Economics

An introduction

Economic activity

Why study economics

Why the world is what it is….. Soviet Union collapsed …. setting countries

throughout Eastern Europe and Asia free The nations of Latin America are struggling with

progress and development General Motors loses $4 billion and millions of

workers worry that their jobs and pension plans Housing bubble burst in USA and thousands in

India lose their jobs

A true story Spring 1996 – 19yr college sophomore, who had just

finished taking introductory economics, was faced with a choice – to continue college education or to devote time to a job.

The job – become a professional golfer on the Pro Tour Choice had to be made – time was scarce Completing college had a great cost –

Two years of college expenses Forgone tournament winnings Advertising endorsements

The golfer made a choice – he became a pro.

Fall of 1996 – selected Sprotsman of the Year by Sports Illustrated

1997 – record setting win of Masters Tournament

First player to hold all four major professional championships at the same time

2005 – earned over $50 million in prizes worldwide + advertising & endorsements

The central idea

People make purposeful choices with scarce resources and interact with other people when they make these choices.

Economics is the study of how people deal with scarcity.

It is the study of how scarce resources are allocated among unlimited wants.

Scarcity

The shortage that exists when less of something is available than is wanted at a zero price.

Choice

A selection among alternative goods, services or actions.

Lord Lionel Robbins

1898 – 1984 “An Essay on the

Nature and Significance of Economic Science” (1932)

Economics is a Science which studies human behaviour as a relationship between ends and scarce means, which have alternative uses.

Lord Robbins

“Economics is a social science which deals with human behaviour pertaining to production, exchange and consumption of goods and services (wealth)”

Classical view

Adam Smith

Scottish Economist and Philosopher

1723 - 1790 “ Virtue is more to be feared than

vice, because its excesses are not subject to the regulation of conscience.”

He became famous for his influential book "The Wealth of Nations" written in 1776 and launched the economic doctrine of free enterprise.

Economics is the study of the nature and causes of national wealth.

Adam Smith

Alfred Marshall

1842 – 1924 Professor of Political Economy at

the University of Cambridge from 1884-1908

Founder of the Cambridge School of Economics

A.C. Pigou and J.M. Keynes were among his pupils.

Principles of Economics was his magnum opus and the most influential treatise of its era.

Economics is a study of man’s actions in the ordinary business of life; it enquires how he gets his income and how he uses it. Thus, it on the one side a study of wealth and on the other, and more important side, a part of the study of man.

Alfred Marshall

Economics is a social science that seeks to understand how different societies allocate scarce resources to meet the unlimited wants and needs of its members

Neoclassical

Rational self-interest

People make choices that give them the greatest satisfaction given the information at that time

Measure and compare the costs and benefits of a decision

Individual’s perception of his/her best interest

Some Recent Definitions

The study of how in a civilized society one obtains the share of what other people have produced and of how the total product of a society changes and is determined.

Henry Smith

Economics is what economists do.

Jacob Viner

Cateris paribus

“with other things (being) the same” or

“all other things being equal” Assumption applied to all economic

analysis where causal relationship between two variables can be studied

The economic approach

Positive and Normative Analysis Positive – analysis of what is – analysis

that does not impose the value judgments of one individual on the decision of others

Normative – analysis of what ought to be

Central Problems of an Economy

What to produce How to produce For Whom to produce What provision (if any) be made for

economic growth.

Micro & Macro

In the 1930s Ragnar Frisch classified economics into two branches.

The terms are derived from the Greek terms micros and macros, meaning small and large respectively.

Microeconomics

Micro means a millionth part. It deals with a small part or a small

component of the national economy. Studies economic actions of individual

units and small groups like particular households, individual prices, wages, income, individual industry, particular commodities.

Macroeconomics

Studies the economy as a whole and its large aggregates, such as total national output and income, total employment, total consumption, aggregate investment.

John Maynard Keynes

1883 – 1946 He revolutionized economics

with his classic book, The General Theory of Employment, Interest and Money (1936). 

Probably the most influential social science treatise of the 20th Century.

It quickly and permanently changed the way the world looked at the economy and the role of government in society.

