Pre-Reading Material Economics

7/27/2019 Pre-Reading Material Economics

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Economics Page 1

SYDENHAM INSTITUTE OF MANAGEMENTSTUDIES, RESEARCH AND

ENTREPRENEURSHIP EDUCATION

SIMSREE PRE-INDUCTION ASSIGNMENT

Economics

SIMSREE 2013-15


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Table of Contents

MICROECONOMICS ................................................................................................................3DEMAND ................................................................................................................................. 3

DIRECT DEMAND AND DERIVED DEMAND ............................................................................... 3

TYPESOFGOODS ................................................................................................................ 4Complementary goods ........................................................................................................... 4Substitute goods..................................................................................................................... 5Normal goods ......................................................................................................................... 5Inferior goods ......................................................................................................................... 5Giffen goods ............................................................................................................................ 5Snob or Veblen goods............................................................................................................. 5

DETERMINANTS OFDEMAND........................................................................................... 5

ELASTICITY........................................................................................................................... 7

Price elasticity of demand..................................................................................................... 7Cross-Price Elasticity............................................................................................................. 8Income Elasticity.................................................................................................................... 9

SUPPLY ..................................................................................................................................9

DETERMINANTS OFSUPPLY ............................................................................................ 10

ELASTICITYOFSUPPLY ..................................................................................................... 11

EQUILIBRIUM ..................................................................................................................... 11

MACROECONOMICS ............................................................................................................. 13GROSS DOMESTIC PRODUCT (GDP) ........................................................................................ 13

ECONOMIC POLICIES: ............................................................................................................ 14

SOME OTHER TERMINOLOGIES:.................................................................................. 18


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The field of economics is broken down into two distinct areas of study:

Microeconomics and Macroeconomics.

MICROECONOMICS

Microeconomics is that branch of economics that analyzes the market behavior of

individual consumers and firms in an attempt to understand the decision-making

process of firms and households. It is concerned with the interaction between

individual buyers and sellers and the factors that influence the choices made by

buyers and sellers. In particular, microeconomics focuses on patterns of supply and

demand and the determination of price and output in individual markets.

Demand

Demand: It is defined as an individuals desire to buy a particular product backed by

his/her willingness and abilityto purchase that product, at a given price.

Note: In case the individual has the desire as well as the willingness to pay the current

price but he/she lacks the ability to do so, then a demand does not occur. E.g.: A

Middle Income household may desire a luxurious car, but that household may lack

the ability and so the desire remains only a desire and does not translate into demand

for that product.

Direct Demand and Derived Demand

Direct Demand is for consumption goods. They are for those goods and services that

directly satisfy an individual consumers desire. For example: Automobiles

Derived Demand is generally for intermediate goods. It is the demand for the goods

used by the producers to manufacture consumption goods.

For example: demand for steel (intermediate good) is derived from the demand for

automobiles (final goods). If demand for automobiles increases, demand for steel will

increase.


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Law of Demand: All other things remaining unchanged, the quantity of goods

demanded increases when its price decreases and vice versa.

This relationship can be shown by a demand schedule and a demand graph givenbelow:

Demand Schedule: Prices and quantity demanded normally move in oppositedirections.

Prices Quantity

4 30

8 25

12 15

16 10

20 6

Demand Curve: A curve showing the relationship between the price of a good andthe quantity demanded.

Price

DD Quantity

TYPES OF GOODS

Complementary goods are a pair of goods consumed together. As the price of one

goes up, the demand for the other falls.

Example- car and petrol (when price of petrol increases, demand for cars willdecrease)


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Substitute goods are alternatives to each other. As the price of one goes up thedemand for the other also goes up.Example Pepsi and Coke (when Pepsi price increases, demand for coke will increase

as people will switch from Pepsi to Coke)

Normal goods are those goods whose demand goes up when the consumers income

increases.

Example: television, air- conditioners

Inferior goods are those goods whose demand falls when the consumers income

increases.

Example: kerosene (as income increases more people start using LPG and so the

demand for kerosene decreases)

Giffen goods are those goods whose demand moves in same direction as price. Thus

Giffen goods are goods which people, paradoxically, consume more as the price rises.

Example: Inferior staple foods: If the price of these inferior staples increases, then

poor income groups wont have spare money to buy other food stuffs to satisfy their

hunger thus they will have to buy more of these inferior staples. Hence as the price of

this inferior quality food rises paradoxically its demand also rises.

