MODULE 1

INTRODUCTION
TO
ECONOMICS

Compiled By: Sonal Revankar

What is an Economy / Economic System?

People and firms produce, exchange and consume
goods and services in an economy.
An economic system is a system of production and
exchange of goods and services as well as allocation of
resources in a society.
An economy can be of any size, with any number of
people and firms involved.
All economies must choose which wants to satisfy and
how they allocate the resources unlimited wants v/s
limited resources.

Basic Economic Problems

What to Produce?
How to Produce?
For whom to Produce?

PPC
The Production Possibilities Curve (PPC)
shows the different combination of two
goods that can be produced using full
employment of resources.
Also called as production possibilities
frontier.
Shows the concepts of scarcity,
opportunity costs, trade offs and efficiency

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Shift in PPC
Change in Quantity or Quality of resources
Change in Technology
Trade and Specialization

Changes in PPC when:

There are faster computers and better
technology
Destruction of power plants
High Unemployment
Better education

Types of Economic Systems

Market Economy
Command Economy
Traditional Economy
Mixed Economy

Market Economy
NO government involvement in economic
decisions. Private firms account for all
production.
Consumers decide WHAT should be
produced. They do this through the
purchases they make.
Businesses determine HOW the products will
be produced. They must be competitive.
WHO buys the products? The people with the
most money are able to buy more goods and
services.

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Command Economy
All resources are government-owned.
One person (dictator) or a group of officials
decide WHAT products are needed.
The government runs all businesses, controls
all employment, and decides HOW goods
and services will be produced.
The government decides WHO receives the
products that are produced.

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Traditional Economy
Economy is shaped largely by custom or
religion.
Customs and religion determine the WHO,
WHAT, and HOW.
Example: India has a caste system which
restricts occupational choice. (A social class
separated from others by distinctions of
hereditary rank, profession, or wealth.)

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 South America, Asia and Africa support

some traditional economies of thriving
agricultural villages. Tradition decides
what an individual does for his living, so
industry, clothing and shelter are the same
as in previous generations.

Mixed Economy
Most economies in the world today are
mixed.
Classification is based on how much
government intervention there is.
In the U.S. the government accounts for
about 1/3 of all U.S. economic activity.

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Example of Economies

Pure
Market
Economy

Mexico
U.S.

Sweden

Russia

Pure
Command
Economy

Mainland North
Korea
China

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Government Philosophies

Countries also have different

philosophies of government which reflect
not only the laws and rules, but how
individuals are treated.
There are three political philosophies:
1. Capitalism
2. Socialism
3. Communism

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Capitalism
Capitalism features private ownership of
businesses and marketplace competition.
It is the same as a free enterprise
system.
The political system most frequently
associated with capitalism is democracy.

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Socialism
The main goal of socialism is to keep prices low
for all people and to provide employment for
many.
The government runs key industries, generally in
telecommunications, mining, transportation, and
banking.
Socialist countries tend to have more social
services.

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Communism
Have a totalitarian form of government; this
means that the government runs everything and
makes all decisions.
Theoretically, there is no unemployment in
communist countries.
The government decides the type of schooling
people will receive and also tells them where to
live.

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Economies in Transition
Many countries are in transition from either
communism or socialism to capitalism.
Privatization is a common aspect of transition
from a command economy to free enterprise
system. Privatization means state-owned
industries are sold to private individuals
and companies.

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What is Economics?
The word Economics was derived from
two Greek words, oikos (a house) and
nemein (to manage) which would mean
managing an household using the limited
funds available, in the most satisfactory
manner possible.

 Economics is a science of management of

limited resources with the unlimited wants
of human beings
It includes production, distribution
(exchange) and consumption of goods
and services

Economics definitions

Wealth definition by Adam Smith

Welfare definition by Alfred Marshall
Scarcity definition by Lionel Robbins
Growth definition by Prof. Paul Samuelson

Nature of Economics
Economics is a science or art?
Economics as social science.
Economics as positive science or
normative science.
Methodology of economics.
Economics as a subject matter.

Scope of Economics

Micro economics
Macro economics
International economics
Public finance
Development economics
Health and education
economics
Environmental economics
Urban and rural economics

Managerial Economics
Managerial economics is the application of
economic theory and methodology to
decision making process within an
enterprise.
It refers to those aspects of economic
analysis which are relevant to the practice
of management processes in a business
organisation.

 According to Spencer and Siegalman,

Managerial Economics is the integration of
economic theory with business practice for
the purpose of facilitating decision making
and forward planning by the
management.

