Economic Notes
Economic Notes
Economic Notes
● Economics: The science which studies human behavior as a relationship between ends
and scarce means which have alternative uses.
● Circular Flow of Income: Visual model of an economy that shows how the money flows
through markets among households and firms.
o Explanation: Basically, shows how the economy works
o Households to Firms: Households provide labor to the firms as a factor of
production and that leads to the production of goods by the Firms. Firms then
sell these produced goods which are bought by the households through the
income earned as wages.
o Firms to Households: The labor provided by households is repaid in the form of
wages also known as income. This income when spent by households is
converted to revenue for firms.
DIAGRAM IS IMPORTANT TO DRAW
DIAGRAM IS IMPORTANT
● With additional resources or an improvement in Tech, the economy can produce more guns
or more wheat or their combination. Economic growth shifts the PPF outward.
● The PPF could be a straight line or bow-shaped
o If opp. cost remains constant, PPF is a straight line.
o If opp. The cost of a good rise as the economy produces more of the good, and PPF is
bow-shaped.
● The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency,
unemployment, and economic growth.
● Profit Analysis - Distinction between Accounting Profit and Economic Profit: An accountant
looks at a profit as a surplus of revenues over costs, as recorded in the books of accounts. An
accountant is interested in accounting, auditing, planning, and budgeting profit. The
accountant does not take care of implicit or opportunity costs.
● The economists are very much concerned with opportunity costs. From the accounting profit,
he takes out these implicit costs to compute his economic profit.
Economic Profit = AP - OC
= R–C -OC
C = Explicit costs
OC = Opportunity costs
● Since every decision involves a sacrifice of alternatives, the opportunity costs are implied in
any decision-making. Since in real-world decision situations, the assumption of zero
opportunity costs is a highly unrealistic one, economic profit would tend to be less than
accounting profit.
o establish objectives
o specify the decision problem
o identify alternatives
o evaluate alternatives
o select the best alternative
o implement the decision
o monitor the performance.
Internal External
Þ INTERNAL ECONOMIES:
1. Managerial Economies – functional specialization at important levels
can be introduced, such as production management, sales management,
research section, designing section, accounts department etc.
large output.
3. Financial Economies : A big firm has more credibility & can easily
raise funds. Its requirement of working capital is met very easily & at a
substantially low cost.
Loss = Rs. 1 cr
Diversification of output
Diversification of markets
Diversification of suppliers i.e. ordering raw materials & inputs from more
than one supplier
EXTERNAL ECONOMIES
Following are some of the important external economies which accrue to the firms &
reduce their costs of production:
EXTERNAL DISECONOMIES
(i) Rise in the prices of raw materials and capital goods which are in
short supply.
(iv) In the real world of scarcity, an expanding industry may create more
external diseconomies than external economies.
● Market Demand: The quantity demanded in the market is the sum of quantities demanded
by all the individual buyers at each price.
● Demand Curve Shifters: Price being a constant factor
o Buyers: If there is an increase in the number of buyers, then there is an
increase in quantity demanded and a rightward shift of the demand curve as
the price is constant.
o Income: If there is a change in the income, then there is a change in quantity
demanded and a shift of the demand curve as the price is constant.
▪ Normal Good: Increase in income causes an increase in quantity
demanded at each price. Positively related to income. Eg, a TV box
branded goods
▪ Inferior Goods: Increase in income causes a decrease in quantity
demanded at each price. Negatively related to income. Eg. LCD TV,
o Price of Related Goods: If there is a change in the price of related goods, then
there is a change in quantity demanded and a shift of the demand curve as
the price is constant.
▪ Substitute Goods: Two goods are substitutes if an increase in the
price of one causes an increase in demand for the other. Eg. Coke
& Pepsi
▪ Complementary Goods: Two goods are complements if an increase in the
price of one causes a fall in demand for the other. Eg. Computers and
Software
o Expectations: Expectations affect consumers’ buying decisions.
▪ Eg. If people expect their incomes to rise, their demand for meals at
expensive restaurants may increase now.
● Branches of economic theories:
o Theory of Demand
o Theory of Production
o Theory of Exchange / Price Theory
o Theory of Profit
o Theory of Capital & Investment
SUPPLY
● Quantity Supplied: The number of goods that sellers are willing to and able to sell.
● Law of Supply: The claim that the quantity supplied of a good rises when the price of
the good rises, other factors of supply being constant.
