Basics of Economics
Economics: The Basics
When wants exceed the resources available to satisfy them, there
Faced with scarcity, people must make choices.
Economics is the study of the choices people make to cope with
Choosing more of one thing means having less of something else.
The opportunity cost of any action is the best alternative forgone.
The Basics (Cont..)
Microeconomics - The study of the decisions of people and
businesses and the interaction of those decisions in markets. The
goal of microeconomics is to explain the prices and quantities of
individual goods and services.
Macroeconomics - The study of the national economy and the
global economy and the way that economic aggregates grow and
fluctuate. The goal of macroeconomics is to explain average
prices and the total employment, income, and production.
Positive statements - Statements about what is.
Normative statements - Statements about what ought to be.
Ceteris paribus - Other things being equal” or “if all other
relevant things remain the same.
The Basics (Cont..)
The fallacy of composition - What is true of the parts may not be
true of the whole. What is true of the whole may not be true of
The post hoc fallacy - The error of reasoning from timing to
cause and effect.
Economic efficiency - Production costs are as low as possible and
consumers are as satisfied as possible with the combination of
goods and services that is being produced.
Economic growth - The increase in incomes and production per
person. It results from the ongoing advance of technology, the
accumulation of ever larger quantities of productive equipment
and ever rising standards of education.
Economic stability - The absence of wide fluctuations in the
economic growth rate, the level of employment, and average
The Modern economy
Economy - A mechanism that allocates scarce resources among
alternative uses. This mechanism achieves five things: What,
How, When, Where, Who.
Decision makers - Households, Firms, Governments.
Household - Any group of people living together as a decision-
making unit. Every individual in the economy belongs to a
Firm - An organization that uses resources to produce goods
and services. All producers are called firms, no matter how
big they are or what they produce. Car makers, farmers,
banks, and insurance companies are all firms.
Government - A many-layered organization that sets laws and
rules, operates a law-enforcement mechanism, taxes
households and firms, and provides public goods and services
such as national defense, public health, transportation, and
Market - Any arrangement that enables buyers and sellers to
get information and to do business with each other.
Role of Government
Not so very long ago, economic planning and public ownership
of the means of production were the wave of the future.
Planners cannot find out what needs to be done to co-ordinate
the production of a modern economy.
Even if a technically feasible plan could be drawn up, there is no
reason to believe it will be implemented.
How could a central planner know better than the consumers
what the individual woman wants? Planners can only provide
users with what they believe they should want.
Because prices bear no relation to costs, there is no way to
calculate what production needs to increase and what
production needs to be reduced.
The state has three functions:
To provide things - known as public goods - that the market
cannot provide for itself;
To internalize externalities or remedy market failures;
To help people who, for a number of reasons, do worse from the
market or are more vulnerable to what happens within it than
society finds tolerable.
In addition to providing public goods, governments directly
finance or provide certain merit goods. Such goods are
consumed individually. But society insists on a certain level or
type of provision.
The role of the state in a modern market economy is, in short,
pervasive. The difference between poor countries and richer
ones is not that the latter do less, but that what they do is better
directed (on the whole) and more competently executed (again,
on the whole). Cont….
The first requirement of effective policy is a range of qualities
credibility, predictability, transparency and consistency.
The more the government focuses on its essential tasks and the
less it is engaged in economic activity and regulation, the better
it is likely to work and the better the economy itself is likely to
If one needs a large number of bureaucratic permissions to do
something in business, the officials have an opportunity to
Once it is known that a government is prepared to create such
exceptional opportunities, there will be lobbying to create them.
Then there is not just the corruption of the government, but the
waste of resources in such 'rent-seeking' or 'directly
unproductive profit-seeking activities'.
Governments are natural monopolies over a given territory.
One of the strongest arguments for an open economy is that it
puts a degree of competitive pressure on government.
Factors of Production
Factors of production - The economy’s productive resources;
Labor, Land, Capital, Entrepreneurial ability.
Land - Natural resources used to produce goods and services.
The return to land is rent.
Labor - Time and effort that people devote to producing goods
and services. The return to labour is wages.
