Economics DP

Introduction to economics
Economics is a social science on how to deal with scarcity. It is the study of choices leading to the best
possible use of scarce resources in order to best satisfy unlimited human needs and wants.

Nine key concepts:

Concept Explanation
Scarcity This refers to the idea that resources are insufficient to satisfy unlimited human needs
and wants. Thus, economics is the study of how our scarce resources can best be used
to satisfy the unlimited wants and needs of human beings.
choice Since resources are scarce, a choice must be made about what will be produced and
what will be foregone.
Efficiency Refers to making the best possible use of the scarce resources to avoid resource
waste. It means using the fewest possible resources for goods and services.
Equity Refers to the equality in the distribution of income, wealth and human opportunities.
Economic well- It refers to levels of prosperity, economic satisfaction and standards of living among
being the members of a society.
Sustainability The ability of the present generation to meet its needs without compromising that
ability from future generations.
Change The field of economics is characterized by constant change, and economists need to
take this into account when developing new models and refining old ones.
Interdependence With high national and international economic interaction, choices made by one agent
affect the economic state of others.
Intervention Government involvement in the organizing of markets and economic activity.

The basic economic problem is about scarcity and choice. Every society has to decide the following:
1. What good and service to produce?
This includes the decision on what resources should be allocated in the production of certain
goods and services.
2. How best to produce goods and services?
This includes decision on what is the best use of our scarce resources for having high efficiency.
3. Who is to receive goods and services?
Considers equity and distribution.

In economic analysis, production occurs using four factors of production, which are characterized as:
Opportunity cost: The value of the next best alternative that is lost while making a choice.

Economic goods: Goods that are produced with scarce resources, and therefore have an opportunity
cost, are called economic goods. Most goods and services are economic goods.

Free goods: free goods are those that are not produced with scarce resources, do not have an
opportunity cost, and therefore do not have a price – for example, air, sunlight and rainwater.

Productive efficiency: This suggests that there is no waste and output is produced using the smallest
possible number of resources. Productive efficiency means that, given the available inputs and
technology, it’s impossible to produce more of one good without decreasing the quantity of another
good that’s produced.

Resource allocation refers to assigning available resources, or factors of production, to specific uses
chosen among many possible alternatives, and involves answering what to produce and how to produce
questions.

Economic systems

An economic system is a network of organizations used by a society to resolve the basic problem of
what, how much, how and for whom to produce.

When the government makes decisions that affect the economy, this is known as government
intervention.

Free market economy

 Light touch regulation of labour, product and financial markets.
 Legal system focuses on protecting property rights.
 Freedom to trade internationally promote free movement of capital and labour.
 Limited market intervention (eg. Indirect taxes, subsidies, maximum and minimum prices)
 Small size of government (including a small size, scope of welfare benefits)
  Low tax environment/ focus on “ease of doing business.”
 Consumer preference determine allocation of resources.
Advantages
i. An efficient allocation of scarce resources- factor resources tend to go where the expected profit
is highest.
ii. Competitive prices for consumers as suppliers look to increase and then protect market share.
iii. Competition drives innovation and invention bringing higher profits for business and better
products for consumers.
iv. The profits motive stimulates investment which encourages economies of scale and lower prices
for consumers.
v. Competition through trade in goods and services helps to reduce domestic monopoly power and
increase choice.
Disadvantages
i. Business can develop monopoly power which leads to higher prices and damage to consumer
welfare.
ii. Under or non-provision of pure public goods (eg. Defense- goods which are non-rival and non-
excludable)
iii. Under-provision of merit goods such as health and education-which many cannot afford- leading
to lower social welfare.
iv. Free markets may fail to address negative externalities from production and consumption-
unsustainable growth.
v. Deregulated financial markets often prone to bouts of instability- the fall out from which affects
millions not directly involved.

Command economy/ Planned economy

In a planned economy, decisions about what to produce, how much to produce and for whom are
decided by central planners working for the government rather than allocated using the price
mechanism.
Advantages
i. The government can ensure that there is full employment.
ii. The government can control inflation.
iii. The government can direct businesses to invest in certain sectors of the economy.
iv. The government can develop specific industries.
Disadvantages
i. There is less economic freedom.
ii. Businesses do not have the freedom to make decisions about what to produce and how much to
produce.
iii. The government can distort pricing signals, which can lead to inefficiencies in the economy.
iv. The level of production is not always responsive to market demand.
v. The government can be wasteful with resources.

