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UNIT 1

ECONOMICS

Prepared By

Kunal Mojidra

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ECONOMY. . .

. . . The word economy comes from a Greek word

for one who manages a household.

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Economic

s,Unit1,MBA

A household and an economy

face many decisions:

Who will work?

What goods and how many of them should be

produced? What resources should be used in production?

At what price should the goods be sold?

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Society and Scarce Resources:

The management of societys resources 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.

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WHAT IS ECONOMICS

Economics is the study of how society manages

its scarce resources.

In most societies, resources are allocated not by

an all-powerful dictator but through the

combined actions of millions of households and

firms.

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Making decisions requires tradingoff one goal against another.

To get one thing, we usually have to give upanother thing.

Food vs. clothing

Study Economics vs. QA

Leisure time vs. work

Efficiency vs. equity

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Efficiency v. Equity Efficiency means society gets the most that it can from

its scarce resources.

Equity means the benefits of those resources are

distributed fairly among the members of society.

Principle 1: People face tradeoffs.

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PRINCIPLE#2: THE COST OF SOMETHING IS

WHATYOU GIVE UP TO GET IT.

Decisions require comparing costs and benefits of

alternatives.

Whether to go to college or to work?

Whether to study or go out with friends?

Whether to go to class or sleep in?

The opportunity cost of an item is what you give up toobtain that item.

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Principle 2: The cost of something iswhat you give up to get it.

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Rational people systematically and

purposefully do the best they can to achieve their

objectives, given the available opportunities.

Marginal changes are small, incremental

adjustments to an existing plan of action.

Why is water so cheap, while diamonds are so

expensive?

Humans need water to survive, while diamondsare unnecessary; but for some reason, people are

willing to pay much more for a diamond than for

a cup of water.8

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PRINCIPLE#4: PEOPLE RESPOND TO

INCENTIVES.

People make decisions by comparing costs and

benefits at the margin.

Marginal changes in costs or benefits motivate

people to respond.

The decision to choose one alternative overanother occurs when that alternatives marginal

benefits exceed its marginal costs!

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Principle 3: Rational people think at themargin.

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An incentive is something that induces a person

to act, such as the prospect of a punishment or a

reward.

Seat-belt safety Law

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Principle 4: People respond to incentives.

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People gain from their ability to trade with one

another.

Competition results in gains from trading.

Trade allows people to specialize in what they do

best.

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Principle 5: Trade can make everyonebetter off.

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PRINCIPLE#6: MARKETSARE USUALLY A

GOOD WAY TO ORGANIZE ECONOMIC

ACTIVITY.

Amarket economy is an economy that allocates resources

through the decentralized decisions of many firms and

households as they interact in markets for goods and

services.

Households decide what to buy and who to work for.

Firms decide who to hire and what to produce.

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Adam Smith made the observation that households and firmsinteracting in markets act as if guided by an invisible hand.

Because households and firms look at prices when deciding what

to buy and sell, they unknowingly take into account the social

costs of their actions.

As a result, prices guide decision makers to reach outcomes that

tend to maximize the welfare of society as a whole.

Principle 6: Markets are usually a good

way to organize economic activity

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PRINCIPLE#7: GOVERNMENTS CAN

SOMETIMES IMPROVE MARKET OUTCOMES.

Market failure occurs when the market fails to allocate

resources efficiently.

Market failure may be caused by

an externality, which is the impact of one person or firms

actions on the well-being of a bystander.

market power, which is the ability of a single person or firmto unduly influence market prices.

When the market fails (breaks down) government canintervene to promote efficiency and equity.

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Principle 7: Governments can sometimes

improve economic outcomes.

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PRINCIPLE#8: THE STANDARD OF LIVING

DEPENDS ON ACOUNTRYS PRODUCTION. Productivity the quantity of goods and services

produced from each unit of labor input

Standard of living may be measured in different

ways:

By comparing personal incomes.

By comparing the total market value of a nationsproduction.

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Principle 8: The standard of living

depends on a countrys production.

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PRINCIPLE#9: PRICES RISE WHEN THE

GOVERNMENT PRINTS TOO MUCH MONEY.

In January 1921, a daily newspaper in Germany cost 0.30

marks.

Less than two years later, in November 1922, the same

newspaper cost 70,000,000 marks. All the prices in the economy rose by similar amounts.

Inflation is an increase in the overall level of

prices in the economy.

One cause of inflation is the growth in the

quantity of money.