Capital - All the equipment, buildings, tools and other
manufactured goods used to produce other goods and services.
The return to capital is interest.
Entrepreneurial ability - A special type of human resource that
organizes the other three factors of production, makes business
decisions, innovates, and bears business risk. Return to
entrepreneurship is profit.
Markets - Coordinate individual decisions through price
Command mechanism - A method of determining what, how,
when, and where goods and services are produced and who
consumes them, using a hierarchical organization structure
in which people carry out the instructions given to them.
Market economy - An economy that uses a market
Command economy - An economy that relies on a command
Mixed economy - An economy that relies on both markets
and command mechanism.
Production Possibility Frontier
The quantities of goods and services that can be produced are
limited by the available resources and by technology. That limit
is described by the production possibility frontier.
Production Possibility Frontier (PPF) - The boundary between
those combinations of goods and services that can be produced
and those that cannot.
Production efficiency - When it is not possible to produce more
of one good without producing less of some other good.
Production efficiency occurs only at points on the PPF.
Economic growth - Means pushing out the PPF. The two key
factors that influence economic growth are technological
progress and capital accumulation.
Technological progress - The development of new and better
ways of producing goods and services and the development of
Capital accumulation - The growth of capital resources.
Absolute Advantage - If by using the same quantities of inputs,
one person can produce more of both goods than some one else
can, that person is said to have an absolute advantage in the
production of both goods.
Comparative Advantage - A person has a comparative advantage
in an activity if that person can perform the activity at a lower
opportunity cost than anyone else.
Law of Demand
Demand curve - Shows the relationship between the quantity
demanded of a good and its price, all other influences on
consumers’ planned purchases remaining the same.
Other things remaining the same, the higher the price of a
good, the smaller is the quantity demanded.
• Substitution effect
• Income effect.
As the opportunity cost of a good increases, people buy less of
that good and more of its substitutes.
Faced with a high price and an unchanged income, the
quantities demanded of at least some goods and services must
Substitute - A good that can be used in place of another good.
Complement - A good that is used in conjunction with another
Normal goods - Goods for which demand increases as income
Inferior goods - Goods for which demand decreases as income
If the price of a good changes but everything else remains the
same, there is a movement along the demand curve.
If the price of a good remains constant but some other influence
on buyers’ plans changes, there is a change in demand for the
A movement along the demand curve shows a change in the
quantity demanded and a shift of the demand curve shows a
change in demand.
Law of Supply
Law of supply – Other things remaining the same, the higher
the price of a good, the greater is the quantity supplied.
Supply of a good depends on:
• The price of the good;
• The prices of factors of production;
• The price of other goods produced; Expected future
• The number of suppliers;
Supply curve - Shows the relationship between the quantity
supplied and the price of a good, everything else remaining
If the price of a good changes but everything else influencing
suppliers’ planned sales remains constant, there is a
movement along the supply curve.
If the price of a good remains the same but another influence
on suppliers’ planned sales changes, supply changes and there
is a shift of the supply curve.
A movement along the supply curve shows a change in the
quantity supplied. The entire supply curve shows supply. A
shift of the supply curve shows a change in supply.
Equilibrium: A situation in which opposing forces balance each
other. Equilibrium in a market occurs when the price is such
that the opposing forces of the plans of buyers and sellers
balance each other. The equilibrium price is the price at with
the quantity demanded equals the quantity supplied. The
equilibrium quantity is the quantity bought and sold at the
When both demand and supply increase, the quantity
increases. The price may increase, decrease, or remain
When both demand and supply decrease, the quantity
decreases. The price may increase, decrease, or remain
When demand decreases and supply increases, the price falls.
The quantity may increase, decrease, or remain constant.
When demand increases and supply decreases, the price rises
and the quantity increases, decreases, or remains constant.
The total revenue from the sale of a good equals the price of
the good multiplied by the quantity sold. An increase in price
increases the revenue on each unit sold. But an increase in
price also leads to a decrease in the quantity sold. Whether
the total expenditure increases or decreases after a price hike,
depends on the responsiveness of demand to the price.
Price elasticity of demand – A measure of the responsiveness of
the quantity demanded of a good to a change in its price,
other things remaining the same. It is the percentage change
in demand divided by percentage change in price.
