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CHAPTER ONE

BASIC CONCEPTS OF ECONOMICS

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Every field of study has its own terminology

Economics

Supply

Demand

ElasticityOpportunity cost

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Economics trains you to. . . .

Think in terms of alternatives. Evaluate the costs. Examine and understand how certain

events and issues are related.

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Definition

According to Lionel Robbins, “Economics is a science which Studies human behavior as a relationship between ends and scarce means which has alternative uses”

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Economics

MICROECONOMICS

Which deals in small, individuals, particular, specific area.

Example--• Consumer• Producer• Firm• Industry

MACROECONOMIC

Which deals in total, aggregates, whole area.

Example--• National Income• Population• Poverty• Unemployment

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Scope

1. Demand Analysis and forecasting

2. Production Function

3. Cost Analysis

4. Inventory Management

5. Advertising

6. Price system

7. Cost – Benefit Analysis

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Importance

Decisions of business are to be taken under the conditions of Uncertainty and Risk.

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The Circular-Flow Model

The circular-flow model is a simple way to visually show the

economic transactions that occur between households and firms in

the economy.

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FIVE SECTORS OF THE ECONOMY

HouseholdsHouseholds

Households supply factors of production to firms for which they receive INCOME. They spend that income on

CONSUMPTIONCONSUMPTION goods and services

FirmsFirms

Firms PRODUCEPRODUCE goods and services and pay wages, profits etc to households. Firms also INVESTINVEST in plant

and equipment

GovernmentGovernment Governments TAXTAX and spend (GOVT EXPENDITUREGOVT EXPENDITURE)

$$$$$$$$$$BanksBanks Households deposit their SAVINGSAVING with banks and

Banks lend firms money to INVESTINVEST

RestRestofof

WorldWorldIMPORTSIMPORTS and EXPORTSEXPORTS

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The Circular Flow of Income and ExpenditureThe Circular Flow of Income and Expenditure2 Sector Model: Households and Firms

HouseholdsHouseholds

FirmsFirms

Income

$100

Consumption Expend $100

Firms produce goods and

services. The value of income must always be

equal to the value of production.

This is a National Accounting

INDENTITY INDENTITY This is a fully sealed circular flow - there are no leakages

from, or injections into the flow of income and expenditure between firms and households

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HouseholdsHouseholds

FirmsFirms

Income

$100

Consumption Expend $100

The Circular Flow of Income and ExpenditureThe Circular Flow of Income and Expenditure3 Sector Model: Households, Firms & Banks

Saving$20

Consumption$80

$$$$$$$$$$BanksBanks

Investment$20

Assume households save 20% of their

disposable income.

This is a functional relationship Income (Y) = C + I

Income (Y) = 80 + 20 = 100

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HouseholdsHouseholds

FirmsFirms

Income

$100

Consumption Expend $100

The Circular Flow of Income and ExpenditureThe Circular Flow of Income and Expenditure4 Sector Model: Households, Firms, Banks & Government

Saving$20

Consumption$80

$$$$$$$$$$BanksBanks

Investment$20

GovernmentGovernment

Taxes $40

Disposable Income $60

Saving$12

Consumption$48

Investment$12

Govt Expend

$40

Income (Y) = C + I + G

Income (Y) = 48 + 12 + 40 = 100

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The Circular Flow of Income and ExpenditureThe Circular Flow of Income and Expenditure5 Sector Model: Households, Firms, Banks, Government& Rest of World

HouseholdsHouseholds

FirmsFirms

Income

$100

Consumption Expend $100

Saving$20

Consumption$80

$$$$$$$$$$BanksBanks

Investment$20

GovernmentGovernment

Taxes $40

Disposable Income $60

Saving$12

Consumption$48

Investment$12

Govt Expend

$40

Closed (Domestic) Economy

RestRestofof

WorldWorldImportsExports

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Objectives of Firm

1. Profit Maximization2. Sales Maximization.Firms often seek to increase their market

share – even if it means less profit. This could occur for various reasons:

3. Growth Maximization.4. Social/ Environmental concerns.

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Various Concepts of Economics

1- Incremental Principal2- Opportunity Cost3- Principle of time-perspective4-Discounting principle5- Risk and Uncertainty6-Marginal Analysis

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Incremental Principal

Incremental concept involves two important activities which are as follows:

Estimating the impact of decision alternatives on costs and revenues.Emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.

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A decision is obviously a profitable one if:

It increases revenue more than costsIt reduces costs more that revenues.It decreases some costs to a greater extent than it increases other costsIt increases some revenues more than it decreases other revenues

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The two basic components of incremental reasoning are as follows:

Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.

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Opportunity Cost

A benefit, profit, or value of something that must be given up to acquire or achieve something else. Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice, or decision has an associated opportunity cost.

Opportunity costs are fundamental costs in economics, and are used in computing cost benefit analysis of a project. Such costs, however, are not recorded in the account books but are recognized in decision making by computing the cash outlays and their resulting profit or loss.

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Principle of time-perspective

Economists often differentiate in two time periods:

Short-RunLong-Run

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According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value.

Discounting can be defined as a process used to transform future value of money into an equivalent number of present value of money.

FV = PV*(1+r)t

Discounting Principle

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Risk and Uncertainty

Risk: We don’t know what is going to happen next, but we do know what the distribution looks like.

Uncertainty: We don’t know what is going to happen next, and we do not know what the possible distribution looks like.

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Tools for reducing the impact of risk

1- Insurance 2 –Hedging3- Diversification

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Maximization & Optimization

Finding an alternative with the most cost effective or highest achievable performance under the given constraints, by maximizing desired factors and minimizing undesired ones. In comparison, maximization means trying to attain the highest or maximum result or outcome without regard to cost or expense.

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Aiming to achieve only satisfactory results because the satisfactory position is familiar, hassle-free, and secure, whereas aiming for the best-achievable result would call for costs, effort, and incurring of risks.

Satisficing

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Principal Agent Problem

Conflicts of interest and moral hazard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent.

The principal-agent problem develops when a principal creates an environment in which an agent has incentives to align its interests with those of the principal, typically through incentives.

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Accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm's balance sheet. These consist of the explicit costs a firm has to maintain production (for example, wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.

Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit. 

Accounting Vs. Economic Profit

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Invisible Hand Theory

A term coined by economist Adam Smith in his 1776 book "An Inquiry into the Nature and Causes of the Wealth of Nations".

Adam Smith presented a theory, that it is the natural forces that by itself guides any free market economy, through competition for scarce resources.

Adam smith pleaded the “system of natural liberty” and supported the free market capitalism. A symbol which is known as Invisible hand.

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First Chapter

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