Introduction

Dr. Akshay Dhume

Economics: First Thoughts
Government and
Development Policy
and Growth - Fiscal
Banking and - Monetary
Financial - International
Institutions Trade and
Finance

Markets
- Stock Macroeconomic
- Goods & Aspects
Services - Output
- Forex - Money
- Unemployment
- Inflation

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 Why Study Economics? You cannot have
everything!
Doesn’t Resources are Scarce.
scarce mean No!! Not
rare? Quite!!

I want to have
everything!!

That is the
distinguishing Then?
characteristic
of any
economic good.

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Scarcity
What is Scarcity?
 A good is said to be scarce if it is limited with respect to the demand for the good
 Such goods are not freely available
 Rationed either by price or by some other means

Is water scarce??

 Depends on the type of water
 Approximately 71% of Earth’s surface is covered by water - water is neither rare
nor scarce
 Water that can be utilized is scarce
 You have to pay a price for water – tax or price for bottled water

Scarcity does not mean merely ‘limited’, but limited with respect to the
demand for the good

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 I have 3 hours
Implications of Scarcity at my disposal.
I need 3 hours
to prepare for
You are facing the exam.
a trade-off!!!

But I also want to

watch the new
movie that is 3
hours long.

I don’t know what I

should do?

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Implications of Scarcity – Trade-off
Bollywood understands trade-off

“Kabhi jeetne keliye kuch haarna padta hai”

(Remember SRK in Baazigar!!!)

Grades versus Satisfaction in the previous example as time is a

scarce resource

Agents are required to give up something in order to get

something else as resources are scarce

Trade-off is commonly expressed in terms of opportunity cost

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Implications of Scarcity – Opportunity
Cost
Opportunity cost of a decision is the value of the next
best alternative foregone

Opportunity cost of watching a movie is the value of

the grades foregone

What is the opportunity cost of pursuing MBA?

What is the total economic cost of pursuing MBA?

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Implications of Scarcity – Efficiency
Scarce resources – efficient use needed

What is efficiency?
 Most effective use of society’s resources in satisfying people’s
wants and needs
 No Shortage No Excess
 Highest quantity and quality of goods and services given
technology and resources

“An economy is producing efficiently when no individual’s

economic welfare can be improved unless someone else is made
worse off”

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Application of Efficiency and Opportunity
Cost - PPF
Production Possibility Frontier (PPF)
 Curve showing the maximum possible combinations of
two goods that can be produced with the given amount
of resources (inputs) and technology

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Application of Efficiency and Opportunity
Cost - PPF
PPF shows all efficient
combinations of outputs
 Points A-F: Efficient Points
 Point U: Inefficient
 Point I : Infeasible
 PPF is downward sloping –
efficient combination and
scarce resources
 PPF is concave – slope  Marginal rate of transformation
increases as the level of (MRT) – Slope of PPF – Amount
production of food of a good that must be foregone
increases in order to create one unit of
another good – Opportunity
cost 10
Economics: Formally
“Study of how the societies allocates scarce resources
to produce valuable good and services and distribute
them among the different sections of the society”

Production Allocation Distribution

Functions
What to How to For Whom
of
Produce? Produce? to Produce?
Economics

Central
Questions of
Economics

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Central Questions of Economics
What to Produce?
 Pizza or Dosa or Shirts or Jeans or …
 High quality shirts or cheap quality shirts?
 Capital Goods or Consumption Goods

“What to produce and in what quantity?”

How to Produce?
 Who farms and who teaches?
 Should electricity be generated from coal, oil or renewable resources?
 Will factories be run by humans or by robots?

“Who will do the production, with what resources and what production techniques?”

For Whom to Produce?

 Poor or Rich
 Males or Females
 Adults or Children

“Who gets to eat the fruit of economic activity?”

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Who Answers the Central Questions?
Types of Economic Systems

Market Command
Major decisions Mixed Major decisions
regarding regarding
production and Combination of production and
consumption are Market and distribution are
taken by Command taken by
individuals and Government
firms

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Command Economy
China, Cuba, North Korea, …

Government plays a central role in making economic

decisions
 Owns most of the means of production (land, labor and
capital) and decides on how these should be used
 Own and directs the operations of enterprises in most
the industries

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Market Economy
Market is a mechanism through which buyers and sellers
interact to determine prices and exchange goods and services

Governed by price mechanism

 System where the forces of demand and supply determine the prices
of goods and services
 Prices serve as signal
If consumers demand more, price rises signaling the producer that more
quantity is required.
 Prices coordinate decisions of consumers and producers

Extreme form of market economy – government keeps its hands

off economic decision – is called laissez-faire

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Market Economy: Market Mechanism

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Market Economy: Invisible Hand
Principle

“Every individual… neither intends to promote the

public interest, nor knows how much he is
promoting it… he intends only his own security;
and by directing that industry in such a manner as
its produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many
other cases, led by an invisible hand to promote an
end which was no part of his intention”
Adam Smith (1783), The Wealth of Nations, Book IV, Chapter II

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Market Economy: Extent of Market
Boundaries of a market, both geographical and in terms
of range of products produced and sold within it.

