Economics (extract from Economics by Samuelson and Nordhaus)

Definition – Economics is the study of how societies use scarce resources to produce valuable
goods and services and distribute them among different individuals

Two central Themes – Scarcity and Efficiency

Ours is a world of scarcity, full of economic goods. A situation of scarcity is one in which goods
are limited relative to desires. Given unlimited wants, it is important that an economy make the
best use of its limited resources. This brings us to the critical notion of efficiency. Efficiency
denotes the most effective use of a society’s resources in satisfying people’s wants and needs.

Economic efficiency requires that an economy produce the highest combination of quantity and
quality of goods and services given its technology and scarce resources. An economy is
producing efficiently when no individual’s economic welfare can be improved unless someone
else is made worse off.

Micro and Macro Economics

Micro economics is concerned with the behavior of individual entities such as markets, firms and
households. Macro economics views the performance of the economy as a whole.

Logic of Economics

Economists use the scientific approach to understand economic life. This involves observing
economic affairs and drawing upon statistics and the historical record.

Often, economists relies upon analyses and theories. Theoretical approaches allow economists
to make broad generalizations, such as those concerning the advantages of international trade
and specialization or the disadvantages of tariffs and quotas.

A special technique developed known as econometrics, applies the tools of statistics to

economic problems.

Two important and Common fallacies encountered in economic reasoning-

The post hoc fallacy – This involves the inference of causality. This occurs when we assume
that, because one event occurred before another event, the first event caused the second
event.

Failure to hold other things constant – Remember to hold other things constant, when you
are analyzing the impact of a variable on the economic system.

The fallacy of composition – When you assume that what is true for the part is also true for
the whole, you are committing the fallacy of composition.

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Positive and Normative Economics

Positive Economics deals with questions such as – Why do accountants earn more than
teachers? Do free trade agreements raise or lower national income? Is there an impact of
increase in interest rates on slowing down the economy and lowering inflation?

Normative economics involves ethical issues and norms of fairness. For instance, post 1991,
has the distribution of income in the country become too unequal? Here there are no right or
wrong answers. What matters here is the society’s fundamental values.

The ultimate goal of economic science is to improve the living conditions of people in their
everyday lives. This calls for not mere economic growth (measured in terms of growth in GDP)
but also economic development reflected in terms of improvement in primary education,
availability of clean drinking water to all, fresh air for breathing free from any form of pollution,
freedom from hunger, improved public health, etc.

The three problems of economic organizations

Every society must answer three fundamental questions – what, how and form whom?

 What kinds and quantities are produced among the wide range of all possible goods and
services?
 How are resources used in producing these goods?
 And for whom are the goods produced (that is, what is the distribution of income and
consumption among different individuals and classes?)

Societies answer these questions in different ways. The most important forms of economic
organization today are command and market. The command economy is directed by
centralized government control; a market economy is guided by an informal system of prices
and profits in which most decisions are made by private individuals and firms. (The extreme
case of a market economy in which the government keeps its hands off economic decisions, is
called laisssez-faire economy). All societies have different combinations of command and
market; all societies are mixed economies.

Society’s Technological Possibilities

With given resources and technology, production choices between two goods such as textiles
and housing can be summarized in the production possibility frontier (PPF). The PPF shows
how the production of one good (textiles) is traded off against the production of another good
(such as housing). In a world of scarcity, choosing one thing means giving up something else.
The value of the good or service foregone is its opportunity cost.

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Productive efficiency occurs when production of one good cannot be increased without
curtailing production of another good. This is illustrated by PPF. When an economy is on its
PPF, it can produce more of one good only by producing less of another good.

Production possibility frontiers illustrate many basic economic processes – how economic
growth pushes out the frontier, how nation chooses relatively less food and other necessities as
it develops, how a country chooses between private goods and public goods, and how societies
choose between consumption goods and capital goods that enhance future consumption.

Societies are sometimes inside their production-possibility frontier because of macroeconomic

business cycles or microeconomic market failures. When credit conditions are tight or spending
suddenly declines, a society moves inside its PPF in recessions; this occurs because of macro
economic rigidities, not because of technological forgetting. A society can also be inside its
PPF if markets fail because prices do not reflect social priorities, such as with environmental
degradation from air and water pollution.

