Economics-1 (Economic Theory)

 Economics-1 

(Economic Theory)

1. What is Economics? Definition of Economics

Economics is a social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Economics analyzes how people make choices under scarcity, how they respond to incentives, and how they coordinate and cooperate with each other. Economics also examines the causes and consequences of economic growth, development, inequality, poverty, unemployment, inflation, trade, and public policies.

2. Nature and Scope of Economics

The nature and scope of economics refer to the subject matter and boundaries of the discipline, as well as the method of analysis used by economists. There are different perspectives on the nature and scope of economics, but some common themes are:

- Economics is both a science and an art, as it uses scientific methods to test hypotheses and empirical data to support theories, but also requires creativity and judgement to apply the theories to real-world problems.

- Economics is divided into two main branches: microeconomics and macroeconomics. Microeconomics studies the decisions and behaviour of individual agents, such as consumers, firms, workers, and households, and how they interact in markets. Macroeconomics studies the aggregate behaviour and performance of the economy as a whole, such as national income, output, employment, inflation, trade, and fiscal and monetary policies.

- Economics is also subdivided into various fields and specializations, such as international economics, development economics, environmental economics, health economics, behavioural economics, and so on. Each field applies the basic principles and tools of economics to analyze specific issues and topics.

- Economics is a positive science, as it seeks to describe and explain the facts and phenomena of the economic world, and a normative science, as it also evaluates and prescribes policies and actions based on ethical and social values.

- Economics is a dynamic and evolving discipline, as it constantly adapts and responds to the changing conditions and challenges of the real world, and incorporates new ideas and insights from other disciplines, such as psychology, sociology, history, and mathematics.

3. Central Problem of an Economy - The central problem of an economy is how to allocate the scarce resources among the competing ends or wants. Since human wants are unlimited and resources are limited, every society has to face the problem of choice and decide what to produce, how to produce, and for whom to produce. These are the three basic questions that every economy has to answer.

- What to produce? This problem refers to the selection of the goods and services that the economy will produce, and the quantity of each. The economy has to decide which goods and services are more important and urgent, and which are less so. For example, the economy has to choose between producing more consumer goods or more capital goods, more agricultural goods or more industrial goods, more public goods or more private goods, and so on.

- How to produce? This problem refers to the choice of the techniques or methods of production that the economy will use. The economy has to decide how to combine and utilize the available factors of production, such as land, labour, capital, and entrepreneurship, to produce the desired goods and services. For example, the economy has to choose between using more labour-intensive or more capital-intensive techniques, more traditional or more modern technologies, more renewable or more non-renewable resources, and so on.

- For whom to produce? This problem refers to the distribution of the goods and services among the members of the society. The economy has to decide how to allocate the output among the different groups and individuals, based on their contribution, needs, or preferences. For example, the economy has to choose between distributing more income and wealth to the rich or to the poor, to the urban or to the rural areas, to the producers or to the consumers, and so on.

4. Production Possibility Curve and Opportunity Cost

The production possibility curve (PPC) is a graphical representation of the possible combinations of two goods or services that an economy can produce with a given amount of resources and technology, assuming full and efficient use of resources. The PPC shows the trade-offs and opportunity costs involved in production decisions.

- Trade-offs are the alternatives that are given up or sacrificed when choosing one option over another. For example, if an economy decides to produce more of one good, it has to produce less of another good, given the limited resources.

- Opportunity cost is the value of the next best alternative that is foregone or lost as a result of making a choice. It is measured by the amount of the other good that could have been produced instead of the chosen good. For example, if an economy moves from point A to point B on the PPC, the opportunity cost of producing 10 more units of good X is 5 units of good Y that are given up.

The shape of the PPC depends on the nature of the opportunity cost. If the opportunity cost is constant, the PPC is a straight line. If the opportunity cost is increasing, the PPC is concave or bowed out. If the opportunity cost is decreasing, the PPC is convex or bowed in.

