Samir K Mahajan

BASIC ECONOMIC CONCEPTS

Basic economic activities are production, distribution, consumption and

investment.

Production is transformation of inputs into output/finished products. It is creation oraddition of utilities. We can not produce matter. Matters are free gift of nature. We makethem more useful by transforming them into finished goods.

Distribution is the sharing of produced goods and services among the various individualsthat comprises a society.

Consumption is use of goods and services. It is destruction or decrease in utility in aparticular commodity.

Investment also called captain formation is surplus of current year’s production over itsconsumption which is used for further production of goods and services. It is the productionof new capital goods.

BASIC ECONOMIC ACTIVITIES

Economics is the study of the use of scarce resources which have alternative uses.

An economy exists because two basic facts, such as:

Multiplicity of wants (Human wants for goods and services are unlimited). Scarcity of means of production (Productive resources which produce goods and services are limited).

With our wants being virtually unlimited and resources scare, we cannot satisfy all our wants and desires byproducing everything we want. At any one time the society can produce only a limited amount of goods and services.Goods are scarce because productive resources are scarce.

Economics studies how society manages its scarce resources to satisfy unlimited human wants having differentpriorities.

WHAT IS ECONOMICS contd.

A WIDELY ACCEPTED DEFINITION OF ECONOMICS

THE CENTRAL PROBLEM OF AN ECONOMY

The central problems of an economy are :

What goods and services are going to be produced and in what quantities, since there are not enough resources toproduce all the things people desire? This basic choice give rise to the problem of allocation of resources betweenalternative uses.

How are things going to be produced, given that there is normally more than one way of producing things? Whatresources are going to be used and in what quantities? What techniques of production are going to be adopted? Thisproblem relates to the choice of a product method or technique of production.

For whom are things going to be produced? In other words, how will the national income/ produced goods andservices be distributed among different individuals that comprises the society? This is the problem of distribution.Ideally, it is sought that distribution of income is more equal so that share of individuals are more equal.

All societies have to make these choices, whether they be made by individuals, groups or the government.

Problem of efficient or fuller utilization of resources: Resources being scarce, it is desirable that they are mostefficiently/properly used. There should not be any wastage of these resources. Resources would be utilized efficientlyor fully when maximum output can be produced by using the given resources or a given level output can be producedby using minimum resources.

Problem of Economic Growth: Increase in population is a common feature. It is desirable that a reasonable standardof living of the growing population is mantianed. For this, it is important to know whether the productive capacity ofthe economy is growing, declining or remaining static over time. If the productive capacity of the economy isgrowing, it will be able to produce progressively more and more goods and services with the result that the standardof living standard of people will rise. The increase in the capacity to produce goods over time is called economicgrowth.

THE CENTRAL PROBLEM OF AN ECONOMY contd.

RESOURCES / MEANS OF PRODUCTION/ FACTORS OF PRODUCTION / INPUTS OF

PRODUCTION

Resources are the inputs into the production of goods and services which includes the

followings:

Human Resources: Labour. It All forms of human input, both physical and mental, into current

production. The labour force is limited both in number and in skills.

Natural Resources: Land, mineral resources and Raw Materials. These are inputs into production that

are provided by nature: e.g. unimproved land and mineral deposits in the ground. The world’s land areais limited, as are its raw materials.

Manufactured Resources: Capital. Capital consists of all those inputs in production that have

themselves been produced: e.g. factories, machines, transport equipments and tools. The world has a

limited stock/supply of capital: The productivity of capital is limited by the state of technology.

Subject matter of Economics is traditionally divided into two

main branches – macroeconomics and microeconomics,

where ‘macro’means big, and ‘micro’means small.

These terms were firs coined by Ragner Frisch.

DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO

ECONOMICS

Macroeconomics looks at the economy as an organic whole. Macro

economics studies economic aggregates such as: total output, total

demand, aggregate income, total savings, total investment, total

employment, rise and fall in general price level, interest rates.

Study of economic growth or how governments use monetary and

fiscal policy to seek growth with economic stability etc. also falls

under the domain of macroeconomics.

Macroeconomics focuses on the big picture and ignores the fine

details.

Micro economic theory studies theory of employment, theory of

general price level, theory of economic growth, macro/aggregate

theory of distribution.

MACROECONOMICS

DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.

Macro Economic Theory

Theory of Income and Employment

Theory of Consumption

Theory of Investment

Theory of Trade or Business Cycles

Theory of General Price Level and

Inflation

Theory of Econmic Growth

Macro Theory of Distribution (Relative Share of Wages and Profits)

DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.

MICROECONOMICS

Microeconomics looks at the individual parts of the economy.

Microeconomics studies the behavior of individual economic entities

and small group of economic entities such as: households, business

firms, markets and governments.