Inelastic demand - If the percentage change in the quantity
demanded is less than the percentage change in price, then the
magnitude of the elasticity of demand is between zero and 1,
and demand is said to be inelastic.
If the quantity demanded remains constant when the price
changes, then the elasticity of demand is zero and demand is
said to be perfectly inelastic.
Elastic demand - If elasticity is greater than 1, it is elastic.
If the quantity demanded is indefinitely responsive to a price
change, then the magnitude of the elasticity of demand is
infinity, and demand is said to be perfectly elastic.
When markets do not work
Price ceiling - A regulation that makes it illegal to charge a
price higher than a specified level. When a price ceiling is
applied to rents in housing markets, it is called a rent ceiling.
Black market - An illegal trading arrangement in which buyers
and sellers do business at a price higher than legally imposed
Minimum wage law - A regulation that makes hiring labor
below a specified wage illegal.
Externalities – Social costs, but no private costs.
Consumption & Utility
A household’s consumption choices are determined by
• Budget constraint
Utility - The benefit or satisfaction that a person gets from the
consumption of a good or service.
Total utility - The total benefit or satisfaction that a person gets
from the consumption of goods and services.
Marginal utility - The change in total utility resulting from a
one-unit increase in the quantity of a good consumed.
Consumer equilibrium - A situation in which a consumer has
allocated his or her income in the way that, given the prices of
goods and services, maximizes his or her total utility.
Short run - Period of time in which the quantity of at least one
input is fixed and the quantities of the other inputs can be
Long run - Period of time in which the quantities of all inputs
can be varied. Inputs whose quantity can be varied in the
short run are called variable inputs. Inputs whose quantity
cannot be varied in the short run are called fixed inputs.
Firm’s total cost - The sum of the costs of all the inputs it uses
Fixed cost -The cost of a fixed input.
Variable cost - The cost of a variable input.
Total fixed cost - The total cost of fixed inputs.
Total variable cost - The cost of the variable inputs.
Marginal cost - The increase in total cost for increasing output
by one unit.
Average fixed cost (AFC) - Total fixed cost per unit of output.
Average variable cost (AVC) - Total variable cost per unit of
Average total cost (ATC) - Total cost per unit of output.
Long-run average cost curve - Traces the relationship between
the lowest attainable average total cost and output when both
capital and labor inputs can be varied.
Economies of scale - As output increases, long-run average
Diseconomies of scale - As output increases, long run average
There are many firms, each selling an identical product.
There are many buyers.
There are no restrictions on entry into the industry.
Firms in the industry have no advantage over potential new
Firms and buyers are completely informed about the prices of
the product of each firm in the industry.
Firms in perfect competition are said to be price takers. A
price taker is a firm that cannot influence the price of a good
Monopoly - An industry that produces a good or service for
which no close substitute exists and in which there is one supplier
that is protected from competition by a barrier preventing the
entry of new firms.
Price discrimination - The practice of charging some customers a
lower price than others for an identical good or of charging an
individual customer a lower price on a large purchase than on a
small one, even though the cost of servicing all customers is the
Monopolistic competition - A market structure in which a large
number of firms compete with each other by making similar but
slightly different products.
Oligopoly - A market structure in which a small number of
producers compete with each other.
Trends and cycles
Economic developments should be judged in the context of trends and
Trends - The trend is the long-term rate of economic expansion.
Cycles - The cycle reflects short-term fluctuations around the trend. There
are always a few months or years when growth is above trend, followed by a
period when the economy contracts or grows below trend.
Long-term growth - In the long term the growth in economic output depends
on the number of people working and output per worker. Output per
worker grows through technical progress and investment in new plant,
machinery and equipment. Investment and productivity are therefore the
basis for continued and sustained economic expansion.
Recession - A period during which real GDP decreases – the growth rate of
real GDP is negative – for at least two successive quarters.
Consumption expenditure - The amount spent on consumption
goods and services. Saving is the amount of income remaining
after meeting consumption expenditures.
Savings – What remains out of income after consuming.