The PPC can also shift due to changes in the quantity or quality of resources or technology. An increase in these factors will shift the PPC outward, indicating economic growth and expansion of production possibilities. A decrease in these factors will shift the PPC inward, indicating economic decline and contraction of production possibilities.

5. Consumer Behaviour and Demand

Consumer behaviour is the study of how consumers make decisions about what to buy, when to buy, where to buy, how much to buy, and why to buy. Consumer behaviour is influenced by various factors, such as preferences, tastes, income, prices, expectations, habits, social norms, culture, and so on. Consumer behaviour affects the demand for goods and services in the market.

Demand is the quantity of a good or service that consumers are willing and able to buy at various prices, during a given period of time, holding other factors constant. Demand is determined by the following factors:

- Price: The price of a good or service is the amount of money that consumers have to pay to obtain it. Price affects demand inversely, meaning that as price increases, demand decreases, and vice versa. This is known as the law of demand.

- Income: Income is the amount of money that consumers earn or receive from various sources. Income affects demand positively or negatively, depending on the type of good or service. Normal goods are those whose demand increases as income increases, and decreases as income decreases. Inferior goods are those whose demand decreases as income increases, and increases as income decreases.

- Prices of related goods: Related goods are those that have a complementary or substitutive relationship with the good or service in question. Complementary goods are those that are used together with the good or service, such as bread and butter. The demand for complementary goods moves in the same direction as the price of the other good, meaning that as the price of one good increases, the demand for the other good decreases, and vice versa. Substitutive goods are those that can be used instead of the good or service, such as tea and coffee. The demand for substitutive goods moves in the opposite direction as the price of the other good, meaning that as the price of one good increases, the demand for the other good increases, and vice versa.

- Tastes and preferences: Tastes and preferences are the subjective likes and dislikes of consumers for certain goods and services. They are influenced by personal, psychological, social, and cultural factors. Tastes and preferences affect demand positively, meaning that as consumers like a good or service more, they demand more of it, and vice versa.

- Expectations: Expectations are the beliefs or anticipations of consumers about the future prices, income, availability, or quality of goods and services. Expectations affect demand positively or negatively, depending on the nature of the expectation. For example, if consumers expect the price of a good to rise in the future, they may demand more of it in the present, and vice versa.

The demand for a good or service can be represented by a demand schedule, which is a table that shows the quantity demanded at different prices, and a demand curve, which is a graph that plots the demand schedule. The demand curve slopes downward from left to right, indicating the inverse relationship between price and quantity demanded. A change in price causes a movement along the demand curve, which is called a change in quantity demanded. A change in any other factor causes a shift of the demand curve, which is called a change in demand.

6. Different facets of costs & revenues of production

Costs and revenues are the two main components of the profit function of a firm. Costs are the expenses incurred by the firm to produce a certain quantity of output. Revenues are the income earned by the firm from selling the output in the market.

There are different facets or aspects of costs and revenues, such as:

- Total cost: The total cost (TC) is the sum of all the costs incurred by the firm to produce a given level of output. It includes both fixed costs and variable costs. Fixed costs are the costs that do not vary with the output, such as rent, salaries, depreciation, etc. Variable costs are the costs that vary with the output, such as raw materials, wages, electricity, etc. Mathematically, TC = TFC + TVC, where TFC is the total fixed cost and TVC is the total variable cost.

- Average cost: The average cost (AC) is the total cost per unit of output. It is obtained by dividing the total cost by the quantity of output. It also equals the sum of average fixed cost and average variable cost. Average fixed cost (AFC) is the total fixed cost per unit of output. It is obtained by dividing the total fixed cost by the quantity of output. Average variable cost (AVC) is the total variable cost per unit of output. It is obtained by dividing the total variable cost by the quantity of output. Mathematically, AC = TC/Q = AFC + AVC, where Q is the quantity of output.