Note: There exists no Giffen good currently in the world.

Snob or Veblen goods are those goods whose demand falls when price falls. Veblen

goods are a group of commodities for which people's preference for buying those

increases as their price increases, as greater price confers greater status.

Example: Mercedes, BMW (Mercedes and BMW are seen as a status symbol)

DETERMINANTS OF DEMAND

When price changes quantity demanded will also change. There will be a movementalong the same demand curve. When factors other than price changes, demand curve

will shift to the left or to the right. These are the determinants of the demand curve:

1. Income:An increase in a persons income will lead to an increase in demand (shift

demand curve to the right), a decrease will lead to a decrease in demand for normal


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goods. Goods whose demand varies inversely with income are called inferior goods.

2. Consumer Preferences: Favorable change leads to an increase in demand,unfavorable change lead to a decrease.

3.Number of Buyers: More buyers lead to an increase in demand; fewer buyers leadto decrease.

4. Price of related goods:

a. Substitute goods (those that can be used to replace each other): If the price ofa good increases the demand for its substitute good increases.

Example: price of Pepsi rises, the demand for Coke would increase.

b. Complementary goods (those that can be used together): If the price of agood increases the demand for its complement good also increases.

Example: if the price of petrol rises, the demand for automobiles will decrease.

5. Expectation of future:

a. Future price: Consumers current demand will increase if they expect higherfuture prices; their demand will decrease if they expect lower future prices.

b. Future income: Consumers current demand will increase if they expecthigher future income; their demand will decrease if they expect lower future

income.


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Shift along the demand curve Demand curve shifts due todue to change in price of the goodfactors other than price of the good

Shift along the supply curve Supply curve shifts due todue to change in price ofthe goodfactors other than price of the good

ELASTICITY

It is a measure of the responsiveness of one variable to changes in another variable;

the percentage change in one variable that arises due to a given percentage change

in another variable.

Price elasticity of demand: The Sensitivity of the quantity demanded to changes

in price is called price elasticity of demand denoted byEp


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Ep =% change in quantity demanded = Q/Q

% change in price P/P

If Ep = o then demand is said to be perfectly inelastic. This means that demanddoes not change at all when the price changes the demand curve will be vertical.

Example: Life-saving drugs (people will continue to buy them irrespective of the

increase in price)

If Ep is between 0 and 1 (i.e. the percentage change in demand from A to B is

smaller than the percentage change in price), then demand is inelastic. Producers

know that the change in demand will be proportionately smaller than the

percentage change in price.

Example: Salt, bread

If Ep = 1 (i.e. the percentage change in demand is exactly the same as the

percentage change in price), then demand is said to be unitary elastic. A 15% rise in

price would lead to a 15% contraction in demand.

If Ep> 1, then demand responds more than proportionately to a change in price i.e.

demand is elastic. For Example a 20% increase in the price of a good might lead to

a 30% drop in demand. The price elasticity of demand for this price change is 1.5.

Example: Foreign travel by low-cost airlines.

Cross-Price Elasticity

It is a measure of the responsiveness of the demand for a good with respect to

changes in the price of a related good; the percentage change in the quantity

demanded of one good divided by the percentage change in the price of a related

good.

The cross-price elasticity is positive whenever goods are substitutes.

Example: Increase in price of coca cola will increase the demand for Pepsi.

The cross-price elasticity is negative whenever goods are complements.


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Example: Increase in the price of petrol will reduce the demand for petrol cars.

Income Elasticity

A measure of the responsiveness of the demand for a good to changes in consumerincome; the percentage change in quantity demanded divided by the percentage

change in income.

The income elasticity is positive whenever the good is a normal good.

Example: Fruits (Income increases by which demand for fruits also increases)

The income elasticity is negative whenever the good is an inferior good. Demand

falls as income rises. Typically inferior goods or services tend to be products where

there are superior goods available.

Example: Demand for bid is decrease as income increases since people now can

afford cigarettes.

SUPPLY

Supply is defined as the quantity of a product that a producer is willing and able to

supply onto the market at a given price in a given time period. Law of Supply states

that all other factors remaining unchanged the supply of good increases as its priceincreases. This can be shown by a supply schedule and a supply curve.

