Unit-1 Basic Concepts

How Economist’s Think

 Introduction
• Economics is no different. Supply, demand, elasticity, comparative
advantage, consumer surplus, deadweight loss—these terms are part
of the economist’s language.
• Economists use in specialized ways.
• its value lies in its ability to provide you a new and useful way of
thinking about the world in which you live.
The economist as Scientist
• Economists try to address their subject with a scientist’s objectivity.

• They approach the study of the economy in much the same way as a
physicist approaches the study of matter and a biologist approaches
the study of life: They devise theories, collect data, and then analyze
these data in an attempt to verify or refute their theories.
• the scientific method—the dispassionate development and testing of
theories about how the world works.
• This method of inquiry is as applicable to studying a nation’s economy
as it is to studying the earth’s gravity or a species’ evolution.
• Isaac Newton, the famous seventeenth-century scientist and
mathematician, allegedly became intrigued one day when he saw an
apple fall from an apple tree
• Newton to develop a theory of gravity that applies not only to an
apple falling to the earth but to any two objects in the universe.
• An economist might live in a country experiencing rapid increases in
prices and be moved by this observation to develop a theory of
inflation.
• The theory might assert that high inflation arises when the
government prints too much money.
• To test this theory, the economist could collect and analyze data on
prices and money from many different countries. If growth in the
quantity of money were not at all related to the rate at which prices
are rising, the economist would start to doubt the validity of his theory
of inflation.
• If money growth and inflation were strongly correlated in
international data, as in fact they are, the economist would become
more confident in his theory.
• Physicists studying gravity can drop many objects in their laboratories
to generate data to test their theories.
• By contrast, economists studying inflation are not allowed to
manipulate a nation’s monetary policy simply to generate useful data.
• Economists, like astronomers and evolutionary biologists, usually
have to make do with whatever data the world happens to give them
• When a war in the Middle East interrupts the flow of crude oil, for
instance, oil prices skyrocket around the world.
• For consumers of oil and oil products, such an event depresses living
standards.
• For economic policymakers, it poses a difficult choice about how best
to respond.
• But for economic scientists, it provides an opportunity to study the
effects of a key natural resource on the world’s economies, and this
opportunity persists long after the wartime increase in oil prices is
over.
 Assumptions
• Economists make assumptions for the same reason: Assumptions can
make the world easier to understand. To study the effects of
international trade, for example, we may assume that the world
consists of only two countries and that each country produces only
two goods.
• Of course, the real world consists of dozens of countries, each of
which produces thousands of different types of goods.
• But by assuming two countries and two goods, we can focus our
thinking.
• Once we under-stand international trade in an imaginary world with
two countries and two goods, we are in a better position to
understand international trade in the more complex world in which
we live.
 Assumptions
• Similarly, economists use different assumptions to answer different
questions.
• Suppose that we want to study what happens to the economy when
the government changes the number of dollars in circulation. An
important piece of this analysis, it turns out, is how prices respond.
• Many prices in the economy change infrequently; the newsstand
prices of magazines, for instance, are changed only every few years.
 Assumptions
• Knowing this fact may lead us to make different assumptions
• when studying the effects of the policy change over different time
horizons.
• For studying the short-run effects of the policy, we may assume that prices
do not change much.
• We may even make the extreme and artificial assumption that all prices are
completely fixed.
• For studying the long-run effects of the policy, however, we may assume
that all prices are completely flexible.
• Just as a physicist uses different assumptions when studying falling marbles
and falling beach balls, economists use different assumptions when
studying the short-run and long-run effects of a change in the quantity of
money.
 Economic Models
• The economy consists of millions of people engaged in many
activities—buying, selling, working, hiring, manufacturing, and so on.

• To understand how the economy works, we must find some way to

simplify our thinking about all these activities.