When the government creates large quantities of

money, the value of the money falls.

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Principle 9: Prices rise when the

government prints too much money.

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PRINCIPLE#10: SOCIETYFACES ASHORT-

RUN TRADEOFF BETWEEN INFLATION AND

UNEMPLOYMENT.

Increasing the amount of money in the economy stimulates

the overall level of spending and thus the demand for goods

and services.

Higher demand may over time cause firms to raise theirprices, but in the meantime, it also encourages them to hire

more workers and produce a larger quantity of goods and

services.

More hiring means lower unemployment.

The Phillips Curve illustrates the tradeoff between

inflation and unemployment:

Inflation Unemployment

Its a short-run tradeoff!

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Principle 10: Society faces a short-run

tradeoff between inflation and

unemployment.

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TEN PRINCIPLES OF

ECONOMICS

How people make decisions.

1. People face tradeoffs.

2. The cost of something is what you give

up to get it.

3. Rational people think at the margin.

4. People respond to incentives.

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TEN PRINCIPLES OF

ECONOMICS

How people interact with each

other.

5. Trade can make everyone better off.

6. Markets are usually a good way to

organize economic activity.

7. Governments can sometimes improveeconomic outcomes.

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TEN PRINCIPLES OF ECONOMICS

The forces and trends that affect how

the economy as a whole works.

8. The standard of living depends on a

countrys production.

9. Prices rise when the government

prints too much money.10. Society faces a short-run tradeoff

between inflation and unemployment.19

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THE MARKET FORCES

OF SUPPLY AND

DEMAND

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Supply and demand are the two words that

economists use most often.

Supply and demand are the forces that make

market economies work.

Modern microeconomics is about supply, demand,

and market equilibrium.

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Amarket is a group of buyers and sellers of a

particular good or service.

The terms supply and demand refer to the behavior

of people . . . as they interact with one another in

markets.

Buyers determine demand.

Sellers determine supply

MARKETS AND COMPETITION

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COMPETITIVE MARKET

Acompetitive market is a market in which there

are many buyers and sellers so that each has a

negligible impact on the market price.

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Perfect Competition Products are the same

Numerous buyers and sellers so that each has no

influence over price

Buyers and Sellers are price takers

Monopoly One seller, and seller controls price

COMPETITION: PERFECT AND OTHERWISE

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Oligopoly

Few sellers

Not always aggressive competition

Monopolistic Competition

Many sellers

Slightly differentiated products

Each seller may set price for its own product

COMPETITION: PERFECT AND OTHERWISE

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DEMAND

Quantity demanded of any goods is the amount of agood that buyers are willing and able to purchase.

Law of Demand

The law of demand states that, other things equal, thequantity demanded of a good falls when the price of the

good rises.

o Demand ScheduleThe demand schedule is a table that shows the

relationship between the price of the good and the

quantity demanded.

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A BOYS DEMAND SCHEDULE

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THE DEMAND CURVE: THE RELATIONSHIP

BETWEEN PRICE AND QUANTITYDEMANDED

Demand Curve The demand curve is a graph of the relationship between the

price of a good and the quantity demanded.

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A BOYS DEMAND SCHEDULE AND DEMAND CURVE

Price of

Ice-Cream Cone

0

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

1. A decrease

in price ...

2. ... increases quantityof cones demanded.

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MARKET DEMAND VERSUS INDIVIDUAL

DEMAND

Market demand refers to the sum of all individualdemands for a particular good or service.

Graphically, individual demand curves are

summed horizontally to obtain the market demandcurve.

SHIFTS IN THE DEMAND CURVE

Change in Quantity Demanded

Movement along the demand curve.

Caused by a change in the price of the product.

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0

D

Price of Ice-CreamCones

Quantity of Ice-Cream Cones

A tax that raises theprice of ice-creamcones results in a

movement along thedemand curve.

A

B

8

1.00

$2.00

4

CHANGES IN QUANTITYDEMANDED

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Consumer income

Prices of related goods

Tastes

Expectations Number of buyers

FIGURE 3 SHIFTS IN THE DEMAND CURVE

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FIGURE 3 SHIFTS IN THE DEMAND CURVEPrice of

Ice-Cream

Cone

Quantity of

Ice-Cream Cones

Increasein demand

Decreasein demand

Demand curve,D3

Demandcurve, D1

Demandcurve,D2

0

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Consumer Income As income increases the demand for a normal good will

increase.