- Marginal cost: The marginal cost (MC) is the additional cost incurred by the firm to produce one more unit of output. It is obtained by dividing the change in total cost by the change in quantity of output. Mathematically, MC = ΔTC/ΔQ, where ΔTC is the change in total cost and ΔQ is the change in quantity of output.

- Total revenue: The total revenue (TR) is the total income earned by the firm from selling the output in the market. It is obtained by multiplying the price of the output by the quantity of output. Mathematically, TR = P × Q, where P is the price of the output.

- Average revenue: The average revenue (AR) is the total revenue per unit of output. It is obtained by dividing the total revenue by the quantity of output. It also equals the price of the output. Mathematically, AR = TR/Q = P.

- Marginal revenue: The marginal revenue (MR) is the additional revenue earned by the firm from selling one more unit of output. It is obtained by dividing the change in total revenue by the change in quantity of output. Mathematically, MR = ΔTR/ΔQ, where ΔTR is the change in total revenue and ΔQ is the change in quantity of output.

The relationship between costs and revenues determines the profit or loss of the firm. Profit is the difference between total revenue and total cost. Mathematically, Profit = TR – TC. Loss is the difference between total cost and total revenue. Mathematically, Loss = TC – TR.

7. Law of returns increasing, constant and diminishing production function

The law of returns is a concept that describes the relationship between the inputs and outputs of a production process. It explains how the output changes when the inputs are changed, holding other factors constant. A production function is a mathematical expression that shows the functional relationship between the inputs and outputs of a production process.

There are three types of returns that can be observed in a production function, depending on the behaviour of the output as the inputs are increased:

- Increasing returns: This occurs when the output increases more than proportionately to the increase in inputs. This means that the marginal product of the inputs is increasing. For example, if the output increases by 10% when the inputs increase by 5%, this indicates increasing returns. Increasing returns can occur due to economies of scale, specialization, learning by doing, etc.

- Constant returns: This occurs when the output increases proportionately to the increase in inputs. This means that the marginal product of the inputs is constant. For example, if the output increases by 10% when the inputs increase by 10%, this indicates constant returns. Constant returns can occur due to optimal utilization of resources, efficient technology, etc.

- Diminishing returns: This occurs when the output increases less than proportionately to the increase in inputs. This means that the marginal product of the inputs is decreasing. For example, if the output increases by 10% when the inputs increase by 15%, this indicates diminishing returns. Diminishing returns can occur due to diseconomies of scale, congestion, exhaustion of resources, etc.

The law of returns can be illustrated by using a production function of the form Q = f(L, K), where Q is the output, L is the labour input, and K is the capital input. If we assume that the capital input is fixed and only the labour input is varied, we can plot the output against the labour input and obtain a curve called the total product curve. The slope of this curve at any point gives the marginal product of labour, which is the change in output due to a change in labour input. The shape of this curve shows the different phases of returns:

- Phase I: The total product curve is upward sloping and concave, indicating increasing returns. The marginal product of labour is positive and increasing.

- Phase II: The total product curve is upward sloping and convex, indicating diminishing returns. The marginal product of labour is positive but decreasing.

- Phase III: The total product curve is downward sloping, indicating negative returns. The marginal product of labour is negative and decreasing.

8. Different facets of costs & revenues of production

This topic is the same as topic VI, so I will not repeat the summary here. Please refer to the previous summary for the explanation of the different facets of costs and revenues of production.

9. Forms of markets/competition, perfect competition, different forms of imperfect competition

A market is a place or mechanism where buyers and sellers interact and exchange goods and services. A market can be classified into different forms or types based on the degree of competition among the sellers and the buyers. Competition is the rivalry or contest among the sellers and the buyers to attract more customers and gain more profits.

There are two extreme forms of market competition: perfect competition and monopoly. Perfect competition is a market structure where there are many sellers and buyers, selling and buying identical or homogeneous products, with perfect information and free entry and exit. Monopoly is a market structure where there is only one seller and many buyers, selling and buying a unique or differentiated product, with no close substitutes, and with barriers to entry and exit.

