Opportunity cost: whatever must be given up to obtain some item. ▪Externality: the impact of one person’s actions on the well-being of a bystander (e.g. pollution) Example Which of the following are positive externalities and negative externalities? 1) Traffic congestion 2) Education 3) Passive smoking 4) Technology  Economic Analysis and its types ▪ Economists use the scientific method which consists of theory and observation with the help of some assumptions. Economists apply the logic of science to examine how an economy works. ▪ Economic modelling is the main type of analysis done by economists which is the construction of an economic model with the help of mathematical / statistical /econometric techniques. Steps in economic modelling: - Explanation of observed phenomena based on theory. - Construction of an economic model which is a mathematical representation of economic theory using diagrams and equations. - Using data to quantify theory and make predictions with statistics and econometric tools. Note: Economic models are stylized. They omit many details and abstract from reality. ▪ For e.g. Theory of the firm assumes that firms try to maximize profits. The theory uses this assumption to then explain how much labor, capital, and raw materials firms use for production and how much output to produce. It also explains how these choices depend on the prices of inputs (labour, capital) and the prices that firms can receive for their outputs. ▪ Using economic models one can do various types of analysis: - profit maximization (e.g. how much to produce?) - cost minimization (e.g. labour costs, raw materials – should I hire one more worker or buy more flour to bake some more cakes) - cost-benefit (e.g. cost/benefit of policy interventions) - social cost analysis (e.g. vaccines, pollutants) Example Amazon wants to hire an economist to increase their sales of economics textbooks in Bangalore. As an economist what kind of analysis would you make? What kind of data would you like to study? What kind of assumptions will you make – about firm, about customers? - Maximize profits, maximize sales/volume. - Data – sales, price, how many customers buy textbooks. - Some assumptions: ◦ Firm wants to make profit / firm wants to minimize costs (e.g. delivery). ◦ Individuals want to study about economics, there is demand. ◦ Individuals have the money/ are willing to pay the price for the textbooks. Economists formulate equations based on assumptions about firm and individual behaviour, and do quantitative analysis to arrive at optimum levels of prices, quantities, other variables of interest. The Circular Flow Diagram – An Example of a Model Example Identify the parts of the model that correspond to the flow of goods and services and the flow of dollars for each of the following activities. a. Sam pays a storekeeper $1 for a quart of milk. b. Sally earns $4.50 per hour working at a fast-food restaurant. c. Serena spends $7 to see a movie. d. Stuart earns $10,000 from his 10 percent ownership of Acme Industrial. References ▪ N. Gregory Mankiw, “Principles of Microeconomics”, Cengage Learning, 2015. ▪ Pindyck, R.S. and Rubinfeld, D.L; “Microeconomics”, Pearson Education edition- 9, 2022.