Capital - The plant, equipment, buildings, and inventories of
raw materials and semi-finished goods that are used to produce
other goods and services. The amount of capital in the economy
is a crucial factor that influences GDP growth.
Investment - The purchase of new plant, equipment, and
buildings and the additions to inventory. Investment increases
the stock of capital. Depreciation is the decrease in the stock of
capital that results from wear and tear and the passage of time.
Government Purchases - Governments buy goods and services,
called government purchases, from firms.
Net taxes - Taxes paid to governments minus transfer payments
received from governments.
Transfer payments - Cash transfers from governments to
households and firms such as social security benefits,
unemployment compensation, and subsidies.
Measuring Economic Activity
Total economic activity may be measured in three different
but equivalent ways.
Add up the value of all goods and services produced in a given
period of time, such as one year. Money values may be
imputed for services such as health care which do not change
hands for cash. Since the output of one business (for example,
steel) can be the input of another (for example, automobiles),
double counting is avoided by combining only "value added",
which for anyone activity is the total value of production less
the cost of inputs such as raw materials and components
A second approach is to add up the expenditure which takes
place when the output is sold.
Since all spending is received as incomes, a third option is to
value producers' incomes.
Gross domestic product - GDP is the total of all economic
activity in one country, regardless of who owns the
productive assets. For example, India’s GDP includes the
profits of a foreign firm located in India even if they are
remitted to the firm's parent company in another country.
Gross national product - GNP, is the total of incomes earned
by residents of a country, regardless of where the assets are
located. For example, India’s GNP includes profits from
Indian-owned businesses located in other countries.
Omissions in GDP
There are many things which are not in GDP, including the
•Transfer payments - For example, social security and pensions.
•Gifts. For example, $10 from an aunt on your birthday.
•Unpaid and domestic activities. If you cut your grass or paint
your house the value of this productive activity is not
recorded in GDP, but it is if you pay someone to do it for you.
•Barter transactions. For example, the exchange of a sack of
wheat for a can of petrol.
•Second-hand transactions. For example, the sale of a used car
(where the production was recorded in an earlier year).
•Intermediate transactions. For example, a lump of metal may
be sold several times, perhaps as ore, pig iron, part of a
component and, finally, part of a washing machine (the metal
is included in GDP once at the net total of the value added
between the initial production of the ore and its final sale as a
•Leisure. An improved production process which creates the
same output but gives more recreational time is recorded in
the national accounts at exactly the same value as the old
•Depletion of resources. For example, oil production is
recorded at sale price minus production costs and no
allowance is made for the fact that an irreplaceable part of the
nation's capital stock of resources has been consumed.
•Environmental costs. GDP figures do not distinguish between
green and polluting industries.
•Allowance for non-profit-making and inefficient activities.
The civil service and police force are valued according to
expenditure on salaries, equipment, and so on (the
appropriate price for these services might be judged to be
very different if they were provided by private companies).
•Allowance for changes in quality. You can buy very
different electronic goods for the same inflation-adjusted
outlay than you could a few years ago, but GDP data do not
take account of such technological improvements.
GDP may under-record economic activity, not least because of
the difficulties of keeping track of new small businesses and
because of tax avoidance or evasion.
Deliberately concealed transactions form the black, grey,
hidden or shadow economy. This is largest at times when taxes
are high and bureaucracy is heavy. Estimates of the size of the
shadow economy vary enormously. For example, differing
studies put America's at 4-33%, Germany's at 3-28% and
Britain's at 2-15%. What is agreed, though, is that among the
industrial countries the shadow economy is largest in Italy, at
perhaps one-third of GDP, followed by Spain, Belgium and
Sweden, while the smallest black economies are in Japan and
Switzerland at around 4% of GDP.
The only industrial countries that adjust their GDP figures for
the shadow economy are Italy and America and they may well
underestimate its size.
The expenditure measure of GDP is obtained by adding up all
consumption (spending on items such as food and clothing)
+ investment (spending on houses, factories, and so on)
= total domestic expenditure
+ exports of goods and services (foreigners' spending)
= total final expenditure
- imports of goods and services (spending abroad)
Government consumption - The level of government spending
reflects the role of the state. Government consumption is
generally 10-20% of GDP, although it is higher in countries
such as Denmark and Sweden where the state provides many
services. Changes in government spending tend to reflect
political decisions rather than market forces.