• We need a model that explains, in general terms, how the economy

is organized and how participants in the economy interact with one
another.
Our First Model: The Circular Flow Diagram
• A visual model of the economy, called a circular-flow diagram.
• In this model, the economy has two types of
decisionmakers—households and firms.
• Firms produce goods and services using inputs, such as labor, land,
and capital (buildings and machines).
• These inputs are called the factors of production.
• Households own the factors of production and consume all the
goods and services that the firms produce.
• Households and firms interact in two types of markets.
• In the markets for goods and services, households are buyers and
firms are sellers.
• Households buy the output of goods and services that firms produce.
• In the markets for the factors of production, households are sellers
and firms are buyers.
• In these markets, households provide firms the inputs that the firms
use to produce goods and services.
 Circular-flow diagram
• The circular-flow diagram offers a simple way of organizing all the
economic transactions that occur between households and firms in
the economy.
• The inner loop of the circular-flow diagram represents the flows of
goods and services between households and firms.
• The households sell the use of their labor, land, and capital to the
firms in the markets for the factors of production.
• The firms then use these factors to produce goods and services,
which in turn are sold to households in the markets for goods and
services.
• Hence, the factors of production flow from households to firms, and
goods and services flow from firms to households.
 Circular-flow diagram
• The outer loop of the circular-flow diagram represents the
corresponding flow of dollars.
• The households spend money to buy goods and services from the
firms.
• The firms use some of the revenue from these sales to pay for the
factors of production, such as the wages of their workers.
• What’s left is the profit of the firm owners, who themselves are
members of households.
• Hence, spending on goods and services flows from households to
firms, and income in the form of wages, rent, and profit flows from
firms to households.
Circular flow
 Example
• Imagine that the dollar begins at a household, sitting in, say, your wallet.
• If you want to buy a cup of coffee, you take the dollar to one of the
economy’s markets for goods and services, such as your local Starbucks
coffee shop.
• There you spend it on your favorite drink.
• When the dollar moves into the Starbucks cash register, it becomes
revenue for the firm.
• The dollar doesn’t stay at Starbucks for long, however, because the firm
uses it to buy inputs in the markets for the factors of production.
• For instance, Starbucks might use the dollar to pay rent to its landlord for
the space it occupies or to pay the wages of its workers.
• In either case, the dollar enters the income of some household and, once
again, is back in someone’s wallet
Our second Model: THE PRODUCTION
POSSIBILITIES FRONTIER
• The production possibilities frontier is a graph that shows the various
combinations of output—in this case, cars and computers—that the
economy can possibly produce given the available factors of
production and the available production technology that firms can use
to turn these factors into output.
 Example
production possibilities frontier….
• In this economy, if all resources were used in the car industry, the
economy would produce 1,000 cars and no computers.
• If all resources were used in the computer industry, the economy
would produce 3,000 computers and no cars.
• The two end points of the production possibilities frontier represent
these extreme possibilities.
THE PRODUCTION POSSIBILITIES FRONTIER
• . The production possibilities frontier shows the combinations of
output—in this case, cars and computers—that the economy can
possibly produce.
• The economy can produce any combination on or inside the frontier.
• Points outside the frontier are not feasible given the economy’s
resources.
• The economy were to divide its resources between the two
industries, it could produce
• 700 cars and 2,000 computers-shown in the figure by point A.
• By contrast, the outcome at point D is not possible because resources
are scarce: The economy does not have enough of the factors of
production to support that level of output.
• In other words, the economy can produce at any point on or inside
the production possibilities frontier, but it cannot produce at points
outside the frontier.
• When the economy is producing at such a point, say point A, there is
no way to produce more of one good without producing less of the
other.
• Point B represents an inefficient outcome.
• For some reason, perhaps widespread unemployment, the economy
is producing less than it could from the resources it has available: It is
producing only 300 cars and 1,000 computers.
• If the source of the inefficiency were eliminated, the economy could
move from point B to point A, increasing production of both cars (to
700) and computers (to 2,000)
 Opportunity cost
• the cost of something is what you give up to get it. This is called the
opportunity cost.
• The production possibilities frontier shows the opportunity cost of
one good as measured in terms of the other good.
• When society reallocates some of the factors of production from the
car industry to the computer industry, moving the economy from
point A to point C, it gives up 100 cars to get 200 additional
computers.
• In other words, when the economy is at point A, the opportunity
cost of 200 computers is 100 cars.
• The production possibilities frontier in Figure 2-2 is bowed outward.
• This means that the opportunity cost of cars in terms of computers
depends on how much of each good the economy is producing.
• When the economy is using most of its resources to make cars, the
production possibilities frontier is quite steep.
• Because even workers and machines best suited to making
computers are being used to make cars, the economy gets a
