Introduction to Economics

Dr. Rama Pal

H&SS, IITB
Email: [email protected]
 What is Economics?

 Greek word ‘oikonomos’: one who manages a household

 Economics is the study of how societies use scarce

resources to produce valuable goods and services and
distribute them among different individuals

 Scarcity and efficiency

 Equity

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 How People Make Decisions?
•People face trade-offs.
•The cost of something is what you give up to get it.
•Rational people think at the margin.
•People respond to incentives.

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 Principle #1: People Face Trade-offs

 “There is no such thing as a free lunch!”

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 Principle #1: People Face Trade-offs
 To get one thing, we usually have to give up another
thing.
 Food v. clothing
 Leisure time v. work
 Efficiency v. equity

Making decisions requires trading

off one goal against another.

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 Principle #1: People Face Trade-offs
 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.

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 Principle #2: The Cost of Something Is
What You 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 on a date?
 Whether to go to class or sleep in?

 The opportunity cost of an item is what you give up

to obtain that item.

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 Principle #3: Rational People Think at
the Margin
 Marginal changes are small, incremental
adjustments to an existing plan of action.

People make decisions by comparing costs and

benefits at the margin.

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 Principle #3: Rational People Think at
the Margin
 Extra year of education

 Additional movie

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 Principle #4: People Respond to
Incentives
 Marginal changes in costs or benefits motivate
people to respond.

 The decision to choose one alternative over another

occurs when that alternative’s marginal benefits
exceed its marginal costs!

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 Principle #4: People Respond to
Incentives
 Important for policy makers

 Income tax

 Subsidy on petrol/ diesel

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 Problem # 1
 Describe some of the trade-offs faced by following:
1. A family deciding whether to buy a new car

2. A company president is deciding whether to open a

new factory

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 How People Interact?
•Trade can make everyone better off.
•Markets are usually a good way to organize economic
activity.
•Governments can sometimes improve economic
outcomes.

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 Principle #5: Trade Can Make Everyone
Better Off
 People gain from their ability to trade with one
another.

 Trade allows people to specialize in what they do

best.

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 Principle #5: Trade Can Make Everyone
Better Off
 Trade and costs of productions

 Absolute and comparative advantage

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 Absolute and Comparative Advantage
 Two ways to measure differences in costs of
production:

 The number of hours required to produce a unit of

output.

 The opportunity cost of sacrificing one good for

another.

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 Absolute Advantage
 The comparison among producers of a good
according to their productivity.

 Describes the productivity of one person, firm, or

nation compared to that of another.

 The producer that requires a smaller quantity of

inputs to produce a good is said to have an
absolute advantage in producing that good.

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 Opportunity Cost and Comparative
Advantage
 Compares producers of a good according to their
opportunity cost, that is, what must be given up to
obtain some item

 The producer who has the smaller opportunity cost of

producing a good is said to have a comparative
advantage in producing that good.

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 Comparative Advantage: Example

Students CS 101 HS 101

Mala 1 Hrs 2 Hrs

Manasi 2 Hrs 3 Hrs

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 Comparative Advantage: Opportunity
Costs

Students CS 101 HS 101

Mala ½ of HS 101 2 of CS 101

Assignment Assignments
Manasi 2/3 of HS 101 3/2 of CS 101
Assignments Assignments

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 Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.

 A market 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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 Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
 Adam Smith made the observation that households and
firms interacting 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.

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 Principle #7: Governments Can
Sometimes Improve Market Outcomes.
 Markets work only if property rights are enforced.
 Property rights are the ability of an individual to own and
exercise control over a scarce resource
 Public goods

 Market failure occurs when the market fails to allocate

resources efficiently.

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 Principle #7: Governments Can
Sometimes Improve Market Outcomes.
 Market failure may be caused by:
 an externality, which is the impact of one person or firm’s
actions on the well-being of a bystander.
 Market power, which is the ability of a single person or firm to
unduly influence market prices.

 Government may intervene to promote efficiency and

equity.

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 How the Economy as a Whole
Works?
•A country’s standard of living depends on its ability to
produce goods and services.

•Prices rise when the government prints too much money.

•Society faces a short-run trade-off between inflation and

unemployment.

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 Principle #8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services.

 Standard of living may be measured in different ways:

 By comparing personal incomes.

 By comparing the total market value of a nation’s production.

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 Principle #8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services.

 Almost all variations in living standards are explained by

differences in countries’ productivities.

 Productivity is the amount of goods and services produced

from each hour of a worker’s time.

 Public policy

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 Principle #9: Prices Rise When the
Government Prints Too Much Money.

 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 #10: Society Faces a Short-run Trade-
off between Inflation and Unemployment.

 The Phillips Curve illustrates the trade-off between

inflation and unemployment:

 Inflation or Unemployment
 It’s a short-run trade-off!
 The trade-off plays a key role in the analysis of the business
cycle—fluctuations in economic activity, such as employment
and production

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 References

 Mankiw N.G. 2007. Principles of Microeconomics (4th Ed.)

Thomson South-Western. Delhi.

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