As income increases the demand for an inferior good will

decrease.

CONSUMER INCOME

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$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

Price of Ice-Cream Cone

Quantityof Ice-CreamCones

0

Increase

in demand

An increasein income...

D1

D2

CONSUMER INCOME

NORMAL GOOD

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$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

Price of Ice-Cream Cone

Quantity of

Ice-Cream

Cones0

Decrease

in demand

An increasein income...

D1

D2

CONSUMER INCOME

INFERIOR GOOD

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Prices of Related Goods When a fall in the price of one good

reduces the demand for another good, the

two goods are called substitutes. When a fall in the price of one good

increases the demand for another good,

the two goods are called complements.

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OTHERVARIABLES

Tastes: The most obvious determinant of your demand is

your tastes.

Expectations:Your expectations about the future may

affect your demand for a good or service today.

For example, if you expect to earn a higher income next

month, you may choose to save less now and spend more ofyour current income buying ice cream.

As another example, if you expect the price of ice cream to

fall tomorrow, you may be less willing to buy an ice-cream

cone at todays price.

Number of Buyers: market demand depends on the

number of these buyers.

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VARIABLES THAT INFLUENCE BUYERS

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TWO WAYS TO REDUCE THE QUANTITY

OF SMOKING DEMANDED

Public policymakers often want to reduce the

amount that people smoke.

There are two ways that policy can attempt to

achieve this goal.

One way to reduce smoking is to shift the demand

curve for cigarettes and other tobacco products.

Public service announcements, mandatory health

warnings on cigarette packages, and the prohibition

of cigarette advertising on television are all policiesaimed at reducing the quantity of cigarettes

demanded at any given price.40

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Alternatively, policymakers can try to raise the

price of cigarettes.

If the government taxes the manufacture of

cigarettes, for example, cigarette companies pass

much of this tax on to consumers in the form ofhigher prices.

A higher price encourages smokers to reduce the

numbers of cigarettes they smoke.

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SUPPLY

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SUPPLY

Quantity supplied is the amount of a good that sellersare willing and able to sell.

Law of Supply The law of supply states that, other things equal, the

quantity supplied of a good rises when the price of the good

rises.

o Supply Schedule: The supply schedule is a table that

shows the relationship between the price of the good and

the quantity supplied.

AMULS SUPPLY SCHEDULE

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AMULS SUPPLYSCHEDULE

The supply curve is the graph of the relationship between

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pp y g p p

the price of a good and the quantity supplied.

SHIFTS IN THE SUPPLY CURVE

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SHIFTS IN THE SUPPLYCURVE

Input prices Technology

Expectations

Number of sellers

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Change in Quantity Supplied Movement along the supply curve.

Caused by a change in anything that alters the quantity

supplied at each price.

CHANGE IN QUANTITY SUPPLIED

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1 5

Price of Ice-

Cream

Cone

Quantity of

Ice-Cream

Cones0

S

1.00 A

C$3.00 A rise in the

price of icecream conesresults in amovementalong the

supply curve.

CHANGE IN QUANTITYSUPPLIED

Caused by a change in anything that alters the quantity supplied ateach price.

SHIFTS IN THE SUPPLY CURVE

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SHIFTS IN THE SUPPLYCURVE

Price of

Ice-CreamCone

Quantity of

Ice-Cream Cones

0

Increasein supply

Decreasein supply

Supply curve,S3

curve,Supply

S1Supply

curve, S2

Caused by a change in a determinant other than price.

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VARIABLES THAT IMPACTS SUPPLIERS

Input Prices: To produce their output of icecream, sellers use various inputs: cream, sugar,

flavoring, ice-cream machines, the buildings in

which the ice cream is made, and the labor of

workers to mix the ingredients and operate the

machines.

When the price of one or more of these inputs

rises, producing ice cream is less profitable, and

firms supply less ice cream.

If input prices rise substantially, a firm might

shut down and supply no ice cream at all.

Thus, the supply of a good is negatively related to

the price of the inputs used to make the good.51

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Technology:

The technology for turning inputs into ice cream

is another determinant of supply.

The invention of the mechanized ice-cream

machine, for example, reduced the amount of

labor necessary to make ice cream.

By reducing firms costs, the advance in

technology raised the supply of ice cream.

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Expectations :

The amount of ice cream a firm supplies today

may depend on its expectations about the future.

