Introduction to Economics

Dr. Rama Pal

HSS, IITB
Email: ramapal@iitb.ac.in

What is Economics?
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 unit of chocolate

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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 alternatives 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.
Competition results in gains from trading.
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 (for example, one pound of potatoes).

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

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Students

CS 101

HS 101

Mala

Manasi

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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

Market failure occurs when the market fails to allocate

resources efficiently.
Government may intervene to promote efficiency and equity.

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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 firms

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.

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How the Economy as a Whole

Works?
A countrys 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 Countrys 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 nations production.

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Principle #8: A Countrys 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 workers time.

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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 Tradeoff between Inflation and Unemployment.
The Phillips Curve illustrates the trade-off between inflation

and unemployment:
Inflation or Unemployment
Its a short-run trade-off!
The trade-off plays a key role in the analysis of the business

cyclefluctuations in economic activity, such as employment

and production

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Thinking Like an Economist

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Thinking Like an Economist

Economics trains you to. . . .
Think in terms of alternatives.
Evaluate the cost of individual and social choices.
Examine and understand how certain events and issues are related.

Economist as an scientist
Scientific method: observation, theory, and more observation
Role of assumptions
Economic models

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The Role of Assumptions

Economists make assumptions in order to make the world easier

to understand.
The art in scientific thinking is deciding which assumptions to
make.
Economists use different assumptions to answer different
questions.

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Economic Models
Economists use models to simplify reality in order to

improve our understanding of the world.

Two of the most basic economic models are:
The Circular Flow Diagram
The Production Possibilities Frontier

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Simple Model of Economy

Market for Goods
and Services

Flow of inputs and

outputs

Households

Firms
Flow of Money

Market for Factors

of Production

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The Production Possibilities Frontier

The production possibilities frontier is a graph that shows

the combinations of output that the economy can possibly

produce given the available factors of production and the
available production technology.

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The Production Possibilities Frontier

Quantity of
Computers
Produced

3,000

C
A

2,200
2,000

1,000

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Production
possibilities
frontier

300

600 700

1,000

Quantity of
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Cars Produced

The Production Possibilities Frontier

Concepts illustrated by the production possibilities frontier
Efficiency
Trade-offs
Opportunity cost
Economic growth

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Shift in the PPF

Quantity of
Computers
Produced
4,000

3,000

2,300
2,200

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G
A

600 650

of
1,000 CarsQuantity
Produced

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Microeconomics and Macroeconomics

Microeconomics focuses on the individual parts of the

economy.
How households and firms make decisions and how they

interact in specific markets

Macroeconomics looks at the economy as a whole.
Economy-wide phenomena, including inflation, unemployment,

and economic growth

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Problem # 2
Classify the following topics as relating to microeconomics or

macroeconomics.
A workers decision to work or take care of her ill mother.
The effect of government spending on nations unemployment

rate.
The optimal choice of output for a firm that produces mobile

handsets.
Effect of Rashtriya Swasthya BimaYojana (RSBY) on households

expenditure on health care.

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Positive vs Normative Analysis

Economist as Policy Adviser
Positive analysis
Normative analysis

Positive statements are statements that attempt to describe

the world as it is.

Normative statements are statements about how the world

should be.

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Problem # 3
Classify statements as positive or normative.
An increase in the minimum wage will increase the rate of

teenage unemployment
The government should raise the tax on tobacco to reduce the

quantity of cigarettes sold

The government should provide health care to anyone who does

not have health insurance

An increase in the interest rate will cause a decline in

investment
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Three Problems of Economic Organization

What?
How?
For whom?

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Economic Systems
Market economy
Command economy
Mixed economy

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Why Economists Disagree?

Differences in scientific judgments
Differences in values

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References
Samuelson P.A. and W.D. Nordhaus. 2010. Economics (19th Ed.)

Tata McGraw Hill. New Delhi.

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

Thomson South-Western. Delhi.

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