Transition Economies
Transition economies are involved in a process of moving from a centrally planned economy to a mixed
or free market economy.
 Liberalization of markets to give prices a bigger role in allocating scarce resources between
competing users.
 Privatization of government (state) assets- transferred to the private sector.
 Reduction in tariff and other trade barriers so that the economy becomes more open.
  Reduction in the scale and scope of government subsidies e.g., to loss making industries.
 Legal reforms e.g., to protect private property rights.
 Banking reform and interest rate liberalization.
Problems faced by transition economies.
i. The removal of subsidies in many countries led to a sharp rise in unemployment as unprofitable
businesses shed thousands of jobs.
ii. Inflation increased as market subsidies and price ceilings were taken away - in some cases,
countries experienced hyper-inflation as prices moved towards market levels.
iii. In many countries, a recession followed in the early stages of transition.
iv. An underlying lack of cost and no-price competitiveness meant that many transition countries
ran large trade deficits.
v. Endemic corruption has proved difficult to reduce.
vi. Wealth and income inequalities have widened.
vii. Many countries have experienced a brain drain of younger and skilled workers in search of better
jobs and conditions in richer nations.

Production Possibilities Curve (PPC)

The production possibilities curve (PPC) represents all combinations of the maximum amounts of two
goods that can be produced by an economy, given its resources and technology, when there is full
employment of resources and efficiency in production. All points on the curve are known as production
possibilities.

Assumptions made by PPC:

1. Only those 2 goods are produced in the economy.
2. The economy has a fixed quantity and quality of resources and fixed technology.
3. All resources must be fully employed.
4. All resources must be used efficiently.

An economy’s actual output, or the quantity of

output actually produced, is always at a point
inside the PPC, because in the real world all
economies have some unemployment of
resources and some inefficiency in production.
The greater the unemployment or the
inefficiency, the further away is the point of
production from the PPC.

For example,
 Combination of the output of
consumer and capital goods lying
inside the PPF happen when there are unemployed resources or when resources are being used
inefficiently. We could increase total output of goods and services by moving towards the PPF.
 Combination of goods and services that lie outside the PPF are unattainable at the moment. A
country would require an increase in factor resources, an increase in productivity and/or an
improvement in technology to achieve an outward shift of the PPF.
The law of diminishing marginal returns is a theory in economics that predicts that after some optimal
level of capacity is reached, adding an additional factor of production will actually result in smaller
increases in output.

PPC of volleyballs and footballs could be a straight line as their factors of production are very similar.

Economic growth refers to increases in the quantity of output produced in an economy over a period of
time.
Actual growth involves a movement from one point inside the PPC to another point closer to the PPC,
and growth in production possibilities involving an outward shift of the PPC. Actual growth is caused by
reduction in unemployment and increases in efficiency in production. Growth in production possibilities
is caused by increases in the quantity of resources, improvements in the quality of resources and
technological improvements.
Circular flow of income
The circular flow of income shows that in any given time period, the value of output produced in an
economy is equal to the total income generated in producing that output, which is equal to the
expenditures made to purchase that output.

 The middle part of the model is a closed economy (no international trade ⇒ no imports and
exports) that has no government (no taxes, no government spending) and no financial sector (no
investment, no savings).
 In this economy, the income of consumers will always be the same as their expenditures because
saving is impossible and there are no taxes.
 In this economy, the earnings of companies will always be the same as consumer expenditure
because consumers can’t spend their income on products from abroad (imports).
 In this economy, all earnings of companies will be the same as the value of their domestic
outputs because companies can’t invest parts of their earnings, nor can they export some of
their output.
 Therefore, in a closed economy without a government and financial sector:
Income = Expenditures = Output
 When we add international trade, a government and a financial sector, injections (value added
to the circular flow: investment, government spending and exports) and withdrawals (value
removed from the circular flow: savings, taxes, imports) are possible.
 In such an economy the change in the value of economic activity can be measured as:
J−W=(I+G+X)−(S+T+M)

Saving and Investments:

Savings is the part of consumer income that is not spent but rather is saved. Investment is spending by
firms for the production of capital goods, which is one of the four factors of production. Savings is a
leakage as it is the income that is not spend to buy goods and services. Firms obtain funds from the
financial market to finance investments, or the production of capital goods. Thus, the money saved by
the household in the financial market is injected back into expenditure flow as investment.