Between these two extremes, there are different forms of imperfect competition, such as:

- Monopolistic competition: This is a market structure where there are many sellers and buyers, selling and buying slightly differentiated or heterogeneous products, with some degree of product differentiation, and with easy entry and exit. For example, the market for toothpaste, shampoo, soap, etc.

- Oligopoly: This is a market structure where there are few sellers and many buyers, selling and buying either identical or differentiated products, with significant barriers to entry and exit, and with interdependence among the sellers. For example, the market for automobiles, airlines, steel, etc.

- Duopoly: This is a special case of oligopoly, where there are only two sellers and many buyers, selling and buying either identical or differentiated products, with high barriers to entry and exit, and with strong interdependence among the sellers. For example, the market for soft drinks, operating systems, etc.

The different forms of market competition have different implications for the behaviour and performance of the firms, such as the price, output, profit, efficiency, innovation, etc. Generally, perfect competition is considered to be the most desirable form of market competition, as it leads to the optimal allocation of resources and maximization of social welfare. However, in reality, perfect competition is rare and imperfect competition is more common. Therefore, it is important to understand the characteristics and consequences of the different forms of imperfect competition as well.

- Introductory macro economics: This is the branch of economics that studies the behavior and performance of the economy as a whole. It focuses on the aggregate variables such as national income, output, employment, inflation, interest rates, trade, and economic growth. It also analyzes the policies and institutions that affect these variables, such as fiscal policy, monetary policy, exchange rate policy, and international trade agreements. Some of the main concepts and models in introductory macro economics are the circular flow of income, the aggregate demand and aggregate supply model, the Keynesian cross, the IS-LM model, the AD-AS model, the Phillips curve, the Mundell-Fleming model, and the Solow growth model.

- National income and related aggregates measurement of national income: National income is the total value of all the goods and services produced by the residents of a country in a given period of time, usually a year. It is also equal to the total income earned by the residents from their participation in the production process. There are different methods of measuring national income, such as the product method, the income method, and the expenditure method. Each method uses different data sources and has different advantages and limitations. The product method measures national income by adding up the value added by all the producing units in the economy. The income method measures national income by adding up the incomes received by all the factors of production in the economy. The expenditure method measures national income by adding up the expenditures made by all the sectors of the economy on final goods and services.

- Expenditure method: This is one of the methods of measuring national income by adding up the expenditures made by all the sectors of the economy on final goods and services. The main components of expenditure are consumption, investment, government spending, and net exports. Consumption is the spending by households on goods and services for their own use. Investment is the spending by firms on capital goods, such as machinery, equipment, and buildings, that increase their productive capacity. Government spending is the spending by the government on public goods and services, such as defense, education, and health. Net exports are the difference between the value of exports and imports of goods and services. The expenditure method can be expressed by the following formula: National income = Consumption + Investment + Government spending + Net exports

- National disposable income (gross & net): National disposable income is the income that is available to the residents of a country for spending or saving after paying taxes and receiving transfers from the government and the rest of the world. It is equal to the national income plus the net current transfers from the government and the rest of the world. Gross national disposable income includes depreciation, which is the wear and tear of the capital stock due to its use in production. Net national disposable income excludes depreciation, and thus measures the net income available to the residents. The difference between gross and net national disposable income is the consumption of fixed capital, which is another term for depreciation.

- Private income, personal income and personal disposable income: Private income is the income received by the private sector, which consists of households and firms, from all sources, such as factor income, transfer income, and net factor income from abroad. Factor income is the income earned by the factors of production, such as wages, rent, interest, and profit. Transfer income is the income received without rendering any productive service, such as pensions, scholarships, and social security benefits. Net factor income from abroad is the difference between the income earned by the residents from the rest of the world and the income paid to the non-residents within the domestic territory. Personal income is the income received by the households from all sources, such as factor income, transfer income, and net factor income from abroad. It is equal to the private income minus the corporate tax and the undistributed profit of the firms. Corporate tax is the tax paid by the firms on their profit. Undistributed profit is the part of the profit that is not distributed to the shareholders and is retained by the firms for future investment. Personal disposable income is the income that is available to the households for spending or saving after paying personal taxes and non-tax payments to the government. Personal taxes are the direct taxes paid by the households, such as income tax, wealth tax, and property tax. Non-tax payments are the fees, fines, and penalties paid by the households to the government for the use of public services.