For example, if a firm expects the price of ice

cream to rise in the future, it will put some of its

current production into storage and supply less to

the market today.

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Number of Sellers :

In addition to the preceding factors, which

influence the behavior of individual sellers,

market supply depends on the number of these

sellers.

If Some mature companies decide to drop or

change from the ice-cream business, the supply

in the market would fall.

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VARIABLES THAT INFLUENCE SELLERS

SUPPLY AND DEMAND TOGETHER

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Equilibrium refers to a situation in which the price hasreached the level where quantity supplied equals quantity

demanded.

Equilibrium Price

The price that balances quantity supplied and quantity

demanded.

On a graph, it is the price at which the supply and

demand curves intersect.

Equilibrium Quantity

The quantity supplied and the quantity demanded at the

equilibrium price.

On a graph it is the quantity at which the supply and

demand curves intersect.


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At $2.00, the quantity demandedis equal to the quantity supplied!


Demand Schedule Supply Schedule

THE EQUILIBRIUM OF SUPPLY AND DEMAND

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Price of

Ice-CreamCone

0 1 2 3 4 5 6 7 8 9 10 11 12

Quantity of Ice-Cream Cones

13

Equilibrium

quantity

Equilibrium price Equilibrium

Supply

Demand

$2.00

FIGURE 9 MARKETS NOT IN EQUILIBRIUM

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Price of

Ice-Cream

Cone

0

Supply

Demand

(a) Excess Supply

Quantity

demanded

Quantity

supplied

Surplus

Quantity of

Ice-Cream

Cones

4

$2.50

10

2.00

7

NOT IN EQUILIBRIUM

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NOT IN EQUILIBRIUM

Surplus When price > equilibrium price,

then quantity supplied > quantity demanded.

There is excess supply or a surplus.

Suppliers will lower the price to increase sales,thereby moving toward equilibrium.

MARKETS NOT IN EQUILIBRIUM

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Q

Price of

Ice-Cream

Cone

0 Quantity of

Ice-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantity

suppliedQuantity

demanded

1.50

10

$2.00

74

Shortage

NOT IN EQUILIBRIUM

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NOT IN EQUILIBRIUM

Shortage When price < equilibrium price, then quantity demanded >

the quantity supplied.

There is excess demand or a shortage.

Suppliers will raise the price due to too manybuyers chasing too few goods, thereby moving

toward equilibrium.

EQUILIBRIUM

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EQUILIBRIUM

Law of supply and demand The claim that the price of any good adjusts to bring the

quantity supplied and the quantity demanded for that good

into balance.

THREE STEPS TO ANALYZING CHANGES IN

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THREE STEPS TOANALYZING CHANGES IN

EQUILIBRIUM

Decide whether the event shifts the supply or demandcurve (or both).

Decide whether the curve(s) shift(s) to the left or to the

right.

Use the supply-and-demand diagram to see how theshift affects equilibrium price and quantity.

HOW AN INCREASE IN DEMANDAFFECTS THEEQUILIBRIUM

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EQUILIBRIUM

Price of

Ice-Cream

Cone

0 Quantity ofIce-Cream Cones

Supply

Initial

equilibrium

D

D

3. . . . and a higher

quantity sold.

2. . . . resultingin a higherprice . . .

1. Hot weather increases

the demand for ice cream . . .

2.00

7

New equilibrium$2.50

10

THREE STEPS TO ANALYZING CHANGES IN

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THREE STEPS TOANALYZING CHANGES IN

EQUILIBRIUM

Shifts in Curves versus Movements along Curves A shift in the supply curve is called a change in supply.

A movement along a fixed supply curve is called a change in

quantity supplied.

A shift in the demand curve is called a change in demand.

A movement along a fixed demand curve is called a change

in quantity demanded.

HOW ADECREASE IN SUPPLYAFFECTS THE EQUILIBRIUM

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Price of

Ice-Cream

Cone

0 Quantity ofIce-Cream Cones

Demand

New

equilibrium

Initial equilibrium

S1

S2

2. . . . resultingin a higherprice of ice

cream . . .

1. An increase in theprice of sugar reducesthe supply of ice cream. . .

3. . . . and a lower

quantity sold.

2.00

7

$2.50

4

WHAT HAPPENS TO PRICE AND QUANTITY

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WHAT HAPPENS TO PRICE AND QUANTITY

WHEN SUPPLY OR DEMAND SHIFTS?

unit 1 efm

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