Market definition is important for two reasons:

A company must understand who its actual and
potential competitors are for the various products that it
sells or might sell in the future

Market definition can be important for public policy

decisions

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WHAT IS A MARKET?
Markets are usually defined in
terms of therapeutic classes of
drugs.

For example, there is a market

for antiulcer drugs that is very
clearly defined.

Sometimes, however, pharmaceutical market boundaries are

more ambiguous, like painkillers.

There are many types of painkillers, and some work better

than others for certain types of pain.
WHAT IS A MARKET?
In 1990, the Archer-Daniels-Midland Company (ADM) acquired
the Clinton Corn Processing Company (CCP).

The U.S. Department of Justice (DOJ) challenged the acquisition

on the grounds that it would lead to a dominant producer of corn
syrup with the power to push prices above competitive levels.

ADM fought the DOJ decision, and the case went to court. The
basic issue was whether corn syrup represented a distinct market.

ADM argued that sugar and corn syrup should be considered part
of the same market because they are used interchangeably to
sweeten a vast array of food products.
WHAT IS A MARKET?

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Central Questions and Economic Systems
Command Economy Market Economy
What to • Government based on the their • Consumers and Producers
produce? assessment of resources and decide
what the people should • Consumers want to maximize
consume satisfaction
• If the government feels that • Producers want to maximize
certain commodities should be profits – maximize revenue
consumed, then those would given cost
be produced • ‘$’ vote

How to • Government decides the input • Producers decide

produce? mix • Input mix that will maximize
• In case of excess labor, labor profit by minimizing cost given
intensive techniques will be revenues
used
For • Government decides who • Depends on supply and
whom to should get the goods and in demand in factor market and
produce? what quantity factor incomes received
• Rationing • Factor incomes determine who
and how much will be
consumed

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Command Economy
Advantages
Inequality may be low as
government has control of the
resources and factor incomes
Promote low unemployment level
Production is not profit driven
and commodities essential
societal welfare would be
produced without regard to
profits or losses
Disadvantages
Preferences of central planner may
not be the same as that of people
and may lead to resources being
channelized in the wrong sectors
Lack of competition may inhibit
innovations which is essential for
economic progress
Bureaucracy and red-tapism
creates inefficiencies in the
economy
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Market Economy
Advantages Disadvantages
Brings about efficiency as Failure of Market Economy
competition forces firms to
utilize resources optimally Inefficiencies
 Monopoly
 Externalities
Increased productivity as factor
 Public Goods
inputs are motivated by
performance-linked incentives
Inequity

Increased innovation as firms

Macroeconomic Issues
need to find ways to remain  Business Cycles
competitive  Slow Economic Growth

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Market Economy: Market Failure and
Government Interventions

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Mixed Economy
Command and Market Economies have limitations

Economy organized with some free market elements and

some command economy elements

Maintain private ownership and control of most of the

means of production, but often under government
regulations

Socialize select industries that are deemed essential or that

produce public goods

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Branches of Economic Analysis
Positive Economics
Describes facts of an economy
Can be resolved by reference to
analysis and empirical evidence
Deals with ‘what is’
Questions/Statements like
 Why do doctors earn more than
janitors?
 Do high interest rates lower
inflation?
Normative Economics
Involves value judgements, ethics
precepts and norms of fairness
No right or wrong answer
Deals with ‘what ought to be’
Questions/Statements like
 Should doctors earn more than
janitors?
 Should unemployment be raised to
reduce inflation?
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Logic of Economics
Post Hoc Fallacy
“The post hoc fallacy occurs when we assume that, because
one event occurred before another event, the first event caused
the second event”

Failure to hold other things constant

 Can lead to incorrect inference about a policy

Fallacy of Composition
“When you assume that what is true for the part is also true
for the whole, you are committing the fallacy of composition”

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REAL VERSUS NOMINAL PRICES
● nominal price Absolute price of a good, unadjusted for
inflation.

● real price Price of a good relative to an aggregate

measure of prices; price adjusted for inflation.

● Consumer Price Index Measure of the aggregate price

level.

● Producer Price Index Measure of the aggregate price

level for intermediate products and wholesale goods.
REAL VERSUS NOMINAL PRICES
The Real Price of Eggs and of a College Education
1970 1980 1990 2000 2007
Consumer Price Index 38.8 82.4 130.7 172.2 205.8
Nominal Prices
Grade A Large Eggs $0.61 $0.84 $1.01 $0.91 $1.64
College Education $2,530 $4,912 $12,018 $20,186 $27,560
Real Prices ($1970)
Grade A Large Eggs $0.61 $0.40 $0.30 $0.21 $0.31
College Education $2,530 $2,313 $3,568 $4,548 $5,196

The real price of eggs in 1970 dollars is calculated as follows:

