Scarcity Trade-off and Opportunity Cost
Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.
Economics is essentially a behavioural or social science and studies how people make choices.
There are two main economic actors
- Consumers: Buyers of Goods and Services & Suppliers of Labour (decisions: what to buy, how much to spend, whether to work, how many hours to work)
- Producers: Owners of Capital, machinery, equipment and produce goods and services (what to produce, how much to produce, how to produce, where to locate)
Microeconomics deals with decisions of
- What (and How much) Goods and Services to produce
- How to produce those Goods and Services
- For whom to produce those Goods and Services
Central Themes of Economics:
- Trade-off & Opportunity cost
- Scarcity
- Marginalism
- Constrained Optimization: Constraints imposed by nature and previous generations: some countries have fertile lands and natural resources; previous generation endowed you with knowledge, technology, productive factories OR the opposite.
Opportunity cost: The full “cost” of making a specific choice includes what we give up by not making the alternative choice. The best alternative that we forgo, or give up, when we make a choice or a decision is called the opportunity cost of that decision.
- e.g., how much a movie costs: Direct cost of Movie ticket price + Opportunity cost: Time spent watching movie in which you could have done something else (or wage you could have earned in that time by working)
- Cost of attending college: Direct cost of Tuition + Opportunity cost of Income you could have earned by working somewhere full time.
- For a firm that buys $1000 worth of machinery: opportunity cost: $1000 could have been deposited in an account to earn interest
WHY OPPORTUNITY COST ARISES
Because Resources are SCARCE (LIMITED)
Most important and scarce resource is TIME. Since there are only 24 hrs in a day, I must decide whether to go and study or work an extra hour somewhere.
MARGINALISM
The process of analysing the additional or incremental costs or benefits arising from a choice or decision.
In economics when we Measure costs and benefits of a decision, we look at ONLY the costs and benefits that arise from the DECISION.
THINKING ON THE MARGIN:
Example: Cost and benefit of visiting New York and meeting Mom: Flying home (return air ticket) + Time spent meeting mom. Instead suppose college trip goes to New Jersey, then the cost of visiting Mom would only be additional ticket to be spent from New Jersey to ney York and the marginal time.
Sunk cost: Costs that cannot be avoided because they have already been incurred.
Restaurant with 100 seats: 99 filled: Sunk cost: machines, tables, chairs, equipment, food prepared. Then Cost of feeding one additional seat is almost 0. (marginal cost)
For an airplane that is about to take off with empty seats, the marginal cost of an extra passenger is essentially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger.
Marginal Benefit: Suppose on Studying 2 hrs everyday GPA is 7, Studying 2.5 hrs everyday raises GPA to 8. Then, the Marginal Benefit of studying 30 minutes extra every day is 1 grade point.
Modelling Economic Decisions
- Economic actors: Consumers and Producers
- Relationship between 2 or more variables is known as a Model: Economic models are not precise like science models and can only capture insights based on assumptions.
Consumers:
Maximise satisfaction, i.e., make themselves as well off as possible: Constrained by their income and wealth (Budget constraints).
Firms:
Maximise profit, constrained by Demands of consumers as well as input costs. (What the consumer wants me to make and how much it costs me to make it)
Answering the Three fundamental questions of Microeconomics
What goods and services should be produced?
How to produce those Goods & Services?
Who gets them?
All three of these questions are all solved by the key variable “PRICES” in the economy.
Consumer and firms will interact in a market > Emerges a set of prices > Decides all 3
Example:
What to produce: Will people be willing to pay for an iPhone: what price?
How to make the iPhone: what country is what cheapest: shop for inputs: price of inputs
Who’s going to get the iPhone? whoever is willing to pay the price that the firm decides to charge.
Microeconomics & Macroeconomics
Microeconomics looks at the individual unit—the household, the firm, the industry for their economic decisions regarding production, prices, income, employment.
Macroeconomics looks at the aggregate of those choices for total production (GDP), price level, Personal income and Overall employment.
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Positive Economics and Normative Economics
Positive economics is an approach to economics that seeks to understand behaviour and the operation of systems without making judgments. Positive economics only describes what exists and how it works.
E.g. what determines the wage rate for labour? or What would happen if we abolished the income tax?
Normative economics is an approach to economics that analyses outcomes of economic behaviour, evaluates them as good or bad, and may prescribe courses of action. Normative economics is also known as policy economics since it looks at the outcomes of economic behavior and asks whether they are good or bad and whether they can be made better. Normative economics involves judgments and prescriptions for courses of action.
E.g.: Should the government subsidize education? Should the government regulate the cost of petroleum products?
Ockham’s razor: The principle that irrelevant detail should be cut away.
While building economic models, abstraction helps in analysing specific aspects of behaviour however, too much abstraction can also lead to an over simple model that lacks social and political reality. Thus, even though economic theory is used for making actual government policies, underlying political and social conditions must be ascertained for a sound policy making.
To isolate the impact of one single factor, we use the device of ceteris paribus, or all else equal. Ceteris paribus (meaning all else equal) is a device used to analyse the relationship between two variables while the values of other variables are held unchanged.
E.g.: “What is the impact of a change in pulses price on eating behaviour, ceteris paribus, or assuming that nothing else changes?”
Economic Systems
Command economy is an economy in which a central government either directly or indirectly sets output targets, incomes, and prices. In a pure command economy, the basic economic questions are answered by a central government. Through a combination of government ownership of state enterprises and central planning, the government, either directly or indirectly, sets output targets, incomes, and prices.
At the opposite end of the spectrum from the command economy is the laissez-faire economy.
The term laissez-faire, in French means “allow [them] to do,” implies a complete lack of government involvement in the economy. In this type of economy, individuals and firms pursue their own self-interest without any central direction or regulation; the sum total of all individual decisions ultimately determines all basic economic outcomes. The central institution through which a laissez-faire system answers the basic questions is the market, an institution through which buyers and sellers interact and engage in exchange. The behaviour of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it.
Mixed Economies: Both these pure forms do not exist in the world; all real systems are in some sense “mixed.” That is, individual enterprise exists and independent choice is exercised even in economies in which the government plays a major role.
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