substantial increase in the number of computers for each car it gives
up.
• By contrast, when the economy is using most of its resources to make
computers, the production possibilities frontier is quite flat.
• In this case, the resources best suited to making computers are
already in the computer industry, and each car the economy gives up
yields only a small increase in the number of computers.
• The production possibilities frontier shows the tradeoff between the
production of different goods at a given time, but the tradeoff can
change over time.
• For example, if a technological advance in the computer industry
raises the number of computers that a worker can produce per week,
the economy can make more computers for any given number of
cars.
• As a result, the production possibilities frontier shifts outward.
• Because of this economic growth, society might move production
from point A to point E, enjoying more computers and more cars.
A SHIFT IN THE PRODUCTION POSSIBILITIES FRONTIER.
• An economic advance in the computer industry shifts the production
possibilities frontier outward, increasing the number of cars and
computers the economy can produce.
Problem # 1. What to Produce and in What
Quantities?
• The first central problem of an economy is to decide what goods and
services are to be produced and in what quantities.
• This involves allocation of scarce resources in relation to the
composition of total output in the economy.
• Since resources are scarce, the society has to decide about the goods
to be produced: wheat, cloth, roads, television, power, buildings, and
so on.
• Once the nature of goods to be produced is decided, then their
quantities are to be decided.
• How many tonnes of wheat, how many televisions, how many million
kws of power, how many buildings, etc.
• Since the resources of the economy are scarce, the problem of the
nature of goods and their quantities has to be decided on the basis of
priorities or preferences of the society.
• If the society gives priority to the production of more consumer
goods now, it will have less in the future.
• A higher priority on capital goods implies less consumer goods now
and more in the future.
• But since resources are scarce, if some goods are produced in larger
quantities, some other goods will have to be produced in smaller
quantities.
Problem # 2. How to Produce these Goods?
• The next basic problem of an economy is to decide about the
techniques or methods to be used in order to produce the required
goods.
• This problem is primarily dependent upon the availability of resources
within the economy.
• If land is available in abundance, it may have extensive cultivation.
• If land is scarce, intensive methods of cultivation may be used.
• If labour is in abundance, it may use labour-intensive techniques;
while in the case of labour shortage, capital-intensive techniques may
be used
• The technique to be used also depends upon the type and quantity
of goods to be produced.
• For producing capital goods and large outputs, complicated and
expensive machines and techniques are required.
• On the other hand, simple consumer goods and small outputs require
small and less expensive machines and comparatively simple
techniques.
• Further, it has to be decided what goods and services are to be
produced in the public sector and what goods and services in the
private sector.
• But in choosing between different methods of production, those
methods should be adopted which bring about an efficient
allocation of resources and increase the overall productivity in the
economy.
• Suppose the economy is producing certain quantities of consumer
and capital goods at point A on PP curve in Figure 2.
• adopting new techniques of production, given the supplies of factors,
the productive efficiency of the economy increases. As a result, the
PP0 curve shifts outwards to P1P1.
 Microeconomics and Macroeconomics
Microeconomics Macroeconomics
Microeconomics focuses on the choices made by individual Macroeconomics studies the economic progress and steps
consumers as well as businesses concerning the fluctuating taken by a nation. It also includes the study of policies and
cost of goods and services in an economy. Microeconomics other influencing factors that affect the economy as a whole.
covers several aspects, such as – Macroeconomics follows a top-down approach, and involves
Supply and demand for goods in different marketplaces. strategies like –
Consumer behaviour, as an individual or as a group. The overall economic growth of a country.
Demand for service and labour, including individual labour Reasons that are likely to influence unemployment and
markets, demand, and determinants like the wage of an inflation.
employee. Fiscal policies are likely to influence factors like interest
rates.
One of the main features of microeconomics is it focuses on Effect of globalization and international trade.
casual situations when a marketplace experiences certain Reasons that affect varying economic growths among
changes in the existing conditions. It takes a bottom-up countries.
approach to analyse the economy.
Another feature of macroeconomics is that it focuses on
What are the Different Components of Microeconomics? aggregated growth and its economic correlation.
The different components of microeconomics include:
Market demand and supply (For example Textile) What are the Different Components of Macroeconomics?
Consumer Behavior ( for example Consumer Choice Theory) The different components of macroeconomics include:
Producers are driven by individual preferences. National Output
Market-specific labor markets ( For example demand labor Unemployment
wage determination in specific markets). Inflation
 Questions
Q1. How is economics a science?
Q2. Why do economist make assumptions?
Q3. Draw a circular flow diagram. Identify the parts of the model that
corresponds to the flow of goods and services and the flow of dollars for each of
the following activities:
a. Selena pays a storekeeper $1 for a quart of milk.
b. Stuart earns $4.50 per hour working at a fast-food restaurant.
c. Shanna spends $30 to get a haircut.