EQUILIBRIUM
● Equilibrium Price: The price that equates quantity supplied with quantity demanded.
DIAGRAM IS IMPORTANT
● Equilibrium Quantity: The quantity supplied and quantity demanded at the equilibrium
price. Diagram same as the equilibrium price.
ELASTICITY
● Elasticity: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of
its determinants. In simple words, elasticity is the degree of responsiveness and how
much one variable responds to change in another variable.
● Price Elasticity of Demand: It measures how much quantity is demanded in response to
a change in price.
● If the change in price or quantity is negative ( Decrease), then the minus price elasticity
will be negative. Minus signs will not be represented.
● Price Elasticity on other factors
o Price elasticity is higher when close substitutes are available.
o Price elasticity is higher for narrowly defined goods than broadly defined ones.
o Price elasticity is higher for luxuries than for necessities.
o Price elasticity is higher in the long run than in the short run.
● Rule of thumb:
o The flatter the curve, the bigger the elasticity.
o The steeper the curve, the smaller the elasticity.
● Inelastic: When the elasticity of demand is less than 1, then it is inelastic demand.
● Elastic: When the elasticity of demand is more than 1, then it is elastic demand.
● Price elasticity and Total Revenue: Price elasticity affects the total revenue in that it
governs how much more or less revenue a business will make by changing the prices of
products or services.
● To maximize sales revenue, increase the price when demand is inelastic and decrease
price when demand is elastic
● Income Elasticity: The degree of responsiveness of quantity demanded to change in
consumer income.
o Normal Goods: For normal goods, income elasticity > 0.
o Inferior Goods: For inferior goods, income elasticity < 0.
● Cross-price Elasticity of Demand: The responsiveness of quantity demand for one good
to changes in the price of another good.
o Substitutes: For substitutes, cross-price elasticity > 0
o Complements: For complements, cross-price elasticity < 0
o A firm may face any of the five situations in the short run :
▪ AR > AC (Abnormal profits )
▪ AR = AC (No profit no loss )
▪ AR > AVC <ATC (Partial losses )
▪ AR = AVC (Maximum permissible losses )
▪ AR < AVC (Shutdown situation where production Is stopped)
● Marginal Physical Product of Labor: Additional labor contribution to the total output.
o Labor contribution refers to the labor cost, it helps to make decisions regarding
the total output.
o MPL diminishes because the addition in the labor affects the fixed input i.e
capital or land
● Marginal Revenue Product of Labor: Additional labor contribution to the total sales
revenue.
o MPRL= MPL*Price of product
o Simple equilibrium in production analysis is MPRL = Labor Cost
● Marginal Cost: increase in Total Cost for producing more output, by employing one
more unit of labor.
o MC = ΔTC/ΔQ
o MC is important because when MC>MR, fall in profit. In other words, it helps us
to evaluate profit.
● Average Total Cost: equals total cost divided by the quantity of output:
o ATC = TC/Q
o equals total cost divided by the quantity of output:
o ATC = TC/Q
● All costs in the short run are fixed
● All costs in long run are divided into variable and fixed.
TR TOTAL REVENUE
TC TOTAL COST
TFC TOTAL FIXED COST
P.Q PRICE*QUANTITY
P PRICE
Q QUANTITY
F FIXED COST
V VARIABLE COST
● BREAK EVEN ANALYSIS: This represents when the level of output in the short-run, the
total revenue just covers the total costs.
o BREAK-EVEN OUTPUT
● Profit Maximization: This refers to the aim of the firm to maximize its profit.
▪ MR>MC, then increase in Q to raise profit
▪ MR<MC, then reduce Q to raise profit
● Long Run Equilibrium: P=MC=AC=AR
● Sunk Cost: A cost has already been committed and cannot be recovered. It is irrelevant
for decision-making. Example Fixed Cost
● Entry and Exit in the Long run: In the long run, the number of buyers and sellers can
change.
o If there is positive profit. New firm's market Supply shifts right. P falls, reduces
profit, and slows entry, and vice -e versa.
● Perfect Competition: Many buyers and sellers deal is dealing in homogeneous goods.
Firms can freely enter or exit the market.
o Each buyer and seller are a price taker because there are large in no. selling
Homogeneous products.
o Here MR=P, being in a competitive market firms can increase their output
without affecting the market price.
o It is an imaginative situation
o All resources & inputs are perfectly mobile. (Free entry and exit)
o Members have perfect knowledge.