Taxes and Government spending

Households pay taxes to the government; this is a leakage because it is income that is not spent to buy
goods and services. The government use the tax funds to finance government expenditures (on
education, health, defense, etc.) and this spending is an injection back into the expenditure flow.

Imports and Exports

Imports are goods and services produced in other countries and purchased by domestic buyers. Exports
are goods and services produced domestically and purchased by foreigners. Imports are a leakage
because they represent household spending that leaks out as a payment to the other countries that
produced the goods and services. Exports are an injection because they are spending by foreigners who
buy goods and services produced by the domestic firms.

In the circular flow of income model if injections are larger than leakages the size of the flow inceases, if
leakages are larger than injections the size of the flow shrinks.

The Economic Approach to the World

Positive Economics: Positive economics is built around positive statements. They are objective, factual
statements that can be proven true or false by scientific experiments. Hypotheses, models, theories,
assumptions (like the ceteris paribus assumption), and empirical evidence are all a part of positive
economics.
Normative Economics: Normative statements are value statements used in policy making that determine
what the economy “should be” or “ought to be” like.

Microeconomics: Competitive markets- Demand and Supply

Competitive Markets
The term market includes any kind of arrangement where buyers and sellers of goods, services or
resources are linked together to carry out an exchange.

Local market eg. Small neighborhood bakery

National market eg. Labor market
International market eg. Oil trade industry

Good and services- product market

Factors of production- Resource market

Demand
Demand for a good or service is the quantity that purchasers are willing and able to buy at a given price
in a given period of time.
Individual demand indicates the various quantities of a good (or service) the consumer is willing and
able to buy at different possible prices during a particular time period, ceteris paribus.
Market demand is the sum of all individual demands for a good. The market demand curve illustrates
the law of demand, shown by the negative relationship between price and quantity demanded.

According to the law of demand, there is a negative relationship between the price of a good and its
quantity demanded over a particular time period, ceteris paribus: as the price of the good increases,
quantity demanded falls, as the price falls, quantity demanded increases, ceteris paribus.

Non-price determinants of demand and shifts of the demand curve (change in demand):
Rightward shift is increase in demand and leftward shift is decrease in demand.
1. Income in case of normal goods:
Normal good is a good whose demand increases in response to an increase in consumer income.
Increase in income leads to a rightward shift and decrease leads to vice-versa.
2. Income in case of inferior goods:
Inferior good is a good whose demand increases in response to a decrease in consumer income.
Eg. Second-hand clothes, used cars, bus tickets, etc. Increase in income leads to a leftward shift
and decrease leads to vice-versa.
3. Preference and taste:
If preferences and tastes change in favor of the good, then its demand increases. However, the
opposite happens if the change in taste and preferences are not in favor of the good.
4. Prices of substitute goods:
Two goods are substitutes (substitute goods) is they satisfy a similar need. Eg. Coca-cola and
Pepsi. A fall in price of one would result in the fall in demand for the other.
5. Prices of complementary goods:
Two goods are complements (complementary goods) is they tend to be used together. Eg.
Computer and computer softwares. A fall in price of one would result in the increase in demand
for the other good.
6. Number of consumers:
Increase in the number of consumers, demand increases and therefore the market demand
curve shifts to right.
7. Future price expectations
when a consumer expects the price of a good to increase in the future, they will take advantage
of lower prices by demanding more of the good in the present. This leads to a shift in the
demand curve to the right.

Movements along a demand curve (Change in quantity demanded):

When the price of a good changes, ceteris paribus, it leads to a movement along the demand curve.
An increase in price gives rise to a decrease in quantity demand, resulting in a movement along the
demand curve. However, any change in a non-price determinant of demand results in a shift of the
demand curve and results in the change of demand (increase in demand, decrease in demand).

Exceptions to the law of demand:

1. Giffen goods
A giffen good is where a higher price causes an increase in demand. This is due to the income
effect of the higher price outweighing the substitution effect.
2. Veblen good
A Veblen good is a good where demand rises as price rises because people enjoy the status that
comes from conspicuous consumption of high-quality luxury products.

Reasons why the demand curve is downward sloping/ assumptions underlying the law of demand:
1. Law of diminishing marginal utility
Law of Diminishing Marginal Utility states that as consumption increases, marginal utility derived
from each additional unit declines. This law directly relates to the concept of diminishing prices.
As the utility (satisfaction) of a product decrease when its consumption increases, consumers are
willing to pay less for more of a product.
2. Substitution effect
A change in the demand of a good as a result of a change in the relative price of the good
compared to that of substitute goods. This is because we assume the price of substitute goods
stays the same.
3. Income effect
As the price of a good or service drops, the amount of the good or service which can be
purchased using the same amount of money rises. This is because we assume that income stays
constant.