- Determination of income and employment: This is the process of finding the equilibrium level of national income and employment in an economy. According to the Keynesian theory, the equilibrium level of national income and employment is determined by the intersection of the aggregate demand and aggregate supply curves. Aggregate demand is the total demand for goods and services in the economy at a given price level. It consists of consumption, investment, government spending, and net exports. Aggregate supply is the total supply of goods and services in the economy at a given price level. It depends on the production function, the state of technology, and the availability of factors of production. In the short run, aggregate supply is assumed to be horizontal, meaning that the price level is fixed and the output adjusts to the level of demand. In the long run, aggregate supply is assumed to be vertical, meaning that the output is determined by the full employment level of factors of production and the price level adjusts to clear the market.

- Aggregate demand, aggregate supply and their components: Aggregate demand is the total demand for goods and services in the economy at a given price level. It consists of four components: consumption, investment, government spending, and net exports. Consumption is the spending by households on goods and services for their own use. It depends on the disposable income, the interest rate, the wealth, the expectations, and the preferences of the households. Investment is the spending by firms on capital goods, such as machinery, equipment, and buildings, that increase their productive capacity. It depends on the expected profit, the interest rate, the business confidence, and the technological innovation of the firms. Government spending is the spending by the government on public goods and services, such as defense, education, and health. It depends on the fiscal policy, the political objectives, and the social welfare of the government. Net exports are the difference between the value of exports and imports of goods and services. Exports are the goods and services sold to the rest of the world. They depend on the foreign income, the exchange rate, and the competitiveness of the domestic producers. Imports are the goods and services bought from the rest of the world. They depend on the domestic income, the exchange rate, and the preferences of the domestic consumers. Aggregate supply is the total supply of goods and services in the economy at a given price level. It depends on the production function, the state of technology, and the availability of factors of production. The production function shows the relationship between the output and the inputs of production, such as labor, capital, and natural resources. The state of technology reflects the level of knowledge, skills, and innovation that affect the productivity of the factors of production. The availability of factors of production depends on the quantity and quality of the labor force, the stock and depreciation of capital, and the endowment and exploitation of natural resources.

- Propensity to save and propensity to consume: Propensity to save is the fraction of an increase in income that is saved rather than spent on consumption. It measures the responsiveness of saving to a change in income. It is also known as the marginal propensity to save (MPS). It is calculated by dividing the change in saving by the change in income. For example, if the saving increases by 20 cents for every dollar increase in income, the MPS is 0.2. Propensity to consume is the fraction of an increase in income that is spent on consumption rather than saved. It measures the responsiveness of consumption to a change in income. It is also known as the marginal propensity to consume (MPC). It is calculated by dividing the change in consumption by the change in income. For example, if the consumption increases by 80 cents for every dollar increase in income, the MPC is 0.8. The propensity to save and the propensity to consume are related by the following identity: MPS + MPC = 1. This means that the increase in income is either saved or consumed, and the sum of the fractions of saving and consumption is equal to one.

- Determination of income and employment, Keynesian theory: This is the theory of income and employment developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money, published in 1936. Keynes challenged the classical view that the economy would automatically adjust to full employment and stable prices in the long run. He argued that the economy could get stuck in a situation of involuntary unemployment and low output due to insufficient aggregate demand. He proposed that the government should intervene to stimulate aggregate demand by increasing its spending, lowering taxes, or reducing the interest rate. He also introduced the concept of the multiplier, which shows how a change in autonomous spending, such as investment or government spending, can have a multiplied effect on the income and employment of the economy.