Supply schedule: There exists a positive relation between quantity and price

Price Quantity

1 2

5 10

8 15

13 25

20 35


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SUPPLY CURVE

Price

SS

Quantity

DETERMINANTS OF SUPPLY

When price changes quantity supplied will change. That is a movement along the

same supply curve. When factors other than price change, supply curve will shift.

Here are some determinants of the supply curve.

1. Production cost

Since most private companies goal is profit maximization. Higher production cost

will lower profit, thus hinder supply. Factors affecting production cost are: inputprices, wage rate, government regulation and taxes, etc.

2. Technology

Technological improvements help reduce production cost and increase profit, thus

stimulate higher supply.

3. Number of sellers

More sellers in the market increase the market supply.

4. Expectation for future prices

If producers expect future price to be higher, they will try to hold on to their

inventories and offer the products to the buyers in the future, thus they can

capture the higher price.


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ELASTICITY OF SUPPLY

Price Elasticity of Supply: The responsiveness of supply to changes in prices iscalled

Price elasticity of supply

Es = Percentage change in quantity supplied / Percentage change in price

Availability of raw materials: Example, availability may cap the amount of gold

that can be produced in a country regardless of price.

Length and complexity of production: It also depends on the complexity of the

production process.

Mobility of factors: If the factors of production are easily available and if a

producer producing one good can switch their resources and put it towards the

creation of a product in demand, then it can be said that the Es is relatively elastic.

The inverse applies to this, to make it relatively inelastic.

Time to respond: The more time a producer has to respond to price changes the

more elastic the supply.

Excess capacity: A producer who has unused capacity can (and will) quickly

respond to price changes in his market assuming that variable factors are readily

available.

Inventory: A producer who has a supply of goods or available storage capacity can

quickly increase supply to market

EQUILIBRIUM

Equilibrium = perfect balance in supply and demand. It determines market

output and price.

At prices < equilibrium level: excess demand (amount by which quantity

demanded exceeds quantity supplied at the specified price)


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At price > equilibrium level: excess supply

Equilibrium price is market clearing price: no excess demand or excess supply

Any price above the equilibrium causes an excess supply and any price below the

equilibrium causes a shortage. The market if uncontrolled will automatically arrive

at the equilibrium price at which supply equals demand.


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Macroeconomics

Macroeconomics, as the name suggests, studies the behavior of the aggregate

economy. It examines economy-wide phenomena such as changes in

unemployment, national income, rate of growth, gross domestic product (GDP),

inflation and price levels.

Macroeconomics is a huge topic and hence this short write up tries to cover as

much of it without going too much into details.

Lets start with the GDP

Gross domestic product (GDP) of a country refers to the market value of all the

final goods and services produced within a country in a given period. There are 3ways of calculating GDP of a country.

1) Market Price method

In market price method we multiply each and every good and service produced in

country with the price charged for it and adds it up to get GDP.

2) Factor cost method

For producing goods and services firms need to pay wages to labour, interest forusing capital to banks, rent for land to owner of land and profit to owners of

company. The sum of all these expenses for each and every firm in the country also

gives you the GDP. It is an indirect method of calculating GDP.

3) Expenditure method

Here we look at different sources of demand for these products and services and

equate it to GDP and then get an equation for GDP which serves as a basis to

understand most topics of macroeconomics going forward.

Gross Domestic Product = Consumption + Investment + Government Spending +Exports Imports

Y = C + I + G + X - M (eqn.1)


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C - ConsumptionConsumption is total personal consumption expenditure by all individual people

of the country

I - InvestmentInvestment is aggregate spending by all the firms. Remember firms invest and not

individuals. What is called as investing commonly (like I invested in stocks) is not

considered in economics as investing. It is called as saving. Firms buying new

machinery is called investing.

G - Government SpendingGovernment spending or government expenditure consists of government

purchases.

X- ExportsDemand for products of a country in foreign countries.

M- ImportsDemand for some part of C, I and G can be fulfilled by imported products and thus

it is reduced from GDP of this country.

Economic Policies:

In order to influence GDP of a country the factors at Right Hand Side of equation 1

can be adjusted or changed. This leads to different policies.

1) Fiscal Policy:

If Government spending (G) is changed it is called as Fiscal Policy(done by the

government). If government wants to increase GDP it will increase its spending by

building roads, bridges , gardens and other such public utilities. Thus demand

from government will boost the GDP. If it wants to slow down GDP growth then itcan increase taxes thus decreasing GDP (its a disincentive to produce more).

