Economics

• Economy – “oikonomos” (Greek)

– “One who manages a household”
• Economy is composed of households and
firms.
• Economics is the study of how households
and firms make decisions under scarcity
– Scarcity – all resources are scarce (finite)
• Decisions about how to use them implies
tradeoffs are involved
1
Adam Smith & Alfred Marshall on Economics
The founding of modern Western Economics is
generally credited to the publication of Scottish
philosopher Adam Smith's (widely regarded as
the father of modern economics) 1776 book, An
Inquiry Into the Nature and Causes of the Wealth
of Nations. into four divisions i.e. consumption,
distribution, production and exchange of wealth.
(Wealth refers to the accumulation of resources.)
Alfred Marshall defines economics as “a study of
humans as they live and move and think in the
ordinary business of life.”
The economy devil that we don’t know
There is a fundamental problem of demand today. At the core of it is incomes that aren’t rising enough
13 August 2019 | India traditionally never had a demand problem. On the contrary, its
economy was always supply-constrained. Proof of no demand paucity is that between
2000-01 and 2015-16, domestic consumption of both finished steel and cement roughly
trebled, from 26.3 million tonnes (mt) and 92 mt, to 81.5 mt and 269 mt, respectively.
During the same period, annual sales of passenger vehicles quadrupled (from 6.9 lakh to
27.9 lakh), while growing 4.5 times in the case of two-wheelers (from 36.3 lakh to 164.6
lakh) and five times for commercial vehicles (from 1.4 lakh to 6.9 lakh). Also, the total air
passengers flown jumped nearly 10 times (from 14 million to 135 million) and the number
of telephone connections 30-fold (from 36.3 million to 1059.3 million). Supply not keeping
up with demand — recall those long waiting periods for telephones, LPG connections and
Bajaj Chetak scooters — was also manifested in inflation. Annual retail food inflation during
the Nineties, and even the 10 years from 2006-07 to 2015-16, averaged 9.8 per cent. Not
surprisingly, “supply management” measures — be it stocking limits under the Essential
Commodities Act, export bans, zero-duty imports or selective credit control to restrict bank
finance against cereals, pulses, sugar, oilseeds and raw cotton — were par for the course.
All this has changed in the last three years or less. The certainty that producers once
enjoyed — of finding buyers for their wares without doing much beyond minor price
adjustments to bring supply and demand into equilibrium — has ceased to exist….
 Economics Revolves Around
• Scarcity - limited nature of society’s resources
• Economists study:
– How people make decisions
– How people interact with one another
– Analyze forces and trends that affect the
economy as a whole

4
Ten Principles of Economics By N. Gregory Mankiw

How People Make Decisions

1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
5
The circular flow
This diagram is a
schematic representation
of the organization of the
economy. Decisions are
made by households and
firms. Households and
firms interact in the
markets for goods and
services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of
arrows shows the flow of
dollars, and the inner set of
arrows shows the
corresponding flow of
inputs and outputs.
6
 How People Make Decisions
Principle 1: People face trade-offs
• Making decisions
– Trade off one goal against another
– Society
• National defense vs. consumer goods
• Clean environment vs. high level of income
• Efficiency vs. equality

7
 How People Make Decisions
Principle 1: People face trade-offs
• Efficiency
– Society - maximum benefits from its scarce
resources
– Size of the economic pie
• Equality
– Benefits - uniformly distributed among
society’s members
– How the pie is divided into individual slices
8
 The production possibilities frontier

Quantity of
Computers The production possibilities
Produced frontier shows the
combinations of output - in
C this case, cars and
3,000 F
computers - that the
Production
economy can possibly
A Possibilities
2,200 produce.
B Frontier
2,000 The economy can produce
any combination on or
inside the frontier.
D Points outside the frontier
1,000
are not feasible given the
E
economy’s resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
9
 The Economist as a Scientist
• Efficient levels of production
– Economy’s getting all it can
• From the scarce resources available
– Points on the production possibilities frontier
– Trade-off:
• The only way to get more of one good
• Is to get less of the other good
• Inefficient levels of production
– Points inside production possibilities frontier
10
 How People Make Decisions
Principle 2: The cost of something is what you
give up to get it
• People face trade-offs
– Make decisions
• Compare cost with benefits of alternatives
– Opportunity cost
• Whatever most be given up to obtain one item
• PPF – Opportunity cost is what you give up as you
produce more of another good

11
 How People Make Decisions
Principle 3: Rational people think at the margin
• Rational people
– Systematically & purposefully do the best
they can to achieve their objectives
• Marginal changes
– Small incremental adjustments to a plan of
action
• Rational decision maker – take action only if
– Marginal benefits > Marginal costs
12
 How People Make Decisions
Principle 4: People respond to incentives
• Incentive
– Something that induces a person to act
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

13
 Incentives for Firms

• First Law of Supply:

• the higher the market price the greater the
quantity supplied by each firm
 Incentives - Consumers

• First Law of Demand

– The higher the price, the lower is quantity
demanded
 How People Interact
Principle 5: Trade can make everyone better off
• Trade
– Specialization
• Allows each person/country to specialize in the
activities individually they do best
– People/countries can buy a greater variety of
goods and services at lower cost