- In the short run, managers of a firm should shut down the operation if price is
below average variable cost. AR<AVC(Shutdown Point).
- If price is greater than average variable cost but less than average total cost, the
firm should continue to produce in the short run because a contribution can be
made to fixed costs. ATC>AR>AVC (Partial loss).
- Over the long – run, any positive economic profits will attract new firms in the
industry or an expansion by the existing firms or both. As this happens, the
industry supply gets expanded depressing the price of the product.
P= MC = AC = AR
- When every firm is making just the normal profit, no new firms enter, none of
the existing firms quit and equilibrium prevails. The industry as such is in
equilibrium when no firm is earning above – normal profits.
o - We find that the profit – maximizing o/t does not occur at the minimum
point on the firm’s AC curve i.e. the firm is operating at an inefficient output rate.
o - However, the above result does not necessarily imply inefficiency. The
downward slope of the dd curve is the result of product differentiation in the
market. These differences are of value to consumers as they select goods that
meet their particular needs.
o -
o
● Monopoly: It has a single seller selling goods without any close substitutes.
o Firm has the market power and so is the price maker. However, the monopolist
can set either the price or the quantity but not both.
o The monopolist will operate at that level where his profits are maximum i.e.
where MR = MC
o Here there is also a possibility of price discrimination. Price discrimination is the
method of treating people differently based on some characteristics and selling
them goods at different prices. It is also possible in a monopolistic market if the
buyer is willing to pay.
o - PRICE DISCRIMINATION & CONSUMER SURPLUS :
o - First degree PD: take it or leave it PD. In negotiating with each buyer the
monopolist charges him the maximum price he is willing to pay under threat of
denying the selling of any quantity to him: he offers each buyer a ‘ take – it – or
– leave – it choice’ and tries to extract the maximum consumer surplus from the
consumers.
o
o The Cross Elasticity of demand between the product of the monopolist & the
product of any other producer is very small.
o There exist strong barriers to entry of new firms into the industry
o Downward sloping curve
● Price discrimination: Here in a monopoly, there is also a possibility of price
discrimination. Price discrimination is the method of treating people differently based on
some characteristics and selling them goods at different prices. It is also possible in a
monopolistic market if the buyer is willing to pay.
o Personal when different prices are charged from different persons.
o Local when different prices are charged from people living in different localities.
o According to use when e.g., higher rates are charged for commercial use of
electricity as compared to domestic use.
o Consumer Surplus: take it or leave it PD. In negotiating with each buyer, the
monopolist charges, him the maximum price he is willing to pay under the threat
of denying the selling of any quantity to him: he offers each buyer a ‘ take – it –
or – leave – it choice’ and tries to extract the maximum consumer surplus from
the consumers.
● Case of Dumping: This is a special case when the firm is a monopolist in the domestic
market but faces competition in the world market. Because of this condition, the
producer charges less price in the world market than in the home market.
● Bilateral Monopoly: It is a market that consist of single seller and buyer.
o The equilibrium in such a market cannot be determined by the traditional tools
of demand & supply, The precise level of the price & output will ultimately be
defined by non-economic factors, such as the bargaining power, skill & other
strategies of the participant firms.
o
● Oligopoly: It is a market structure in which only a few sellers offer similar or identical
products.
o Firm’s decision about P or Q can affect the other firms and causes them to react.
There is a cause-and-effect relationship in this market.
o OPEC is an example of an oligopoly
o
The price-output decision is one of the key management decisions. What to
produce and how much of it to sell to whom, at what price, and what
discount, if any, constitute a set of very important managerial
decisions.
a) Demand
b) Cost of production & capacity
f) Government policy
● Price skimming is the strategy where marketers charge higher price of its product and
service in the beginning, and then reduce it over time.
● Price Leadership refers to a situation where the dominant firm sets up the price of
goods or services in the market. It generally happens when the goods are
homogeneous, i.e., there is no difference in the goods or services provided by
different firms. Therefore, customers don’t have a preference and choose the
lowest price.
PRICE LEADERSHIP
2. The dominant firm price leader: The dominant firm is a relatively large firm
in the sense that it produces a very large part of the market output. Other
firms are smaller in comparison & accept the price leadership of the
dominant firm. The dominant firm knows well that the small firms will
follow its price; and hence it chooses that price where it can make
maximum profits.