Basic Elements of Supply and Demand-

1. The analysis of supply and demand shows how a market mechanism solves the three
problems of what, how, and for whom. A market blends together demands and supplies.
Demand comes from consumers who are spreading their dollar votes among available goods
and services while businesses supply the goods and services with the goal of maximizing their
profits.

A. The Demand Schedule

2. A demand schedule shows the relationship between the quantity demanded and the price of
a commodity, other things held constant. Such a demand schedule, depicted graphically by a
demand curve, holds constant other things like family incomes, tastes, and the prices of other
goods. Almost all commodities obey the law of downward-sloping demand, which holds that
quantity demanded falls as a good's price rises. This law is represented by a downward-sloping
demand curve.

Note – Quantity demanded tends to fall as price rises for two reasons. First is the substitution
effect, which occurs because a good becomes relatively more expensive when its price rises.
Hence one substitutes with less costly good. A higher price generally also reduces quantity
demanded through income effect. This comes into play because when a price goes up, the
consumer finds himself somewhat poorer than he was before. He will be left with in effect less
“real” income and so will naturally curb his consumption.

3. Many influences lie behind the demand schedule for the market as a whole: average family
incomes, size of the market indicated in terms of population, the prices of related goods, tastes
or preferences of consumers, and special influences. When these influences change, the
demand curve will shift.

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B. The Supply Schedule

4. The supply schedule (or supply curve) gives the relationship between the quantity of a good
that producers desire to sell - other things constant - and that good's price. Quantity supplied
generally responds positively to price, so the supply curve is upward-sloping.

5. Elements other than the good's price affect its supply. The most important influence is the
commodity's production cost, determined by the state of technology and by input prices. Other
elements in supply include the prices of related goods, government policies, and special
influences.

C. Equilibrium of Supply and Demand

6. The equilibrium of supply and demand in a competitive market occurs when the forces of
supply and demand are in balance. The equilibrium price is the price at which the quantity
demanded just equals the quantity supplied. Graphically, we find the equilibrium as the
intersection of the supply and demand curves. At a price above the equilibrium, producers want
to supply more than consumers want to buy, which results in a surplus of goods and exerts
downward pressure on price. Similarly, too low a price generates a shortage, and buyers will
therefore tend to bid price upward to the equilibrium.

7. Shifts in the supply and demand curves change the equilibrium price and quantity. An
increase in demand, which shifts the demand curve to the right, will increase both equilibrium
price and quantity. An increase in supply, which shifts the supply curve to the right, will
decrease price and increase quantity demanded.

8. To use supply-and-demand analysis correctly, we must (a) distinguish a change in demand or

supply (which produces a shift in a curve) from a change in the quantity demanded or supplied
(which represents a movement along a curve); (b) hold other things constant, which requires
distinguishing the impact of a change in a commodity's price from the impact of changes in
other influences; and (c) look always for the supply-and-demand equilibrium, which comes at
the point where forces acting on price and quantity are in balance.

9. Competitively determined prices ration the limited supply of goods among those who demand
them.

Applications of Supply and Demand

A. Elasticity of Demand and Supply

1. Price elasticity of demand measures the quantitative response of demand to a change in

price. Price elasticity of demand (ED) is defined as the percentage change in quantity
demanded divided by the percentage change in price. That is,

Price elasticity of demand = ED

ED = (% change in quantity demanded)/(% change in price)

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In this calculation, the sign is taken to be positive, and P and Q are averages of old and new
values.

2. We divide price elasticities into three categories: (a) Demand is elastic when the
percentage change in quantity demanded exceeds the percentage change in price; that is, ED >
1. (b) Demand is inelastic when the percentage change in quantity demanded is less than the
percentage change in price; here, ED < 1. (c) When the percentage change in quantity
demanded exactly equals the percentage change in price, we have the borderline case of unit-
elastic demand, where ED = 1.

3. Price elasticity is a pure number, involving percentages; it should not be confused with slope.

4. The demand elasticity tells us about the impact of a price change on total revenue. A price
reduction increases total revenue if demand is elastic; a price reduction decreases total revenue
if demand is inelastic; in the unit-elastic case, a price change has no effect on total revenue.

5. Price elasticity of demand tends to be low for necessities like food and shelter and high for
luxuries like snowmobiles and vacation air travel. Other factors affecting price elasticity are the
extent to which a good has good substitutes and the length of time that consumers have to
adjust to price changes.