16
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Communist countries – central planning
– Government officials (central planners)
• Allocate economy’s scarce resources
– Decided
» What goods & services were produced
» How much was produced
» Who produced & consumed these goods & services
• Theory: only the government could organize
economic activity to promote economic well-
being for the country as a whole 17
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Market economy - allocates resources
– Decentralized decisions of many firms and
households
– As they interact in markets for goods and
services
– Guided by prices and self interest
– Adam Smith’s “invisible hand”
18
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• We need government
– Enforce the rules
– Maintain institutions - key to market economy
• Enforce property rights
• Property rights
– Ability of an individual to own and exercise
control over scarce resources
19
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• Government intervention
– Change allocation of resources
– To promote efficiency
• Avoid market failure
– To promote equality
• Avoid disparities in economic wellbeing

20
 How People Interact
• Market failure
– Situation in which the market on its own fails
to produce an efficient allocation of resources
• Causes for market failure
– Externality
• Impact of one person’s actions on the well-being
of a bystander
– Market power
• Ability of a single person (or small group) to
unduly influence market prices
21
 How People Interact
• Disparities in economic wellbeing
– Market economy
• Rewards people - ability to produce things that
other people are willing to pay for
– Government intervention
• Public policies
– May diminish inequality
– Process far from perfect

22
The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
 HOW THE ECONOMY AS A WHOLE WORKS
Principle 8: A country’s standard of living depends
on its ability to produce goods & services.

• Huge variation in living standards across

countries and over time:
– Average income in rich countries is more than ten
times average income in poor countries.
– The U.S. standard of living today is about
eight times larger than 100 years ago.

TEN PRINCIPLES OF ECONOMICS 24

IIT along with 7 institutions to use technology to
improve lives of people in Rajasthan's Sirohi
IIT Jodhpur along with 7 other institutions will be using innovative technologies for the improvement
of lives of people in Rajasthan's Sirohi.
India Today (August 2019 Edition )| The Indian Institute of Technology, Jodhpur, in partnership with seven other
institutions will employ innovative technologies to improve the lives of the people of Sirohi, one of the most backward
districts of Rajasthan.
The initiative described as Scientific Social Responsibility
Director of the IIT, Jodhpur, Santanu Chaudhury, said technologies like AI, Internet of Things (IoT), Big Data Analytics,
sensors, and drones will be used in areas of health, agriculture, solar energy, drinking water and communication
facilities to improve the lives of the people.
The initiative is being described as Scientific Social Responsibility (SSR).
Taking it up as a model project, the IIT has already begun work in the district and based on the success of the model, it
will be replicated in the districts of Dholpur, Karauli, Baran, and Jaisalmer in the future.
This is our commitment under Scientific Social Responsibility to improve the living standard of the people of Sirohi by
addressing problems plaguing the area and the people thereby harnessing modern technologies, said Chaudhury.
The primary objective is to improve the working conditions of workers
The foremost issue is tackling the widespread occupational hazard of silicosis.
IIT, AIIMS, and CSIR-IGIB Delhi would be working together
The IIT, AIIMS and CSIR-IGIB Delhi would be working together in devising an AI engine to distinguish between TB and
silicosis by way of augmenting doctors' ability, said Chaudhury, adding this augmentation would speed up diagnosis.
He said the endeavor is to build a predictive mechanism with a view to preventing silicosis. Besides this, other
initiatives are improving the quality of soil and its productivity, AI-based plant disease diagnosis and solar trees to
provide electricity.
We are looking at this project on a continuous basis so that we can get involved in the development of one aspirational
district as part of SCR, he said.
 HOW THE ECONOMY AS A WHOLE WORKS
Principle 8: A country’s standard of living depends
on its ability to produce goods & services.

• The most important determinant of living

standards: productivity, the amount of goods
and services produced per unit of labor.
• Productivity depends on the equipment, skills,
and technology available to workers.
• Other factors (e.g., labor unions, competition
from abroad) have far less impact on living
standards.
TEN PRINCIPLES OF ECONOMICS 26
 HOW THE ECONOMY AS A WHOLE WORKS
Principle 9: Prices rise when the government
prints too much money.
• Inflation: increase in the general level of prices.
• In the long run, inflation is almost always caused
by excessive growth in the quantity of money,
which causes the value of money to fall.
• The faster the govt creates money,
the greater the inflation rate.

TEN PRINCIPLES OF ECONOMICS 27

 HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run tradeoff
between inflation and unemployment
• In the short-run (1 – 2 years),
many economic policies push inflation and
unemployment in opposite directions.
• Other factors can make this tradeoff more or
less favorable, but the tradeoff is always
present.

TEN PRINCIPLES OF ECONOMICS 28

CHAPTER SUMMARY

The principles of decision making are:

• People face tradeoffs.
• The cost of any action is measured in terms
of foregone opportunities.
• Rational people make decisions by
comparing marginal costs and marginal
benefits.
• People respond to incentives.
29
CHAPTER SUMMARY

The principles of interactions among people

are:
• Trade can be mutually beneficial.
• Markets are usually a good way of
coordinating trade.
• Govt can potentially improve market
outcomes if there is a market failure or if
the market outcome is inequitable.
30
CHAPTER SUMMARY

The principles of the economy as a whole are:

• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of
inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.

31