Basic Concepts of Economics

Economics deals with maintaining an efficient balance between unlimited wants

and limited resources in everyone’s life. Economics also deals with the
production, distribution, and consumption of goods and services. In this chapter,
we will study the basic concepts of economics in detail and understand it better.

Economics Concept # 1. Value:

Ordinarily, the concept of value is related to the concept of utility. Utility is the
want satisfying quality of a thing when we use or consume it. Thus utility is the
value-in-use of a commodity. For instance, water quenches our thirst. When
we use water to quench our thirst, it is the value-in-use of water.

Basic Concept of Economics # 2. Value and Price:

In common language, the terms ‘value’ and ‘price’ are used as synonyms (i.e.
the same). But in economics, the meaning of price is different from that of
value. Price is value expressed in terms of money. Value is expressed in terms
of other goods. If one pen is equal to two pencils and one pen can be had for
Rs.10. Then the price of one pen is Rs.10 and the price of one pencil is Rs.5.

Basic Concept of Economics # 3. Wealth:

In common use, the term ‘wealth’ means money, property, gold, etc. But in
economics it is used to describe all things that have value. For a commodity to
be called wealth, it must possess utility, scarcity and transferability. If it lacks
even one quality, it cannot be termed as wealth

Basic Concept of Economics # 4. Stocks and Flows:

Distinction may be made here between a stock variable and a flow variable. A
stock variable has no time dimension. Its value is ascertained at some point in
time. A stock variable does not involve the specification of any particular
length of time. On the other hand, a flow variable has a time dimension. It is
related to a specified period of time. So national income is a flow and national
wealth is a stock.

Basic Concept of Economics # 5. Optimisation:

Optimisation means the most efficient use of resources subject to certain
constraints it is the choice from all possible uses of resources which gives the
best results, it is the task of maximisation or minimisation of an objective
function it is a technique which is used by a consumer and a producer as
decision-maker.
What Is Economics?
Economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses, governments,
and nations make choices on allocating resources to satisfy their wants and needs, trying
to determine how these groups should organize and coordinate efforts to achieve
maximum output.

DEFINITION AND MEANING OF MANAGERIAL ECONOMICS:

 
Managerial economics, used synonymously with business economics. It is a branch of
economics that deals with the application of microeconomic analysis to decision-making
techniques of businesses and management units. It acts as the via media between economic
theory and pragmatic economics. Managerial economics bridges the gap between "theory and
practice". Managerial economics can be defining as :
 
According to Spencer and Siegel man:
 “The integration of economic theory with business practice for the purpose of facilitating decision-making
and forward planning by management”.
 
According to McGutgan and Moyer:
 “Managerial economics is the application of economic theory and methodology to decision-making
problems faced by both public and private institutions”.

Nature of Economics
1. Economics is a science: Science is an organised branch of knowledge, that
analyses cause and effect relationship between economic agents. Further,
economics helps in integrating various sciences such as mathematics, statistics, etc.
to identify the relationship between price, demand, supply and other economic
factors.

2. Economics is an art: Art is a discipline that expresses the way things are to be
done, so as to achieve the desired end. Economics has various branches like
production, distribution, consumption and economics, that provide general rules and
laws that are capable of solving different problems of society. Therefore, economics
is considered as science as well as art.
 Scope of Economics

1. Microeconomics: The part of economics whose subject matter of study

is individual units, i.e. a consumer, a household, a firm, an industry, etc. It analyses
the way in which the decisions are taken by the economic agents, concerning the
allocation of the resources that are limited in nature. It studies consumer behaviour,
product pricing, firm’s behaviour. Factor pricing, etc.

2. Macro Economics: It is that branch of economics which studies the entire economy,
instead of individual units, i.e. level of output, total investment, total savings, total
consumption, etc. Basically, it is the study of aggregates and averages. It analyses
the economic environment as a whole, wherein the firms, consumers, households,
and governments make decisions

Nature of decision making:

1. Goal-Oriented Process: Decision-making is a goal-oriented process

2. Selection Process: Decision-making is a selection process in which best
alternative course of action is chosen from the given alternative courses of
action
3. Continuous Process: Decision-making is a continuous process because a
manager is required to take decisions continuously for different activities.
4. Art as Well as Science: Decision-making is considered both an art and a
science.
5.  Responsibilities of Managers: Decision-making is the responsibility of
managers at different levels of management.
 6. Positive as Well as Negative: Decision-making can be both positive and
negative i.e. it may be positive (to perform certain activities) or negative (not
to perform certain activities)

7. Future Course of Action: Decisions are made for future course of action
based on the basis of past experiences and present conditions.

