Week 1 Copy PDF: Introduction to Economics

Week I: Introduction to Economics What is economics? Economics tries to solve the problems of unlimited wants with scarce resources. It is the study of how choices are made. In general, it deals with society as a whole and human behavior in particular. Economics studies the production, distributio...

Week I: Introduction to Economics What is economics? Economics tries to solve the problems of unlimited wants with scarce resources. It is the study of how choices are made. In general, it deals with society as a whole and human behavior in particular. Economics studies the production, distribution, and consumption of goods and services. It is a science in its methodology and arts in its application. Economy & Economic Activity: Economic activity, so the economy is all the production and exchange activities that take place every day, while economic activity is how much buying and selling in the economy happens over a period of time. The basic assumption of Economics: The first assumption is that of rationality, where we assume that every economic agent is rational in their behavior; from the consumer's perspective, a rational consumer would be someone who would maximize their utility, while for producers, a rational producer is somebody who would maximize their profits or minimize their costs. The second basic assumption is that of “ceteris paribus,” which is a Latin phrase meaning that all other things are the same for other things are equal. These two assumptions are the most basic in economics, where we first assume that everybody is rational, and then we are only looking at some relationships, keeping all the other things as they are. Trade-Offs: The idea of tradeoffs implies that when an individual gets one thing, they usually have to give up something else. We often face a tradeoff, but we may not notice it. For example, we face a tradeoff between whether we need to buy food or clothing. Since our monetary income is limited, we might also face a tradeoff between whether to work more for extra income or have more leisure time with friends and family and lose out on the additional income. Now, these are just some examples; at every point, you encounter such situations/ tradeoffs. If you are aware of your decisions, you will realize that the tradeoff is inherently there in all situations. Similarly, the government or society also faces a tradeoff between equity and efficiency. When we say efficiency, it simply means that the economy can get the most from the scarce resources. When we say equity, it means that the benefits arising from the resources are distributed equally among the members of the society. Hence, the government or the society has to continuously decide whether they should give more importance to equity or efficiency. Trade-Offs – Efficiency Vs. Equity So, in the discussion about which is more important, equity or efficiency, some of you might have felt that equity is more important because everybody should have equal access to the benefits arising out of the resources in the economy. Others might have felt that efficiency is more important because it would help us grow and prosper. However, equity and efficiency are both significant; therefore, this is the most important tradeoff faced by the government or society. If the government or the society focuses on equity, which means that if they want to ensure that the distribution is more equal, then they will have to forego some amount of efficiency in the growth. On the other hand, if they focus on efficiency, it will simply lead to more inequality in the society, which is again not desired. Ideally, what one would want is a high level of equity along with a high level of efficiency, but that does not happen. You have to decide which is more important, and therefore, there is this tradeoff between equity and efficiency. Opportunity Cost: Having understood the idea of tradeoffs, we can now move on to the idea of opportunity cost, which, in straightforward terms, means that it is the cost of the following best alternative forgone to do whatever we are currently doing. Therefore, our decisions require a constant cost-benefit analysis of the alternatives that are at hand to decide what is best for us. For example, you may decide whether you want to go to college or you want to go to work, whether you should study or if you wish to go out on a date, whether you want to attend class or you want to sleep. This is because you cannot do both things at the same time, and therefore you have to choose to do the activity that you feel is the most important, hence the idea of cost and benefit and thus the idea of not being able to do something that you could have done in place of what you are already doing. Production Possibilities Curve: Now, let us very quickly look at the production possibility curve, which highlights both scarcity and opportunity cost concepts. The production possibility curve, or the PPC as it is famously called, indicates the opportunity cost of increasing one item's production in terms of the units of production of the other item foregone. Now, let us finally understand the basic questions that economics tries to answer: number one - what to produce, number two - how to produce, and number three for whom to produce. These questions are extremely important, as the resources at hand are scarce, and the idea is that we should try to fulfill the wants and desires of as many people as possible.  