2) Monetary policy:

The term monetary policy is also known as RBIs credit policy or money

management policy. It is basically the central banks view on what should be the


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supply of money in the economy and also in what direction the interest rates

should move in the banking system. Such and many other questions related to the

demand and supply of money in the economy is explained by the monetary policy.

The objectives of a monetary policy are similar to the five year plans of our

country. In a nutshell it is basically a plan to ensure growth and stability of the

monetary system. The significance of the monetary policy is to attain the following

objectives.

1. Rapid Economic Growth: It is an important objective as it can play adecisive role in the economic growth of the country. It influences the

interest rates and thus has an impact on investments in the country. If the

RBI adopts an easy credit policy, it would be doing so by reducing interest

rates which in turn would improve the investment outlook in the country.

This would in turn enhance the economic growth. However faster economic

growth is possible if the monetary policy succeeds in maintaining income

and price stability.

2. Exchange Rate Stability: Another important objective is maintaining theexchange rate of the home currency with respect to foreign currencies. If

there is volatility in the exchange rate, then the international community

loses confidence in the economy. So it is necessary for the monetary policy

to maintain the stability in exchange rate. The RBI by altering the foreign

exchange reserves tries to influence the demand for foreign exchange and

tries to maintain the exchange rate stability.

3. Price Stability: The monetary policy is also supposed to keep the inflationof the country in check. Any economy can suffer both inflation and

deflation both of which are harmful to the economy. So the RBI has to

maintain a fair balance in ensuring that during recession it should adopt an

easy money policy whereas during inflationary trend it should adopt a

dear money policy

4. Balance of Payments (BOP) Equilibrium: Another key objective is tomaintain the BOP equilibrium which most of the developing economies


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dont tend to have. The BOP has two aspects which are BOP surplus and

BOP deficit. The former reflects an excess money supplyin the domestic

economy, while the later stands for stringency of money. If the monetary

policy succeeds in maintaining monetary equilibrium, then the BOP

equilibrium can be achieved.

5. Neutrality of Money: RBIs policy should regulate the supply of money. Itis possible that the change in money supply causes disequilibrium and the

monetary policy should neutralize it. However this objective of a monetary

policy is always criticized on the ground that if money supply is kept

constant then it would be difficult to attain price stability.

RBI controls both these aspects through the monetary policy tools like CRR, SLR,

repo rate and reverse repo rate.

i) CRR (Cash Reserve Ratio) - Banks in India are required to hold a certainproportion of their deposits in the form of cash. However, actually Banks

dont hold these as cash with themselves, but deposit such cash with

Reserve Bank of India (RBI).This minimum ratio (that is the part of the total

deposits to be held as cash) is stipulated by the RBI and is known as theCRR or Cash Reserve Ratio.

Thus, when a banks deposits increase by Rs. 100, and if the cash reserve

ratio is 6%, the banks will have to hold additional Rs. 6 with RBI and Bank

will be able to use only Rs. 94 for investments and lending / credit purpose.

Therefore higher the ratio, the lower is the amount that banks will be able

to use for lending and investment. This power of RBI to reduce the lendable

amount by increasing the CRR makes it an instrument in the hands of acentral bank through which it can control the amount that banks lend.

Thus, it is a tool used by RBI to control liquidity in the banking system.

ii) SLR (Statutory Liquidity Ratio) - It indicates the minimum percentage of
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deposits that the bank has to maintain in form of gold, cash or other

approved securities. Thus, we can say that it is ratio of cash and some other

approved securities to liabilities (deposits).

iii) Repo (Repurchase) rate - Is the rate at which the RBI lends shot-termmoney to the banks against securities. When the repo rate increases

borrowing from RBI becomes more expensive. Therefore, we can say that in

case, RBI wants to make it more expensive for the banks to borrow money,

it increases the repo rate; similarly, if it wants to make it cheaper for banks

to borrow money, it reduces the repo rate.

iv) Reverse Repo rate - Is the rate at which banks park their short-term excesscash with the RBI. The banks use this tool when they feel that they are

stuck with excess funds and are not able to invest anywhere for reasonable

returns. An increase in the reverse repo rate means that the RBI is ready to

borrow money from the banks at a higher rate of interest. As a result, banks

would prefer to keep more and more surplus funds with RBI.