Supply
Supply refers to the amount of good or service a firm is willing and able to produce.

Law of supply states that there is a positive relationship between the quantity of a good supplied over a
particular time period and its price, ceteris paribus. When price goes up, supply increases and when
price decreases, supply falls.
The supply of an individual firm indicates the various quantities of a good (or service) a firm is willing
and able to produce and supply to the market for sale at different possible prices, during a particular
time period, ceteris paribus.

Market supply is the sum of all individual firms’ supplies for a good. The market supply curve illustrates
the law of supply, shown by a positive relationship between price and quantity supplied.

Vertical Supply Curve

A vertical supply curve tells us that even as price increases, the quantity supplied cannot increase, it
remains constant. Eg. Tickets for a theater show, original antiques, original paintings, etc.

Non-price determinants of supply and shifts of the supply curve (change in supply):
Rightward shift is increase in supply and leftward shift is decrease in supply.
1. Cost of factors of production
When the factors of production become more (less) expensive, the production cost for
producers will increase (decrease). This means they will probably produce less (more) and the
supply curve will shift to the left (right).
2. Level of technology
When technology advances (deteriorates), producers can produce more (less) efficiently. This
means they will probably produce more (less), shifting the supply curve to the right (left).
3. Prices of related goods: competitive supply
Competitive supply of two or more products refers to production of one or the other by a firn;
the goods compete for the use of the same resources and producing more of one means
producing less of the other. Thus, when the prices of a goods increase (decrease), producers will
feel more (less) confident about ‘winning’ the competition. They will increase (decrease)
production, shifting the supply curve to the right (left). However, the supply of its competitive
good would decrease.
4. Prices of related goods: joint supply
Joint supply of two of more products refers to production of goods that are derived from a
single product, so that is not possible to produce more of one without producing more of the
other. Thus, when the prices of related goods increase (decrease), producers will feel more (less)
 confident about selling their goods along with the related good. Therefore, they will produce
more (less) goods, shifting the demand curve to the right (left).
5. Producer (firms) price expectations
If the price of a good is expected to rise in the future, the firm might hold onto its supply to sell it
later for higher prices; in this case, there is a fall in supply in the present and a leftward shift in
the supply curve. However, if the expectation is that the price of their product will fall in the
future, the firm will increase its supply to take advantage of the current higher prices, hence a
rightward shift in the supply curve.
6. Indirect taxes
When the indirect taxes (i.e. taxes levied on the sale of goods) increase (decrease) the price of
goods will increase (decrease). This will make producers feel less (more) confident on selling
their goods so they will decrease (increase) their production and supply. Consequently, the
supply curve will shift to the left (right).
7. Subsidies
When subsidies (i.e. government money given to producers) increase (decrease), producers will
decide to produce more (less) of the good. This will shift the supply curve to the right (left).
8. Numbers of firms
When there are more (less) competitors on the market, the supply curve would shift to the right
(left). This follows from the fact that market supply is the sum of all individual supplies.
9. Change in expectations.
When expectations change so does the production of producers. If a producer, for example,
expects an economic crisis to occur, he will probably decrease supply in order to be prepared for
a sudden loss in demand.
10. ‘Shocks’, or sudden unpredictable events
Events such as weather conditions in case of agricultural products, war, or natural/man-made
catastrophes can affect supply.

Movements along a supply curve (Change in quantity supplied):

Any change in price produces a change in quantity supplies, shown as a movement on the supply curve.
Any change in a determinant of supply (other than price) produces a change in supply, represented by a
shift of the whole supply curve.

Reasons why the supply curve is upward sloping/ assumptions underlying the law of supply:
1. Law of diminishing marginal returns
According to the law of diminishing marginal returns as more and more units of a variable input
(such as labor) are added to one or more fixed input (such as land), the marginal product (extra
output) of the variable input at first increases, but there comes a point when it begins to
decrease. This relationship presupposes that the fixed input(s) remain fixed, and that the
technology of production is also fixed.
2. Increasing marginal cost
The concept that as a producer increases the quantity of a good/service supplied, the additional
cost of producing each additional unit also increases.