Nature and Scope of Economics The Nature of Economics: The following concepts/ sup-topics are included under the nature of economics. Major Players: The major players in any economy are: The consumers: They are the economic agents who demand goods and services to satisfy themselves and cater to the formation of the Demand curve. The producers: They are the economic agents who produce the goods and services and supply with the objective of making profits and catering to the formation of the Supply curve. The market: It is a place where the consumers and producers interact with each other, and goods are bought and sold (a place where Demand and Supply meet/ interact) The government: The government is an agent that ensures that the economy is moving on the desired path and makes policies to provide the same. The most important players in the economy are the consumers and producers, and most microeconomics is devoted to understanding the behavior of the consumers and the producers, including their interaction in the Market. Types of economic analysis: Micro vs. macro analysis: Micro, meaning small is the study of the behaviour of individual economic units; it could be an individual consumer or an individual producer or an individual firm; it could also be the demand and supply for an individual product. Macro analysis is a study of a much larger unit, which is done by studying averages and aggregates. It could be the analysis of an industry with multiple firms in it, or it could focus on aggregate demand and aggregate supply, which is the demand and supply for all the products in an economy compared to an individual product. Both micro and macro analyses are extremely important and depend on the nature of the requirements of the study; hence, we cannot say which one is more important. These analysis methods complement each other rather than work as a substitute for each other. Positive vs. Normative analysis: The second type of economic analysis is the Positive vs. Normative analysis. Positive analysis focuses on what is, or is an analysis based on facts; it establishes a cause-and-effect relationship between the variables that can be tested through economic modeling. On the other hand, normative analysis focuses on what ought to be or what should be and is more concerned with providing value judgments. Economics is both a science and an art: Economics is a science because we use mathematical models for economic theories that hold true and are universal, on the other hand. Economics is an art because we are essentially dealing with society and human behavior, and we are dealing with how consumers and producers interact, which is bound to change. To summarize, Economics is both a science and an art because it has features of both. It is a science because it uses scientific methods to build theories, and it uses analytics and mathematical modeling, which make Economics a science. On the other hand, Economics is an art because it essentially deals with studying human behavior, and the interpretations of the scientific models are more of an art. Deductive and Inductive methods: These are methods that are utilized for building theories: In the deductive method, we basically move from general to specific, so we take a generally acceptable theory, make the hypothesis based on the theory, and then test our hypothesis and confirm whether the hypothesis holds true for specific cases. On the other hand, in the case of an inductive method, we move from specific to general, so we begin by making some observations and then drawing some patterns based on those observations. Based on the pattern, we build a tentative hypothesis, and then we try to generalize the hypothesis to a larger crowd. The Scope of Economics The study of economics, also known as political economy, was a subject matter or a small subset of Politics. With the development of the subject knowledge, most of what we studied earlier as a part of economics is regarded primarily as microeconomics today. Then, with the Keynesian Revolution in the 1930s, the next branch or another branch of Economics known as Macroeconomics came into being. From then on, the study of economics has grown very fast. It's become immense because economics has found relevance in multiple fields like the study of growth and development known as growth and development economics, in the study of public finance, international trade, agriculture and industry, transport, and very recently, even in environment and energy and this scope or the coverage of economics is only growing.  Production Possibility Curve (PPC) Production Possibility Curve (PPC)-An Introduction The production possibility curve, or PPC, highlights the concept of both scarcity and opportunity cost. It indicates the opportunity cost of increasing one item's production in terms of the units of other items forgone. This happens because the resources are limited, so you cannot increase the qualities of both goods. If you need to produce more of one good, you will have to reduce production of the other. The slope of the PPC is measured in absolute terms. Assumptions of the production possibility curve: The first assumption is that the economy is operating at full employment, which implies that all the resources in the economy have been put to the best possible use. The second is that the factors of production, which are basically land, labour, capital, and entrepreneurship, are fixed in supply, which means the supply of the factors of production cannot go on increasing. Third is that the factors of production can be allocated among different uses, which means that the same factors of production are used in the production of both goods; therefore, you can decide where you want to employ the factors of production. The fourth assumption is that technology remains constant, which means that there has been no technological improvement. Because, as a result of a change in technology, the PPC would also change, and you may be able to produce more of both goods. What is the PPC? A production possibility curve shows the different combinations of the quantities of two goods that can be produced in an economy at any given time. The reason for taking only two goods is to make the understanding simpler and logical; as with multiple goods, it would get very complicated and confusing. As depicted in the graph 1 on the left side, we have Consumer goods on the y-axis and defense goods on the x-axis. If you focus, you will also see that on the production possibility curve, there are two points marked as ‘A’ and ‘B’. At point ‘A’, you can produce more consumer goods and fewer defense goods. As we move from point ‘A’ towards point ‘B’ we have to reduce the production of consumer goods to produce more defense goods.  