3) Trade policy:

If Imports (M) and exports (X) are changed it is called as trade policy(generally

by government as is the case with India or somebody that regulates trade). They

can be changes by regulations in import or exports thus restricting them or the

other way of giving subsidies or tax breaks thus encouraging them. Generally one

is encouraged and the other discouraged at a point of time depending on what is

to be achieved at that time.

The Tradeoff

Why doesnt the government keep spending a lot of moneyand the RBI adopts a

monetary policy that encourages a lot of investment so that GDP grows at very fast

rate?

The reason is indiscriminate spending by government and huge investments by


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firms will increase the money supply in the country tremendously. This will cause

inflation in the country wherein goods will become very costly and beyond the

reach of common man. Hence increased GDP comes at the cost of high inflation.

We have to keep inflation in check and this puts a limitation on GDP growth as

well.

Some other terminologies:

1) Inflation:

Inflation is a rise in the general level of prices of goods and services in an economy

over a period of time. When the general price level rises, each unit of currency

buys fewer goods and services. Consequently, inflation also reflects erosion in the

purchasing power of money a loss of real value in the internal medium of

exchange and unit of account in the economy. A chief measure of price inflation is

the inflation rate:

The inflation rate is the percentage change in the price level. Demand-pull inflation is inflation initiated by an increase in aggregate

demand.

Cost-push, or supply-side, inflation is inflation caused by an increase incosts.

2)CPI- Consumer Price IndexIt is a measure that examines the weighted average of prices of a basket of

consumer goods and services, such as transportation, food and medical care. The

CPI is calculated by taking price changes for each item in the predetermined

basket of goods and averaging them; the goods are weighted according to their

importance. Changes in CPI are used to assess price changes associated with the

cost of living. It is sometimes referred to as "headline inflation."

Core inflation: A measure of inflation that excludes certain items that face volatile

price movements. Core inflation eliminates products that can have temporary

price shocks because these shocks can diverge from the overall trend of inflation

and give a false measure of inflation. Core inflation is most often calculated by


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taking the Consumer Price Index (CPI) and excluding certain items from the index,

usually energy and food products.

3) WPI- Wholesale Price Index

It is an index that measures and tracks the changes in price of goods in the stages

before the retail level. Wholesale price indexes (WPIs) report monthly to show the

average price changes of goods sold in bulk, and they are a group of the indicators

that follow growth in the economy. Although some countries still use the WPIs as

a measure of inflation, many countries, including the United States, use the

producer price index (PPI) instead.

4) Business cycle:

It implies the recurring and fluctuating levels of economic activity that an

economy experiences over a long period of time. The five stages of the business

cycle are growth (expansion), peak, recession (contraction), trough and recovery.

At one time, business cycles were thought to be extremely regular, with

predictable durations, but today they are widely believed to be irregular, varying in

frequency, magnitude and duration.

5) Fiscal Deficit:

When a government's total expenditures exceed the revenue that it generates

(excluding money from borrowings).

6) Trade Deficit:

It is an economic measure of a negative balance of trade in which a country's

imports exceeds its exports. A trade deficit represents an outflow of domestic

currency to foreign markets.

7) Current Account Deficit:

It occurs when a country's total imports of goods, services and transfers are greater

than the country's total export of goods, services and transfers. This situation


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makes a country a net debtor to the rest of the world.

8) What are leading, lagging, coincident indicators?

An indicator is anything that can be used to predict future financial or economic

trends. Popular indicators include unemployment rates, housing starts,

inflationary indexes and consumer confidence. Official indicators must meet

certain set criteria; there are three categories of indicators, classified according to

the types of predictions they make.

Leading indicators

These types of indicators signal future events. Think of how the amber traffic light

indicates the coming of the red light. In the world of finance, leading indicators

work the same way but are less accurate than the street light. Bond yields are

thought to be a good leading indicator of the stock market because bond traders

anticipate and speculate trends in the economy (even though they aren't always

right).

Lagging indicators

A lagging indicator is one that follows an event. Back to our traffic light Example:

the amber light is a lagging indicator for the green light because amber trailsgreen. The importance of a lagging indicator is its ability to confirm that a pattern

is occurring or about to occur. Unemployment is one of the most popular lagging

indicators. If the unemployment rate is rising, it indicates that the economy has

been doing poorly.

Coincident Indicator

It is an economic factor that varies directly and simultaneously with the business

cycle, thus indicating the current state of the economy.

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