Theory of Aggregation

Macro is the sum of micro

If an individual salary goes up, he is happy; if salaries of all go up proportionately, no one is happy.

Fallacy of Composition

Increased savings by everyone may lead to decrease in total savings

Paradox of Thrift

Kenneth E. Boulding

1910 – 1993 1944 – produced a

paper on liquidity preference

1950 – “Reconstruction of Economics” on stock-flow distinction.

Forest, though an aggregation of trees, exhibits characteristics and behaviour patters different from individual trees:

a) An individual tree germinates, grows and decays, but forests go on forever.

b) A tree may not burn easily, but forests often catch fire.

c) An individual tree cannot affect the climate of the vicinity in which it grows, but forests can and do affect the climate.

Short-run and Long-run

Introduction of time periods in market analysis – Marshall’s contribution

Short-run: a time period not enough for consumers and producers to adjust completely to any new situation

Long-run: is the ‘planning horizon’ – consumers and producers can adjust to any new situation

Opportunity Cost

The problem of choice makes it necessary to sacrifice some of the alternatives against the one selected.

Opportunity cost is the benefit foregone from the alternative that is not selected.

Production Possibility Curve

Also called Transformation Curve A graph that shows different combinations of the

quantities of the two goods that can be produced (or consumed) in an economy, subject to limited resources.

It represents the Opportunity cost concept – if we want to have more of one good, we must have less of another good

Also measures the OC – slope of the curve Applicable to an individual (microeconomics) – shows

options of production or consumption Used in macroeconomics – shows the production

possibilities of a nation or economy as a whole.

PPC for individual

Different combinations of 2 goods given

Resources (income) Prices

AB – PPC of individual F- food, C – clothing Pt. P => Fp of food and Cp of

clothing More of clothing with same income

=> move to pt. Q Any pt. to the right of AB, e.g. M is

unattainable => income constraint Any pt. below AB, e.g. N is

undesirable => violation of rationality

A

B

Fp

Fq

O CpCq

P

QN

M

PPC for society

Assumptions: Economy is operating at full employment Factors of production are fixed in supply; they can however be

reallocated among different uses Technology remains the same

Economy must sacrifice some units of one product to obtain more units of another => trade-off

“Substitution is the law of life in a full-employment economy. The PPC or frontier depicts the society’s menu of choices” - Samuelson

Slopes downward – shows maximum feasible amount that can be produced given the factors of production and technology

It is concave to the origin – OC increases as more of one good is produced instead of another – shift specialised factors from food to clothing – cost will increase

Food

Clothing

Fp

Fq

O Cp Cq

Infeasible area

Productively inefficient area

P

Q

Types of Macroeconomics

Macrostatics

Comparative Macrostatics

Macrodynamics

Macrostatics

Method to explain certain aggregative relations in a stationary state.

Does not explain the process by which the national economy reaches the final equilibrium. Deals with the final equilibrium at a particular point of time.

Provides a series of ‘still pictures’ at a point of time.

Example

Y = C + I(Y = total income, C = total consumption, I = total investment)

Equation merely explains that Income is equal to aggregate Consumption and Investment

Does not throw light on the process by which the equality is reached.

Comparative Macrostatics

Macro variables change with time Economy reaches new level of

equilibriums. This method involves a comparative study

of different equilibrium achieved Does not detail the process by which

economy moves from one equilibrium to another.

Macrodynamics

Developed by Frisch, Hicks, Kalecki, Tinbergen and Samuelson.

Studies how the equilibrium is reached consequent upon changes in macro variables and aggregates.

Presents a full picture of all the developments taking place in the transitional period.

Indian Economy Per Capita Income (2004): Ranges from a low of US

$ 90 for Burundi to a high of US $ 52,030 for Norway. India US $ 620; USA $ 41,400.

Ranges from Rs. 3557 in Bihar to Rs.33,047 for Chandigarh. India: Rs.11,799 (2003-04 at 93-94 prices)

Growth rate of real income: 1990-2001 –3.7% Russian Federation, 10% China, India 5.9%

(2005-06) (World average of 2.7%) People Below poverty line: 2% Republic of Korea,

43% in Nigeria; India 28.6% External Debt/GDP ratio: Sri Lanka 50%; India 20%