3. The low cost price leader: when one firm has a substantial cost advantage
over others, it assumes the role of a price leader. If the other firms try to
wage a price war and fix their prices at still a lower level, it is conceivable that
they may lose the battle becoz their average cost is much higher than that of
the leader firm. The price leader firm with lower marginal cost, will set that
price where its MC & MR are equal. Other rival firms with higher MC, will
have to fix the same price, becoz if they fix higher prices, they will lose a
substantial share of the market.
- The kink in the demand curve stems from an asymmetry in the response
of other firms to one firm’s price change.
- The important implication of the kinked demand curve model is that firms
in oligopolistic market structures could experience substantial shifts in
marginal costs & still not vary their prices. It’s because of this that price
tends to be sticky in Oligopoly market.
● Price rigidity refers to a situation in which the price remains constant despite
changes in demand and supply conditions. Firms use other methods like
advertising, better customer services, etc., to compete with each other.
AGGREGATE DEMAND ANALYSIS
Keynesian economics is based on two main ideas. First, aggregate demand is
more likely than aggregate supply to be the primary cause of a short-run
economic event like a recession. Second, wages and prices can be sticky, and
so, in an economic downturn, unemployment can result.
Y=C+S
consumption function can be expressed as follows :
Here, C = consumption,
Y = Disposable Income.
C = a + bY
Consumption function tells us, that even when the income is zero, every
person consumes something or the other.
SAVING FUNCTION
Y=C+S
C = a + bY
S = Y – (a + bY)
= Y – a – bY = –a + Y – bY
S = – a + (1 – b) Y
MPC + MPS = 1
THREE SECTOR -
Business and Household and Government
Y = C +I + G
FOUR SECTOR -
Business and Household and Government and Foreign
Exchange
Y=C+G+I+X-M
MULTIPLIER
•A change in the autonomous variable will lead to a
change in the output which will be multiple of the
autonomous variable.
•Value of most of the multipliers is given by : k = 1/1-b
where k is the value of multiplier and b is Marginal
Propensity to Consume.
•Value of Tax multiplier is given by : kt = b/1-b
Q1. C = 40 + 0.75 Y
S/I = 60 cr.
Calculate the equilibrium level of income.
What is the level of Consumption and Saving at equilibrium.
Y=C+S
Y = 40 + 0.75 Y + 60
Y = 100 + 0.75 Y
Y – 0.75 Y = 100
0.25 Y = 100
Y = 100 / 0.25 = 400 cr.
C = 40 + 0.75 Y
C = 40 + 0.75 x 400 = 340 cr & Saving = 60 cr
Q2. The following relations represent a simple model of an open economy
.
Consumption function (C) =250+0.75Y
Investment function (I) = 65+0.15Y
G = 90 cr
X = 125 cr
M= 0.15Y
Calculate equilibrium level of Income.
Y=C+I+G+X-M
Y=250+0.75Y+65+0.15Y+90+125-0.15Y
Y=530+0.75Y
0.25Y =530
Y=530/0.25=2120
Multiplier= 1/MPS=1/0.35=2.85
Increase in GNP= (160+180)x2.85=969
Actual GNP= C+G+I+X-M=1920
GNP after change =1920+969=2889
Potential GNP = 2500
Increase in price level 2889-2500 x100 =15.5 % =2500
NATIONAL INCOME
● Y = C+G+I+X-M
○ Y= NATIONAL INCOME/ AGGREGATE DEMAND
○ C=CONSUMPTION
○ G= GOVERNMENT
○ I=INVESTMENTS
○ X= EXPORTS
○ M= IMPORTS
● Domestic: Whatever related to economy happening within the geographical
boundaries of the country.
● National: When this same happens outside the country's geographical boundaries.
● NATIONAL = DOMESTIC + NFIA
○ NFIA= Net Factor Income from Abroad
○ Salary from an Indian working in USA
● Factory Cost: Cost occurred in a factory (FC)
● Market Price: The price of the product in the market. In other words factory cost
plus profits and Taxes. (MP)
● MP = FC +Indirect Taxes - Subsidies
○ LPG, Fertilizers are certain products whose FC>MP because a lot of Subsidies
are given to these products
● GROSS DOMESTIC PRODUCT = NET DOMESTIC PRODUCT + DEPRECIATION
○ GDP: Value of good and services produced in a country
● NNP at FC = NAtional Income
Domestic Aggregates
Gross domestic Product at Market Price is the market value of all the
final goods and services produced by all producing units located in the
domestic territory of a country during an accounting year. It includes the value
of depreciation or consumption of fixed capital.