Private consumption - This is also called personal consumption
or consumer expenditure. It is generally the largest individual
category of spending. In the industrialised countries,
consumption is around 60% of GDP. The ratio is much higher
in poor countries which invest less and consume more.
Investment - Investment is perhaps the key structural
component of spending since it lays down the basis for future
production. It covers spending on factories, machinery,
equipment, dwellings and inventories of raw materials and
other items. Investment averages about 20% of GDP in the
industrialised countries, but is nearer 30% of GDP in East
The income measure of GDP is based on total incomes from
production. It is essentially the total of:
•wages and salaries of employees;
•income from self-employment;
•trading profits of companies;
•trading surpluses of government corporations and
•income from rents.
These are known as factor incomes. GDP does not include
transfer payments such as interest and dividends, pensions, or
other social security benefits. The breakdown of incomes sheds
additional light on economic behaviour because it is the
counterpart to expenditure in what economists call the circular
flow of money. It also provides a useful basis for forecasting
Labour force or workforce - The number of people
employed and self-employed plus those unemployed but
ready and able to work.
Three factors affect the size of the labour force: population,
migration and the proportion participating in economic
Population. Birth rates in most industrial countries fell to
replacement levels or lower in the 1980s. This implies an
older workforce and higher old-age dependency rates (the
number of retired people as a percentage of the population
of working age) in the future. By 2010, 15-20% of the
population in industrial economies will be over 65 years of
Developing countries have young populations with up to 50%
under 15 years. This suggests an expanding working-age
population with potential problems for housing and job
Migration. In the industrial countries inflows of foreign workers
increased since the late 1980s and a substantial number of
illegal immigrants were granted amnesty in America, France,
Italy and Spain. Foreign-born persons account for over 5% of
the labour force in America, Germany and France; around 20%
in Switzerland and Canada; and over 25% in Australia.
Inward migration may be a bonus for some economies. For
example, German unification boosted that country's productive
potential. However, large numbers of refugees seeking asylum
can have significant adverse effects on income per head.
Wealthier developing countries, especially oil producers, have
large proportions of foreigners in their labour forces. Workers
frequently make a substantial contribution to the balance of
payments in their home countries by remitting savings from
Participation. Participation rates (the labour force as a
percentage of the total population) generally increased in the
1980s and 1990s with earlier retirement for men, especially in
France, Finland and the Netherlands, generally offset by more
married women entering the labour force, especially in
America, Australia, Britain, New Zealand and Scandinavia.
Women account for a smaller proportion of the workforce in
Muslim countries (20%) and a greater proportion in Africa
(up to 50%) where they traditionally work on the land.
The unemployment rate. Usually defined as unemployment as
a percentage of the labour force (the employed plus the
unemployed). National variations are rife: Germany excludes
the self-employed from the labour force; Belgium produces
two unemployment rates expressing unemployment as a
percentage of both the total and the insured labour force. By
changing the definition, which governments are inclined to
do, the unemployment rate can be moved up or, more usually,
down by several percentage points.
The Balance Of Payments
Balance of payments accounts record financial flows in a
specific period such as one year. Financial inflows are treated
as credits or positive entries. Outflows are debits or negative
entries. When a foreigner invests in the country, there is a
capital inflow which is a credit entry. Conversely, the
acquisition of a claim on another country is a negative or debit
Debits = credits. The accounts are double entry, that is, every
transaction is entered twice. For example, the export of goods
involves the receipt of cash (the credit) which represents a
claim on another country (the debit). By definition, the balance
of payments must balance. Debits must equal credits.
Current = capital. One side of each transaction is treated as a
current flow (such as a receipt of payment for an export). The
other is a capital flow (such as the acquisition of a claim on
another country). Arithmetically current flows must exactly
equal capital flows.