6. Price elasticity of supply measures the percentage change of output supplied by producers
when the market price changes by a given percentage.

B. Applications to Major Economic Issues

7. One of the most fruitful arenas for application of supply-and-demand analysis is agriculture.
Improvements in agricultural technology mean that supply increases greatly, while demand for
food rises less than proportionately with income. Hence free-market prices for foodstuffs tend to
fall. No wonder governments have adopted a variety of programs, like crop restrictions, to prop
up farm incomes.

8. A commodity tax shifts the supply-and-demand equilibrium. The tax's incidence (or impact on
incomes) will fall more heavily on consumers than on producers to the degree that the demand
is inelastic relative to supply.

9. Governments occasionally interfere with the workings of competitive markets by setting

maximum ceilings or minimum floors on prices. In such situations, quantity supplied need no
longer equal quantity demanded; ceilings lead to excess demand, while floors lead to excess
supply. Sometimes, the interference may raise the incomes of a particular group, as in the case
of farmers or low-skilled workers. Often, distortions and inefficiencies result.

Demand and Consumer Behaviour

1. Market demands or demand curves are explained as stemming from the process of
individuals' choosing their most preferred bundle of consumption goods and services.

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2. Economists explain consumer demand by the concept of utility, which denotes the relative
satisfaction that a consumer obtains from using different commodities. The additional
satisfaction obtained from consuming an additional unit of a good is given the name marginal
utility, where "marginal" means the extra or incremental utility. The law of diminishing marginal
utility states that as the amount of a commodity consumed increases, the marginal utility of the
last unit consumed tends to decrease.

3. Economists assume that consumers allocate their limited incomes so as to obtain the
greatest satisfaction or utility. To maximize utility, a consumer must satisfy theequimarginal
principle that the marginal utilities of the last dollar spent on each and every good must be
equal.

Only when the marginal utility per dollar is equal for apples, bacon, coffee, and everything else
will the consumer attain the greatest satisfaction from a limited dollar income. But be careful to
note that the marginal utility of a $50-per-ounce bottle of perfume is not equal to the marginal
utility of a 50-cent glass of cola. Rather, their marginal utilities divided by price per unit are all
equal in the consumer's optimal allocation. That is, their marginal utilities per last dollar, MU/P,
are equalized.

4. Equal marginal utility or benefit per unit of resource is a fundamental rule of choice. Take any
scarce resource, such as time. If you want to maximize the value or utility of that resource,
make sure that the marginal benefit per unit of the resource is equalized in all uses.

5. The market demand curve for all consumers is derived by adding horizontally the separate
demand curves of each consumer. A demand curve can shift for many reasons. For example, a
rise in income will normally shift DD rightward, thus increasing demand; a rise in the price of a
substitute good (e.g., chicken for beef) will also create a similar upward shift in demand; a rise in
the price of a complementary good (e.g., hamburger buns for beef) will in turn cause
the DD curve to shift downward and leftward. Still other factors - changing tastes, population, or
expectations - can affect demand.

6. We can gain added insight into the factors that cause downward-sloping demand by
separating the effect of a price rise into substitution and income effects. (a) The substitution
effect occurs when a higher price leads to substitution of other goods to meet satisfactions; (b)
the income effect means that a price increase lowers real income and thereby reduces the
desired consumption of most commodities. For most goods, substitution and income effects of a
price increase reinforce one another and lead to the law of downward-sloping demand. We
measure the quantitative responsiveness of demand to income by the income elasticity, which
measures the percentage change in quantity demanded divided by the percentage change in
income.

7. Remember that it is the tail of marginal utility that wags the market dog of prices and quantities. This
point is emphasized by the concept of consumer surplus. We pay the same price for the last quart of milk
as for the first. But, because of the law of diminishing marginal utility, marginal utilities of earlier units are
greater than that of the last unit. This means that we would have been willing to pay more than the market
price for each of the earlier units. The excess of total value over market value is called consumer surplus.
Consumer surplus reflects the benefit we gain from being able to buy all units at the same low price. In
simplified cases, we can measure consumer surplus as the area between the demand curve and the
price line. It is a concept relevant for many public decisions - such as deciding when the community
should incur the heavy expenses of a road or bridge or set aside land for a wilderness area.