Graph 1 There are arrows that are highlighted in red, which are under the PPC Curve. This implies that all those points are achievable, but that would mean that we are inefficient or not producing to our maximum capacity. On the other hand, the points highlighted in green towards the right side of the PPC are desirable, but that cannot be achieved. Hence, the economy would be somewhere on the production possibility curve. The points on the production possibility curve like point ‘A’ and point ‘B’ are points of maximum productive efficiency. Hence, if you see in the graph, the economy could produce “OCa” amount of consumer goods and “ODa” amount of defense goods and be at equilibrium at point ‘A’ or produce “OCb” amount of consumer goods and “ODb” amount of defense goods and be at equilibrium at point ‘B’. Both these points are points of maximum productive efficiency. The difference is that at point ‘A,’ the production of consumer goods is more, and at point ‘B,’ the production of defense goods is more. On the other hand, all the points inside the frontier are feasible, but they are inefficient, and an economy would never want to produce at an inefficient level. Ideally the economy would prefer to be towards the right side of the PPC (highlighted by green arrows) but that point is unachievable, meaning the resources that the economy has would not be sufficient enough to help the economy reach that point. If you look at the points that are under PPC (highlighted by the red arrows), all the points are achievable. However, they are inefficient, implying that the economy is not operating at the most efficient level. Therefore, the economy would ideally be at point A or point B (or any other point on the PPC Curve) depending on what the economy prefers, whether they want to produce more consumer goods or whether they want to produce more defense goods. So, at every time, they will be operating at some point on the production possibility curve, not below it and not above it. Tradeoff of production possibility curve: The trade-off that the economy faces is in deciding which goods to produce and in what quantities, in our example, the economy had to decide whether it wants to produce more consumer goods or more defense goods. If the economy decides to produce more defense goods and increase the quantity of defense goods from Da to Db, then the economy will also have to reduce the production of Consumer goods from Ca to Cb, and the economy will move from point A to point B as seen in the graph. Therefore, it simply shows that you cannot have more of both goods; the tradeoff is inherent in the production possibility curve. To produce more of one good, you have to reduce the production of the other. Opportunity cost in the production possibility curve: Relooking at the graph, a move from point A to point B indicates an increase in the production units of defense goods and vice versa. This also implies a decrease in the units of production of consumer goods as the production of defense goods increases. This decrease in the production of consumer goods is the opportunity cost of producing more amount of defense goods. To make more defense goods you have to let go of the production of some consumer goods. Outward shift in the production possibility curve: The PPC will shift outward if there is a technological advancement because they can produce more of both goods at the same level of the resources. Hence, if there is an increase in the technology used in production, the production possibility curve will shift outward towards the right, and if there is some downward movement in technology, which never happens, then the production possibility curve shifts inwards towards the left (Refer to Graph 2).  Graph 2 1.6 Implications of the PPC: If the economy is producing under the PPC curve it is operating at less than its potential. The PPC highlights the concepts of choice and trade-offs faced by the economy in deciding what to produce, and it also depicts the concept of the opportunity cost of producing one additional unit of the good with regard to the loss of production of the other good.  Basic Questions in Economics The basic economic questions that need to be answered are: 1. What is to be produced - the economy should decide what goods and services should be produced in the economy 2. How these goods and services should be produced which indicates what method should be employed to produce the goods and services. 3. Among whom the produced goods are to be distributed These three are extremely important and critical questions that need specific answers, the three questions are termed as the basic questions in economics. 1. The first question is What to produce? To understand this question, the economy has to decide what goods the economy should produce; whether they should produce more consumer goods or whether they should produce more capital goods or whether they should produce more defense goods. This question actually deals with the product mix in the economy. Somebody would say that whatever is most important should be produced in the economy, but then how do we decide what's more important? Consumer goods are more important or capital goods are more important or defense goods are more important? There is no clear methodology that determines what goods are important and what are not important, hence, this becomes an extremely important question to be answered. 