This relationship is reflected in the upward-sloping supply curve, indicating that producers are willing
to supply a greater quantity at higher prices to justify the higher costs of production.
Competitive market equilibrium: demand and supply
The existence of excess demand (a shortage) or excess supply (a surplus) in a free market will cause the
price to change so that the quantity demanded will be made equal to the quantity supplied. In the event
of excess demand, price will rise; in the event of excess supply, price will fall.

Competitive market equilibrium, quantity demanded equals quantity supplied, and there is no tendency
for the price to change. In a market disequilibrium, there is excess demand (shortage) or excess supply
(surplus), and the forces of demand and supply cause the price to change until the market reaches
equilibrium.

If the price lies above the market price, the quantity supplied will be higher than the quantity demanded
(QS > QD). In this case there will be excess supply.
If the price lies below the market price, the quantity demanded will be higher than the quantity supplied
(QD > QS). In this case there will be excess demand.
Price determined by the forces of supply and demand in competitive markets are known as the price
mechanism.

Functions of the price mechanism:

1. Prices as signals and incentives and the allocation of resources
The key to the market’s ability to allocate resources can be found in the signaling and incentive
functions of prices in resource allocation. As signals, prices communicate information to decision
makers. As incentives, prices motivate decision makers to respond to the information.

Prices perform a signaling function – i.e., they adjust to demonstrate where resources are
required. Prices rise and fall to reflect scarcities and surpluses. If prices are rising because of high
demand from consumers, this is a signal to suppliers to expand production to meet the higher
demand. If there is excess supply in a market, the price mechanism will help to eliminate a
surplus of a good by allowing the market price to fall.

Through choices consumers send information to producers about their changing nature of needs
and wants. One important feature of a free-market system is that decision-making is
decentralized, i.e., there is no single body responsible for deciding what to produce and in what
quantities.
 This is in contrast to a planned (state-controlled) economic system where there is significant
intervention in market prices and state-ownership of key industries.

2. Rationing function
Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is
bid up – leaving only those with willingness and ability to pay to buy.

Allocative efficiency in competitive markets

Allocative efficiency refers to producing the quantity of goods mostly wanted by society. Allocative
efficiency is achieved when the economy allocates its resources so that the society gets the most
benefits from consumption. Since allocative efficiency refers to producing what consumers mostly want,
it answers what/how much to produce in the best possible way.

Since marginal benefit decreases as the quantity of a good consumed increases, consumers will be
willing to buy an extra unit of the good only if its price falls. The demand curve can therefore also be
called a marginal benefit (MB) curve.

Since marginal cost increases as the quantity of a good produced increases, producers will be willing to
produce and sell an extra unit of the good only if its price increases. The supply curve can therefore also
be called marginal cost (MC) curve.

Where MB=MC, the economy achieves allocative efficiency.

If MB>MC, then society would be placing a greater value on the last unit of the good produced than the
cost to produce it, and so more of it should be produced.
If MC>MB, then it would be costing the society more to produce the last unit of the good than the value
the society puts on it, and so less should be produced.

Consumer surplus is defined as the highest price consumers are willing to pay for a good minus the price
actually paid. The highest price they are willing to pay is given by the demand curve and the actual price
paid is given by the equilibrium price. Thus, consumer surplus is the area under the demand curve and
below the price paid by the consumer, up to the quantity purchased.

Producer surplus is defined as the price received by firms for selling their good minus the lowest price
that they are willing to accept to produce the good. The lowest price they are willing to sell for is given
by the supply curve. Thus, producer surplus is shown as the area above the supply curve and below the
price received by the firms, up to the quantity produced.

The sum of consumer plus producer surplus is maximized at the point of market equilibrium. The sum of
consumer and producer surplus is known as social surplus (or community surplus).

Markets are achieving allocative efficiency, producing the quantity of goods mostly wanted by society.
Society is making the best possible use of its scarce resources.

Welfare is economics refers to the amount of consumer and producer surplus. In competitive markets,
when MC=MB, or when social surplus is maximum, social welfare is maximum.

Both producer and consumer surplus are given in monetary terms because they express a monetary
value that has been gained by consumers and producers.

Microeconomics: Elasticity
Price Elasticity of Demand (PED)
PED is the measure of the responsiveness of the quantity of good demanded to changes in its price. PED
is calculated along a given demand curve. In general, if quantity demanded is highly responsive to a
change in price, demand is referred to as being elastic, if quantity demanded is not very responsive,
demand is price inelastic.

PED is always negative though absolute values are used for making comparison easier.