CPI1970 38.8
Re al price of eggs in 1980   nominal price in 1980   $0.84  $0.40
CPI1980 82.4
CPI1970 38.8
Re al price of eggs in 1990   nominal price in 1990   $1.01  $0.30
CPI1990 130.7
REAL VERSUS NOMINAL PRICES
The Real Price of Eggs and of a College Education (continued)
1970 1980 1990 2000 2007
Consumer Price Index 38.8 82.4 130.7 172.2 205.8
Nominal Prices
Grade A Large Eggs $0.61 $0.84 $1.01 $0.91 $1.64
College Education $2,530 $4,912 $12,018 $20,186 $27,560
Real Prices ($1990)
Grade A Large Eggs $2.05 $1.33 $1.01 $0.69 $1.04
College Education $2,530 $2,313 $3,568 $4,548 $5,196

The real price of eggs in 1990 dollars is calculated as follows:

CPI1990 130.7
Re al price of eggs in 1970   nominal price in 1970   $0.61  $2.05
CPI1970 38.8
CPI1990 130.7
Re al price of eggs in 2007   nominal price in 2007   $1.64  $1.04
CPI 2007 205.8
REAL VERSUS NOMINAL PRICES
The Real Price of Eggs and of a College Education (continued)
1970 1980 1990 2000 2007
Consumer Price Index 38.8 82.4 130.7 172.2 205.8
Nominal Prices
Grade A Large Eggs $0.61 $0.84 $1.01 $0.91 $1.64
College Education $2,530 $4,912 $12,018 $20,186 $27,560
Real Prices ($1980)
Grade A Large Eggs $2.05 $1.33 $1.01 $0.69 $1.04
College Education $2,530 $2,313 $3,568 $4,548 $5,196

The percentage change in real price is calculated as follows:

real price in 2007  real price in 1970 1.04  2.05

Percentage change in real price    0.49
real price in 1970 2.05
REAL VERSUS NOMINAL PRICES

The Minimum Wage

In nominal terms, the

minimum wage has
increased steadily
over the past 70
years.

However, in real
terms its expected
2010 level is below
that of the 1970s.
Managerial Economics

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Managerial Economics
The application of economic theory and the tools of
decision science to examine how an organization can
achieve its aims or objectives most efficiently.
 applications of economic theory
 quantitative methods
 statistical methods
 computational methods

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Importance of Managerial Economics
Evaluating managerial policies
 Timely evaluation of policies which yield no return or are not important in
altering market conditions and ensuring that policies do not pose obstacles
in business decision-making and operational aspects

Advantageous in business organization

 Beneficial in organizing and managing the tasks, events related to the
smooth functioning of business
 Helps in taking the accurate decisions related to the business organization

Recognizes the economic strength and weakness

 Defines the advantages and pitfalls of the business economy
 By exercising managerial economics the business managers can be sure of
the effects of certain activities for growth of business

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Importance of Managerial Economics
Computing the economic relationship
 Relationship among factors viz. income, profit, acquisitions, loss,
demand elasticity etc. are estimated with the help of managerial
economics

Makes business planning much easier

 Helps in planning to achieve rewarding results and operations
 Business planning plays an important role in connecting the tools of
production and systems of operation

Helps in managing the cost

 Helps in deciding the correct and appropriate way for operating a
business and controlling costs

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Importance of Managerial Economics
Systemization of business activities
 Several business activities need to be coordinated and
managed in a systematic manner

Resolves problem related to business taxation

 Giant problem solving tool in various types of issues
related to taxation in the business.

Helps in computing firm’s efficiency

 Helps business managers to measure the ability and
efficiency of the firm

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Nature of Managerial Economics

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Economic Theory
Microeconomics
 Study of the economic behavior of individual decision-
making units.
 Relevance to Managerial Economics.

Macroeconomics
 Study of the total or aggregate level of output, income,
employment, consumption, investment, and prices for
the economy viewed as a whole.

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Economic Methodology
Economic Models
 Abstract from details
 Focus on most important determinants of economic
behavior – cause and effect

Evaluating Economic Models

 A model is accepted if it predicts accurately and if the
predictions follow logically from the assumptions.

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Decision Sciences
Mathematical Economics
 Expresses and analyzes economic models using the tools
of mathematics.

Econometrics
 Employs statistical methods to estimate and test
economic models using empirical data.

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Basic Process of Decision Making

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The Changing Environment of Managerial
Economics
Globalization of Economic Activity
 Goods and Services
 Capital
 Technology
 Skilled Labor

Technological Change
 Telecommunications Advances
 The Internet and the World Wide Web

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WHY STUDY ECONOMICS?
Corporate Decision Making: Ford’s Sport Utility Vehicles

 The design and efficient production of Ford’s SUVs involved not only
some impressive engineering, but a lot of economics as well.

 First, Ford had to think carefully about how the public would react to
the design and performance of its new products.

 Next, Ford had to be concerned with the cost of manufacturing these

cars.

 Finally, Ford had to think about its relationship to the government and
the effects of regulatory policies.