UTILITY
The satisfaction a person can received from the use of goods and services is called utility

Utility is a term in economics that refers to the total satisfaction received from
consuming a good or service. Economic theories based on rational choice usually
assume that consumers will strive to maximize their utility. The economic utility of a
good or service is important to understand, because it directly influences the
demand, and therefore price, of that good or service. In practice, a consumer's utility
is impossible to measure and quantify.

There are two ways to measure utility:

1.Ordinal Utility:  function is a function representing the preferences of an agent on

an ordinal scale. Ordinal utility theory claims that it is only meaningful to ask which
option is better than the other, but it is meaningless to ask how much better it is or how
good it is. All of the theory of consumer decision-making under conditions
of certainty can be, and typically is, expressed in terms of ordinal utility.

2.Cardinal utility: The utility of each commodity is measurable. Utility is a

cardinal concept. The most convenient measure is money: the utility is measured by
the monetary units that the consumer is prepared to pay for another unit of the
commodity.
Definition of 'Indifference Curve'
An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction
and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and all
points give him the same utility.

The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer,
bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as
much utility as point B to the individual. The consumer will be satisfied at any point along the curve assuming
that other things are constant.

An indifference curve is a locus of all combinations of two goods which yield the same
level of satisfaction (utility) to the consumers.
Since any combination of the two goods on an indifference curve gives equal level of
satisfaction, the consumer is indifferent to any combination he consumes. Thus, an
indifference curve is also known as ‘equal satisfaction curve’ or ‘iso-utility curve’.

On a graph, an indifference curve is a link between the combinations of quantities which

the consumer regards to yield equal utility. Simply, an indifference curve is a graphical
representation of indifference schedule.

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. Unit II
What is Demand?
Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service. Holding all other
factors constant, an increase in the price of a good or service will decrease the quantity
demanded, and vice versa. Market demand is the total quantity demanded across all
consumers in a market for a given good. Aggregate demand is the total demand for all
goods and services in an economy.

Factors affecting demand

It is assumed that there are six main factors affecting the demand:

 income: when consumer`s income increases, he or she usually buys more goods which
increases the demand
 prices of substitutes goods: when the price of substitute good (e.g. banana) increases, a
consumer normally gives up at least some of its consumption and as a result the demand
(e.g. for pineapple) increases
 prices of complementary goods: when the price of complementary good (e.g. coffee)
increases, a consumer normally gives up at least some of its consumption and as a result
the demand (e.g. for sugar) decreases
 number of consumers: when the number of consumers increases there are more people
who buy the good and as a result the demand increases
 consumers´ tastes: when a consumer likes the good more he or she buys it more and the
demand increases 
 consumers´ future expectations: when consumers expect higher prices in the future,
they buy more goods in order to avoid higher prices and as a result the demand increases

What is demand schedule?

In economics, a demand schedule is a table that shows the quantity demanded of a
good or service at different price levels. A demand schedule can be graphed as a
continuous demand curve on a chart where the Y-axis represents price and the X-
axis represents quantity

Understanding Demand Schedule

A demand schedule most commonly consists of two columns. The first column lists a price
for a product in ascending or descending order. The second column lists the quantity of the
product desired or demanded at that price. The price is determined based on research of
the market.

When the data in the demand schedule is graphed to create the demand curve, it supplies
a visual demonstration of the relationship between price and demand, allowing easy
estimation of the demand for a product or service at any point along the curve.
 IMPORTANT: A demand schedule tabulates the quantity of goods that consumers
will purchase at given prices

Definition of 'Law of Demand'

Definition: The law of demand states that other factors being constant (cetris peribus),
price and quantity demand of any good and service are inversely related to each other.
When the price of a product increases, the demand for the same product will fall.

Description: Law of demand explains consumer choice behaviour when the price changes. In the market,
assuming other factors affecting demand being constant, when the price of a good rises, it leads to a fall in
the demand of that good. This is the natural consumer choice behaviour. This happens because a
consumer hesitates to spend more for the good with the fear of going out of cash

The above diagram shows the demand curve which is downward sloping. Clearly when the price of the
commodity increases from price 5 to 6, then its quantity demand comes down from 10 to 8 and then to 10 and
vice versa.