2. The second basic question which deals with “how to produce”, this question focuses on how you produce the goods? It seeks answers to Are you going to use more capital in the production process or are you going to use more labor in the production process or are you going to use better Technology? The reason this question arises is because the same goods can be produced using multiple methods. It can be produced using different combinations of labor and capital and Technology and therefore it becomes important to decide what amount of these various factors of production as they are called are to be used in the production of these goods. For example, let's say the economy wants to generate electricity for consumption purposes. How is it that you are going to generate electricity? Whether you would generate it by solar energy or by using nuclear energy or by using wind energy or by burning coal? There are so many methods by which we could generate electricity, which one is it that you are going to employ? This question deals with the mix of factors of production that would be used in the production process.  3. The third basic question is for “whom to produce?” So the goods are produced, now what do we do with them? How do you decide who should get these goods? Should the goods and services produced be provided only to the rich or should the goods and services produced be provided only to the poor or should we just distribute them equally amongst everyone in the economy? What should we do with the goods and services produced and how do we decide as to who should get them? This is dealt with in the third basic question. The answers to these basic questions depend on the nature of the economy, so if it is a capitalist economy then the answers to these questions are provided through the market mechanism or more famously called “the Invisible hand”.On the other hand if it is a socialist economy or an economy controlled by the government then these answers are provided by the government and the government decides what to produce, how to produce and for whom to produce. As per Adam Smith, the Invisible hand determines what is produced, how and for whom. The Invisible hand is not an entity, but it is the way the market functions or also known as the market mechanism or the forces of demand and supply. Therefore, there are millions of individuals that signal the desire for goods and services and their purchases of these goods and services provide a green signal to the producers who are willing to produce more and more of these goods and services. Thus, the producers produce greater quantities of the goods & services that are more in demand in a market economy, as they feel they would make more profit. In the case of a market economy; the question “what is to be produced” gets answered by the demand for goods and services, the goods and services that are in greater demand are produced more while those that are in lesser demand get produced less.The second question “how to produce”, where we talked about the mix of factors of production which are used in the production process; in this case a mix of factors of production that minimizes the cost of produciton for the producers is employed in production process they are not concerned with whether it is more capital or more labor or better technology, whatever reduces the cost of production that is utilized in production process.Finally, “for whom to produce”, the market automatically distributes the goods and services to the areas where the demand is more and to consumers who are willing and able to pay for the goods and services. In case the economy is controlled by the government or if it is a socialist or a Communist economy where the Government or the society would have the ownership of all the resources and the means of production; the government or the society would decide what goods are to be produced and in what quantities. How the goods are to be produced - meaning the technique of production would be determined by the government and the government would also decide who gets these goods that are produced. All the basic questions are answered by the government or the society.If we see around us these days most economies are capitalist in nature or are market driven. It is important for us to also discuss a little about the government intervention which is extremely important in a capitalist economy with the government having a regulatory role. Market mechanism definitely leads to an efficient allocation of resources but at the cost of equity; meaning that although the resources would be put to their best possible use the equality in the economy would suffer; also market mechanism sometimes leads to market failures and this is something that we have been witnessing more and more in recent times. Therefore, it is important for the government to intervene in the economy at different intervals of time to ensure the economy moving on the desired path. It is important for the government to intervene in the economy and regulate the economy through various policies and measures and ensure that the economy is functioning as desired.  Positive Vs. Normative Economics Positive economics deals with making observations and statements of things as they are, i.e. they are based on facts. It could be assumptions about the state of the world and some conclusions. The validity of a positive statement is verifiable or testable at least in principle. For example – The poverty rate in India is very high In the above example we are merely stating that the poverty rate is high in India without discussing whether it is good or bad or whether anyone should do anything about it. Normative economics deals with making value judgments about how things should be and hence has a subjective approach, since people could have various opinions. They generally contain words such as "ought to," "must," "should" etc. that cannot be objectively measured. Thus the Normative statements cannot be verified by scientific methods. For example – The government should focus on reducing poverty In the above example we are making a value judgement that the government should reduce poverty, and not just stating the fact.