The accounts build up in layers. Balances may be struck at
each stage. What follows reflects the IMF'S methodology in
the fifth edition of the Balance of Payments Manual
Net exports of goods (exports of goods less imports of goods)
= the visible trade or merchandise trade balance
+ net exports of services (such as shipping and insurance)
= the balance of trade in goods and services
+ net income (compensation of employees and investment
+ net current transfers (such as payments of international aid
and workers' remittances)
= the current-account balance (all the following entries form
the capital and financial account)
+ net direct investment (such as building a factory overseas)
+ other net investment (such as portfolio investments in
foreign equity markets)
+ net financial derivatives
+ other investment (including trade credit, loans, currency
+ reserve assets (changes in official reserves), sometimes
known as the bottom line
= overall balance
+ net errors and omissions
Thus the current account covers trade in goods and
services, income and transfers. Non-merchandise items are
known as invisibles. All other flows are recorded in the
capital and financial account. The capital part of the
account includes capital transfers, such as debt forgiveness,
and the acquisition and/or disposal of non-produced, non-
financial assets such as patents. The financial part includes
direct, portfolio and other investment.
The balance of payments must balance. When we talk about
a balance of payments deficit or surplus, we mean a deficit
or surplus on one part of the accounts.
Fiscal indicators are concerned with government revenue and
Level of government - Various problems of definition arise
because of different treatment of financial transactions by
central government, local authorities, publicly owned
enterprises, and so on.
In an attempt to standardise, international organisations such
as the OECD focus on general government, which covers
central and local authorities, separate social security funds
where applicable, and province or state authorities in
federations such as in North America, Australia, Germany,
Spain and Switzerland.
There is scope for manipulation, Spending can be shifted to
publicly owned enterprises which are generally classified as
being outside general government. Net lending to such
enterprises is part of government spending, but it is not always
included in headline expenditure figures.
Public spending may be classified in several different ways.
•By level of government: central and local authorities, state or
provincial authorities for federations, social security funds and
•By department: agriculture, defence, trade, and so on.
•By function: such as environmental services, which might be
provided by more than one department.
•By economic category: current, capital, and so on.
Breaking down the economic effect of public spending into
current and capital spending is a useful way to interpret it.
Major categories of current spending include the following.
•Pay of public-sector employees: this generally seems to rise
faster than other current spending.
•Other current spending: on goods and services such as
stationery, medicines, uniforms, and so on.
•Subsidies: on goods and services such as public housing and
•Social security: including benefits for sickness, old age,
family allowances, and so on; social assistance grants and
unfunded employee welfare benefits paid by general
•Interest on the national debt.
Taxes can be Progressive or regressive
•Progressive taxes take a larger proportion of cash from the
rich than from the poor, such as income tax where the
marginal percentage rate of tax increases as income rises.
•Proportional taxes take the same percentage of everyone's
income, wealth or expenditure, but the rich pay a larger
amount in total.
•Regressive taxes take more from the poor. For example, a flat
rate tax of Rs. 5000, takes a greater proportion of the income
of a lower-paid worker than of a higher-paid worker.
Indirect taxes. Levied on goods and services, these include the
Value-added tax (VAT) charged on the value added at each
stage of production; this amounts to a single tax on the final
Sales and turnover taxes which may be levied on every
transaction (for example, wheat, flour, bread) and cumulate as
a product is made.
Customs duties on imports.
Excise duties on home-produced goods, sometimes at penal
rates to discourage activities such as smoking.
Indirect taxes tend to be regressive, as poorer people spend a
bigger slice of their income. They are charged at either flat or
Budget deficits (spending exceeds revenues) boost total demand
and output through a net injection into the circular flow of
incomes. As with personal finances, a deficit on current
spending may signal imprudence. However, a deficit to finance
capital investment expenditure helps to lay the basis for future
output and can be sustained so long as there are pri-vate or
foreign savings willing to finance it in a non-inflationary way.
Budget surpluses (revenues exceed expenditure) may be
prudent if a government is building up a large surplus on its
social security fund in order to meet an expected increase in its
future pensions bill as the population ages.
Tighter or looser. Fiscal policy is said to have tightened if a
deficit is reduced or converted into a surplus or if a surplus is
increased, after taking into account the effects of the economic
cycle. A move in the opposite direction is called a loosening of