 Expansion in Demand

 Contraction in Demand

 Increase or decrease in demand

 Elasticity of demand

“Elasticity of demand is the responsiveness of the quantity demanded of a commodity to

changes in one of the variables on which demand depends. In other words, it is the percentage
change in quantity demanded divided by the percentage in one of the variables on which
demand depends.”
The variables on which demand can depend on are:

 Price of the commodity

 Prices of related commodities
 Consumer’s income, etc.
Types of Elasticity of Demand

1.Price Elasticity
The price elasticity of demand is the response of the quantity demanded to change in the price
of a commodity. It is assumed that the consumer’s income, tastes, and prices of all other goods
are steady. It is measured as a percentage change in the quantity demanded divided by the
percentage change in price

2.Income Elasticity of Demand

The income elasticity of demand measures how the change in a
consumer’s income affects the demand for a specific product. You can
express the income elasticity of demand mathematically as follows:

Income Elasticity of Demand (YED) = % change in quantity demanded / % change in

income

3.Cross Elasticity of Demand

cross elasticity of demand is the responsiveness of demand for a product in relation to the
change in the price of another related product. The relevant word here is “related” product.
Unrelated products have zero elasticity of demand. An increase in the price of pulses will have
no effect on the demand for chocolates. You can measure the cross elasticity of demand by
dividing the percentage of change in the demand for one product by the percentage of change in
the price of another product.

Cross Elasticity of Demand = % of the change in the demand for Product A / % of the
change in the price of product B
Degree of Elasticity Of Demand
Principles of production
In order to produce goods and services which can be sold, and generate revenue and profits, a

firm must purchase or hire scarce inputs, which are its factors of production. These factors can

be fixed or variable

Fixed factor inputs

Fixed factors are those that do not change as output is increased or decreased, and typically
include premises such as its offices and factories, and capital equipment such as machinery and
computer systems.

Variable factor inputs

Variable factors are those that do change with output, which means more are employed when
production increases, and less when production decreases. Typical variable factors include labour,
energy, and raw materials directly used in production.

Time periods for the fi rm

The fundamental principles of production relate closely to the time periods in question, of which
there are four:

The very short run

A firm is said to be in its very short run when the only way to increase output is by using up
existing stocks of inputs.

The short run

A firm is said to be in its short run when it can increase its output by using more variable factors,
such as by hiring more workers, but not by increasing its fixed factors. In the short run firms do not
use extra fixed factors, such moving to new premises, to increase output. Therefore, in the short
run at least one factor of production is fixed.

The long run

A firm enters its long run when it increases its scale of operations. Increasing scale means that no
factor of production is fixed, and all are variable. Typically, this means that a firm expands by
building or renting larger premises, purchasing or leasing new machinery and employing more
workers.

The very long run

A whole industry enters the very long run when there is a significant change in the use of
technology. For example, the widespread use of the internet to book holidays has drastically
altered how the holiday industry is structured.
Economic analysis tends to focus only on the short and long run, and largely ignores the very
short and very long run.

Time periods for a market

A whole market can also be considered in terms of the short and long run.

The industry short run

An industry is in its short run when its capacity is fixed. This usually means that the number of
firms in the industry is fixed, with no new firms entering or leaving the market.

The long run

This exists when there is an increase, or decrease, in the capacity of the industry to produce, and
this usually means that the number of firms in a given market increases, or decreases.

Observations
What happens to productivity?

Marginal productivity is relatively low when only a few workers are employed. However, marginal
productivity rises quickly as each extra worker contributes more than the previous one. Eventually
marginal productivity begins to decline, in this case, with the employment of the fourth worker.
With the employment of seven workers marginal product is zero, and total product is at a
maximum. This means that marginal productivity is low at the extremes of output – at high and low
levels.

Product curves

It can be observed that, at first, the marginal returns curve increases and then decreases. The
marginal returns curve cuts the average returns curve when average returns are at their peak.
cost of production
Meaning and Definition
Cost of production refers to the total sum of money needed for the production of a particular quantity of output.
As defined by Gulhrie and Wallace, “In Economics, cost of production features a special meaning. It is all about
the payments or expenditures essential to get the factors of production of land, labor, capital and management
needed to produce a commodity. It signifies the money costs which are to be incurred for acquisition of the
factors of production.” In the words of Campbell, “Production Costs are the costs which should be essentially
received by resource owners so as to presume that they will continue to supply them in a specific period of time.”
Elements of Production Cost
The key elements included in the production costs are as follows:
 Purchase of raw machinery
 Installation of plant and machinery
 Wages of labour
 Building rent
 Interest on capital
 Wear and tear of building and machinery
 Advertisement expenses
 Payment of taxes
 Insurance charges
 The imputed value of factor of production owned by the firm itself is also added in the production cost.
 The production cost also includes the normal profit of the entrepreneur.