Gross National Product at Market Price ) is the market value of all the
final goods and services produced by normal residents (in the domestic
territory and abroad) of a country during an accounting year.
National Income :It is the sum total of all factors incomes which are
earned by normal residents of a country in the form of wages. rent, interest
and profit during an accounting year.
The Capital A/c (i.e. investment & other capital flows) is made up of items
involving inward and outward flow of currency for investments, and
grants & loans (such as from governments of other countries and
international institutions like the World Bank, IMF etc).
INFLATION
What is Inflation? In economics, inflation (or less frequently, price inflation) is a
general rise in the price level of an economy over a period of time. When the general
price level rises, each unit of currency buys fewer goods and services; consequently,
inflation reflects a reduction in the purchasing power per unit of money – a loss of
real value in the medium of exchange and unit of account within the economy.
Types of Inflation
The different types of inflation in an economy can be explained as follows:
Demand-Pull Inflation
This type of inflation is caused due to an increase in aggregate demand in the
economy.
Causes of Demand-Pull Inflation:
A growing economy or increase in the supply of money – When consumers feel
confident, they spend more and take on more debt. This leads to a steady increase in
demand, which means higher prices.
Asset inflation or Increase in Forex reserves– A sudden rise in exports forces a
depreciation of the currencies involved.
Government spending or Deficit financing by the government – When the
government spends more freely, prices go up.
Due to fiscal stimulus.
Increased borrowing.
Depreciation of rupee.
Low unemployment rate.
Effects of Demand-Pull Inflation:
Shortage in supply
Increase in the prices of the goods (inflation).
The overall increase in the cost of living.
Cost-Push Inflation
This type of inflation is caused due to various reasons such as:
Increase in price of inputs
Hoarding and Speculation of commodities
Defective Supply chain
Increase in indirect taxes
Depreciation of Currency
Crude oil price fluctuation
Defective food supply chain
Low growth of Agricultural sector
Food Inflation
Interest rates increased by RBI
Cost pull inflation is considered bad among the two types of inflation. Because the
National Income is reduced along with the reduction in supply in the Cost-push type
of inflation.
Built-in Inflation
This type of inflation involves a high demand for wages by the workers which the
firms address by increasing the cost of goods and services for the customers.
Also, read about Inflation Targeting in the linked article.
Remedies to Inflation
The different remedies to solve issues related to inflation can be stated as:
Monetary Policy (Contractionary policy)
The monetary policy of the Reserve Bank of India is aimed at managing the quantity
of money in order to meet the requirements of different sectors of the economy and
to boost economic growth.
This contractionary policy is manifested by decreasing bond prices and increasing
interest rates. This helps in reducing expenses during inflation which ultimately helps
halt economic growth and, in turn, the rate of inflation.
Fiscal Policy
Monetary policy is often seen separate from fiscal policy which deals with taxation,
spending by government and borrowing. Monetary policy is either contractionary or
expansionary.
When the total money supply is increased rapidly than normal, it is called an
expansionary policy while a slower increase or even a decrease of the same refers to
a contractionary policy.
It deals with the Revenue and Expenditure policy of the government.
Tools of fiscal policy
Direct Taxes and Indirect taxes – Direct taxes should be increased and indirect taxes
should be reduced.
Public Expenditure should be decreased (should borrow less from RBI and more
from other financial institutions)
To know more about the Fiscal policy in India, refer to the linked article.
Supply Management measures
Import commodities that are in short supply
Decrease exports
Govt may put a check on hoarding and speculation
Distribution through Public Distribution System (PDS).
Measurement of Inflation
Wholesale Price Index (WPI) – It is estimated by the Ministry of Commerce &
Industry and measured on a monthly basis.
Consumer Price Index (CPI) – It is calculated by taking price changes for each item
in the predetermined lot of goods and averaging them.
Producer Price Index – It is a measure of the average change in the selling prices
over time received by domestic producers for their output.
Commodity Price Indices – It is a fixed-weight index or (weighted) average of
selected commodity prices, which may be based on spot or futures price
Core Price Index – It measures the prices paid by consumers for goods and services
without the volatility caused by movements in food and energy prices. It is a way to
measure the underlying inflation trends.