It looks at the choices these individual economic entities make and

how they interact with each other. It seeks to determine the

mechanism by which the different economic units attain the position

of equilibrium/make rational choice, proceeding from the individual

units to a narrowly defined group.

The study of economy as a whole remains outside the domain of

micro economics.

Micro economic theory studies allocation of resources, product and

factor pricing, theory of economic welfare/theory of economic

efficiency.

DIVIDING UP THE SUBJECT: MACRO ECONOMICS VS MICRO ECONOMICS CONTD.

Micro Economic Theory

Product Pricing

Theory of Demand

Theory of Production and Cost

Theory of Market

Factor Pricing

(Functional Theory of Distribution)

Wages

Rent

Interest

Profits

Theory of Economic Welfare/ Theory of Economic Efficiency

PRODUCTION POSSIBILITY CURVE

A production possibility curve (PPC)/production possibility frontier (PPF)/ production possibility

boundary/product transformation curve is a graph that shows the different combinations of amounts of

two commodities that could be produced (alternative production possibilities) by using a given amount of

resources and given technology.

4 KEY ASSUMPTIONS ON WHICH MODEL of PPC IS BASED

•Only two goods can be produced

•Productive Resources are given

•Technology is given

•There is fuller /efficient utilization(employment) of resources

PRODUCTION POSSIBILITIES TABLE

Production Possibilities

CapitalGoods

ConsumerGoods

A 14 0

B 12 2

C 9 4

D 5 6

E 0 8

With given amount of resources andgiven technology, the following tableshowing production possibilities (A, B, C,D, E) between capital goods andconsumer goods is constructed. A PPC isdrawn from production possibilitiestable.

Each production possibility (point)represents a specific combination of goodsthat can be produced given full employmentof resources and given technology.

IMPORTANCE OF PPC

PPC is a basic tool of modern economics to study the nature of basic economicproblems. The model PPC can be used to demonstrate the following:

Scarcity of resources ( fundamental economic problem all societies face)

EfficiencyProductive Allocative

Productive Capacity/Economic Growth(or Decline)

Opportunity costs (marginal rate of transformation)

Production Possibilities Curve contd.

PPC AND SCARCITY

Scarcity is represented by the PPC or frontier line. Given the resource, the economy hasto operate on the given frontier line(PPC).

If the society wants to increase the production of one commodity by moving along thePPC, it has to it has to reduce some production of other commodity.

With given resources and technology, the society can not increase production of thecommodity represented on the two axes.

Production Possibilities Curve contd.

PPC AND PRODUCTIVE EFFICIENCY

The PPF curve shows the maximum possible/attainable output with current resources and technologywhich is productive efficiency. We can’t increase production of one good without

decreasing that of another.

Each point on PPC thus represents productive efficiency.

Whole PPC represents “full production” /productive efficiency /full-employment ofresources/producing at the lowest cost.

A point on the PPC indicates efficient use of the available inputs, while a point beneath the curveindicates inefficiency.

Production Possibilities Curve contd.

PPC AND ALLOCATIVE EFFICIENCY

As the productive resources are limited, the economy has to choose between different goods representedby production possibilities. It has therefore to decide which goods to be produced more and which less.In deciding what amounts of different goods are to be produced, the society would, in fact, decide aboutthe allocation of resources among different possible goods.

There are an infinite number of points(combination of two goods) on the PPC. Any combinationchosen on the PPC represents allocative efficiency (the combination most desired by the society).

Allocative efficiency is a value decision based on values/politics/ autocracy.

Production Possibilities Curve contd.

Capital Goods

Consumer Goods

B

C

E

F

A

G

D

O

Economic growth or shift in PPC (How dowe get to point G) occurs if

Productive resources expand

Technological advancement which

increases productivity

Discover new resources

Take resources (War/ colonization)

Trade for Resources

Production Possibilities Curve contd.

ECONOMIC GROWTH AND SHIFT IN PPC

The PPC shows all possible combinations of two goods that can be produced if all available resources (land,labour, capital equipment) are fully employed (used) with the best technology currently available. A shift inPPC upward and to the right (showing more of both goods can be produced than before) indicateseconomic growth.

OPPORTUNITY COST Opportunity cost is opportunity lost.

The opportunity cost to produce one extra unit of a commodity means the lost production for another good.Opportunity cost is illustrated in terms of moving from one point to another along the PPC. Opportunity cost can bestudied with marginal rate of transformation (MRT). MRT is the rate at which one good must be sacrificed in order toproduce a single extra unit (or marginal unit) of another good, resources and technology being given.

MRT of consumers good for capitals good is given by

𝑴𝑹𝑻𝑪𝑲 =𝒅𝑲

𝒅𝑪= 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝑷𝑷𝑪 = opportunity cost

Where, K stands for capital goods

C stands for consumer goods

The concavity of PPC is due to increasing

opportunity cost/MRT. Opportunity cost rises

or MRT as we move down along the PPC.

Production Possibilities Curve contd.