ME as micro economics
Micro economics is a study of particular
firm, household, individual price, wage,
income, industry and particular commodity.
It is defined as study of economic activities
of consumers, resource owners and
business firms

 Macro economics deals not with individual

quantities but with aggregates of these
quantities, not with individual income but
with national income, not with individual
prices but with price levels, not with
individual outputs but with the national
output

Features of ME
New discipline
Separate branch of economics
Micro (Internal to firm) and Macro(External) in
nature
Pragmatic provides solutions
Normative science prescriptive rather than
descriptive
Science of decision making
Study of allocation of resources
Related to other subjects- Statistics, Accounts,
Mathematics etc

Scope of ME/ Applications of ME

Demand Analysis
Production and Cost analysis
Pricing decisions, policies and practices
Capital management
Profit management

Demand Analysis
Demand Analysis estimate future demand by
taking into consideration income, price and
substitution elasticity, demand determinants,
demand distinctions and demand forecasting.
Demand Theory can help in making the choice
of commodities, finding the optimum level of
production and determining the price of the
product.

Production and Cost analysis

Production theory explains the relationship
between inputs and outputs, maximization of
output, optimum size of the output , helps in
determining the size of a firm, size of output,
amount of capital and labor to be employed
Physical terms of production
Cost Theory Cost ascertainment, cost control
and cost reduction, cost and output relation,
economies of scale- Monetary terms of
production.

Pricing decisions, policies and practices

Pricing theory- what price to charge under
different market conditions, price discrimination,
extent of advertising.

Capital Management
Choice of investment project
Assessing the efficiency of capital.
Most efficient allocation of capital.

Profit management
Profit is the primary measure of success
How to make profit under uncertainity
Profit planning, profit management and
profit measurement.

Objectives of ME
Decision Making
Forward Planning
Problem Solving

Decision Making
Business decision making is essentially a
process of selecting the best out of
alternative opportunities open to the firm.
What should be the price of a product?
What should be the size of the firm?
How many workers should be employed?

Process of decision making

1) Determining and defining the objective to
be achieved
2) Collection and analysis of related dataeconomic, social, political, technological etc
3) Inventing, developing and analyzing the
possible courses of action
4) Selecting a particular course of action
from the available alternatives

Forward planning
Forward planning means establishing the
plans for the future.
Uncertainty v/s forward planning
Forward planning is for the future
Decision making and forward planning are
closely associated.

Problem solving process

Identify and define the problem.

Problem analysis
Generating possible solutions
Analyzing the solutions
Selecting the best solution

Fundamental concepts of managerial

economics

Opportunity cost
Incremental cost / Marginal Principle
Discounting principle
Equi- marginal principle
Time perspective

Opportunity cost
The opportunity cost of availing an
opportunity is the foregone income
expected from the second best opportunity
of using the resources.(Sacrifice of
alternatives)
Arises due to alternative use of resources
Difference between actual earning and
opportunity cost is called economic gain or
economic profit.

Example
Alternative 1: Expansion of size of the firm
Rs 20 million
Alternative 2: Setting up of a new
production unit Rs 18 million
Alternative 3 : Buying shares in another
firm Rs 16 million

Incremental costs
An increase in the total cost of production
due to business decisions.
Example
Incremental revenue, incremental output,
incremental reasoning
Incremental cost includes
Present / Explicit costs- fixed and variable
Opportunity cost
Future costs

Example
Cost

Revenue

Profit

Existing

100 crores

130 crores

30 crores

New

115 crores

150 crores

35 crores

Incremental

15 crores

20 crores

5 crores

Incremental principle
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii It reduces costs more than revenues.
MR-MC= MP
Incremental v/s Marginal difference

Discounting principle
The mathematical technique for adjusting for the
time value of money and computing present
value is called discounting.
for making a decision in regard to any
investment which will yield a return over a period
of time, it is advisable to find out its net present
worth. Unless these returns are discounted and
the present value of returns calculated, it is not
possible to judge whether or not the cost of
undertaking the investment today is worth.

Equi- marginal principle

Equi- marginal principle is applied by the
business managers for allocation of
resources between alternative uses with a
view to maximizing profit in case a firm
carries out more than one business activity
The marginal productivity gains (MP) from
the various activities are equalized.

Example

Time perspective
The time perspective concept states that
the decision maker must give due
consideration both to the short run and
long run effects of his decisions.
Variable factors of production can be
changed in the shortrun but fixed factors
can be altered only in the long run.

Example
Suppose, a firm having a temporary idle capacity, received an
order for 10,000 units of its product. The customer is willing to
pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but
no more.
The short run incremental cost (ignoring the fixed cost) is only
Rs. 3.00. Therefore, the contribution to overhead and profit is
Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm
executes this order, it will have to face the following
repercussion in the long run:
(a) It may not be able to take up business with higher
contributions in the long run.
(b) The other customers may also demand a similar low price.
(c) The image of the firm may be spoilt in the business
community.
(d) The long run effects of pricing below full cost may be more
than offset any short run gain.

Assignment -1
Explain the scope of Economics.
Explain the importance of Managerial
Economics.
What is the relationship of ME with other
disciplines?
Give one example each and explain the
fundamental concepts of ME
What are the applications of PPC?