The Four Types of Market Structures

Perfect Competition

Perfect competition describes a market structure, where a large number of small firms compete
against each other. In this scenario, a single firm does not have any significant market power. As
a result, the industry as a whole produces the socially optimal level of output, because none of the
firms can influence market prices.

The idea of perfect competition builds on several assumptions: (1) all firms maximize profits (2)
there is free entry and exit to the market, (3) all firms sell completely identical (i.e., homogenous)
goods, (4) there are no consumer preferences. By looking at those assumptions, it becomes quite
obvious that we will hardly ever find perfect competition in reality. That is an essential aspect
because it is the only market structure that can (theoretically) result in a socially optimal level of
output.

Probably the best example of a market with almost perfect competition we can find in reality
is the stock market. If you are looking for more information on perfect competition, you can also
check our post on perfect competition vs. imperfect competition.
Monopolistic Competition

Monopolistic competition also refers to a market structure, where a large number of small firms
compete against each other. However, unlike in perfect competition, the firms in monopolistic
competition sell similar, but slightly differentiated products. That gives them a certain degree of
market power, which allows them to charge higher prices within a certain range.

Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2)
there is free entry, and exit to the market, (3) firms sell differentiated products (4) consumers
may prefer one product over the other. Now, those assumptions are a bit closer to reality than the
ones we looked at in perfect competition. However, this market structure no longer results in a
socially optimal level of output because the firms have more power and can influence market
prices to a certain degree.

An example of monopolistic competition is the market for cereals. There is a huge number of

different brands (e.g., Cap’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of them
probably taste slightly different, but at the end of the day, they are all breakfast cereals.

Oligopoly

An oligopoly describes a market structure which is dominated by only a small number of firms.
That results in a state of limited competition. The firms can either compete against each other
or collaborate (see also Cournot vs. Bertrand Competition). By doing so, they can use their
collective market power to drive up prices and earn more profit.

The oligopolistic market structure builds on the following assumptions: (1) all firms maximize
profits, (2) oligopolies can set prices, (3) there are barriers to entry and exit in the market, (4)
products may be homogenous or differentiated, and (5) there is only a few firms that dominate
the market. Unfortunately, it is not clearly defined what a «few firms» means precisely. As a rule
of thumb, we say that an oligopoly typically consists of about 3-5 dominant firms.

To give an example of an oligopoly, let’s look at the market for gaming consoles. This market is
dominated by three powerful companies: Microsoft, Sony, and Nintendo. That leaves all of them
with a significant amount of market power.

Monopoly

A monopoly refers to a market structure where a single firm controls the entire market. In this
scenario, the firm has the highest level of market power, as consumers do not have any
alternatives. As a result, monopolies often reduce output to increase prices and earn more profit.

The following assumptions are made when we talk about monopolies: (1) the monopolist
maximizes profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there is
only one firm that dominates the entire market.

From the perspective of society, most monopolies are usually not desirable, because they result in
lower outputs and higher prices compared to competitive markets. Therefore, they are often
regulated by the government. An example of a real-life monopoly could be Monsanto. This
company trademarks about 80% of all corn harvested in the US, which gives it a high level of
market power. You can find additional information about monopolies our post on monopoly
power.

What Is a Duopoly?
A duopoly is a situation where two companies own all, or nearly all, of the market for a
given product or service. A duopoly is the most basic form of oligopoly, a market
dominated by a small number of companies. A duopoly can have the same impact on the
market as a monopoly if the two players collude on prices or output. Collusion results in
consumers paying higher prices than they would in a truly competitive market, and it is
illegal under U.S. Antitrust law.

KEY TAKEAWAYS

 A duopoly is a form of oligopoly, where only two companies dominate the market.
 Monopolies, oligopolies, and collusion are all examples of duopolies.
 Visa and Mastercard are a duopoly that dominates the payments industry in Europe
and the United States.