1. PRINCIPLES OF ECONOMICS AND THINKING LIKE AN ECONOMIST

NILKANTH ATHALYE

REFERENCE BOOKS

1. ECONOMICS : Principles and Applications by Mankiw ( Cengage Learning )

2. ECONOMICS : Special Indian Edition by Samuelson & Nordhaus ( Mc Graw Hill )

Definitions of Economics•Economics is a study of how societies

( national and international ) manage their resources.

•Economists study how people (and organizations, which are essentially made up of people ) make decisions ; how much they work, what they buy, how much they save and how do they invest their savings.

•Economists also study the regulations of the government and their policies which can affect the behavior of people and organizations.

What does Economics Guide?

1. What to produce2. How much to produce 3. For whom to produce

Some Noteworthy Economists

1. Adam Smith ( 1776 )2. T. R. Malthus ( 1798 )3. Karl Marx ( 1867 )4. J. M. Keynes ( 1936 )5. Modern Mainstream Economists.

Principles of Economics(A) How people make decisions

1. People face trade-offs. ( Sacrificing something to get something , since resources are scarce)

2. Cost of something is what you give up to get it. ( The opportunity cost of an item is what you give up to get that item. No free lunches )

3. Rational people think at the margin. (Comparison of marginal costs and marginal benefits )

4. People respond to incentives ( and disincentives like taxes )

Principles of Economics(B) How people interact

1. Trade can make everyone better off. (Specialization in what one does best.)

2. Markets are usually a good way to organize economic activities. ( In a market economy, millions of firms and households decide and not only one central planner : This is what is called the invisible hand.) .

3. Governments can sometimes improve market outcomes. (Markets work only if property rights are enforced and protected. The invisible hand may not ensure distribution of prosperity equally) Externalities like pollution.

Principles of Economics( C ) How economy as a whole works.

1. A country’s standard of living depends on its ability to produce Goods and Services. (Productivity of its workers )

2. Prices rise when the government prints too much money. ( growth in money supply causes inflation)

3. Societies face a short-run Trade -off between Inflation and Unemployment. (Increase in money supply increases the demand for goods and services, which causes producers to hire more people and produce more. Thus unemployment is reduced, but prices go up.)

Economist as a scientist

• Economists devise theories, collect data and then analyze the data in an attempt to verify or refute their theories.

• While observing, economists have to make do with whatever the world happens to give them, as they can not recreate an economy in a lab.

• Economists make assumptions to simplify the complex world and make it easier to understand . This helps to focus on the essence of the problem.

• Economists also use models to learn about the world. This simplifies the reality to improve our understanding of it.

THE CIRCULAR FLOW MODEL

1. Goods and Services produced by a Firm are bought by Households, who in turn, supply Labor, Land and Capital to the Firms, as input Factors of Production.

2. Wages, Rent and Profits of the Firms go back to the Households, in the form if their Income, which in turn goes to buy the Goods and Services sold by the Firm, constituting the Firm’s Revenue.

PRODUCTION POSSIBILITIES FRONTIER

• Given the Economy’s resources (which are not unlimited), the economy can produce any combination of products on or inside the frontier, not beyond it.

• This is feasible because people tend to trade off.• Also the cost of producing one item is the

opportunity cost of not producing another item.• The PPF curve is bowed outwards because of

the diminishing marginal utility of any item.• Technological advance can shift the PPF

outwards.

MACRO & MICRO ECONOMICS

1. Macroeconomics is the study of economy-wide / country-wide phenomena. ( effect of borrowing by the central government, growth rate of the economy, changes in the rate of unemployment, regulatory policies of the government etc.)

2. Microeconomics is the study of how Households and Firms make decisions and how they interact in specific markets. (Effect of competition on a company, rent control laws affecting availability of housing in a city, increase in household consumption because of lower prices etc. )

Diminishing Returns

1. Diminishing Marginal Returns.2. Diminishing Marginal Utility.3. Diminishing Marginal Productivity.