Economic Analysis for Business Decisions

What is ECONOMICS about?

T.J. Joseph

Why Study Economics?

Understanding the behavior of economic agents

in a better way
To understand how business work and how business

can be made more efficient and profitable

Illustration take any business concern

(Example: Tata Motors)

Adam Smith Father of Economics

(Wealth of Nations)
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Why Study Economics?

Economics helps to solve complex problems that are

great importance to society

Economists are concerned with WHY THE WORLD

IS WHAT IT IS ?
Examine how individuals and firms make decisions

about consumption, investment, pricing, etc.

The Economic Problem

Two general observation: (1) Resources are limited. What are resources? (2) Human wants are abound/unlimited

Scarcity We cannot have everything we want all

the time
Scarce Resources - not enough to satisfy all wants So choices have to be made Any choice involves an opportunity cost - the value of

the best alternative foregone

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Scarcity and Choice

Unlimited Wants (Scarce goods)
Food (bread, milk, meat, eggs, vegetables, coffee, etc.) Clothing (shirts, pants, sarees, shoes, socks, coats, sweaters, etc.) Household (tables, chairs, sofas, beds, goods dressers, television sets, etc.) Space exploration Education National defense Recreation Leisure time Entertainment Clean air Pleasant (trees, lakes, rivers, environment open spaces, etc.) Pleasant working conditions Land Natural Resources

Limited Resources
(various degrees of fertility) (rivers, trees, minerals, oceans, etc.)

Non-human animal resources

Human resources

(the knowledge, skill, and talent of individuals)

Machines and other human-made physical resources Technology

Fundamental Economic Questions

Scarcity and choice raises several unavoidable questions to the society
What to produce?

More guns or more breads? More books or more movies?

How to produce? (optimization)

Use more labour and less machines?

For whom to produce (distribution)

Distribute equally? Then on what basis?

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Economics Defined
Economics is the study of how people cope with

scarcity Economics deals with the problem of how to allocate the limited resources among competing wants in order to satisfy as many of those wants as possible

Scarcity Necessitates Rationing

Every society must have a means to ration scarce resources among competing uses. In a market setting, price is used to ration goods and resources. When price is used, the good or resource is allocated to those willing to give up other things in order to obtain ownership rights.

Emergence of Markets
Markets (and its components) emerge in direct
response to scarcity.
In a market, people exchange things that they like less

or have more, for things they like more or have less

Reallocation of their resources and enhance their

individual welfare

Fundamental Economic Questions

How shall we answer the three basic economic

questions?
Shall we allow for individual freedom of choice? Or

shall we make all these decisions collectively?

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Economic Systems

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Alternative Economic Systems

The nature of economic system depends on
how the fundamental economic questions are resolved and
who coordinates the decisions

Two extremes are Market and Command Economies

In between lies the widely prevalent Mixed Economy

a mix of command and market economies

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Market Economy
Market mechanism or Price mechanism coordinates the decision making of various economic agents
Also known as Free-enterprise economy one in

which government does not control economic activity

The three fundamental economic questions are solved

by the price mechanism (through demand and supply)

Adam Smith and Invisible Hand
Perfectly competitive market
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Command Economy
Also known as Centralized economy The determination of What, How, For Whom goods &

services are produced is done by

a dictator or a planning committee appointed by the dictator or using a hierarchical organizational structure

State owns all the productive resources like land,

factories, financial institutions, etc

Authoritarian methods are used to determine resource

use and prices

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Mixed Economy
Most of the world economies use a mix of both

market and command systems

The government modifies (through taxes, subsidies,

etc.) and in some cases replaces (through direct control of resources) the operation of price mechanism

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Economics A Social Science

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Economics as a Social Science

What differentiate economists from other social

scientists?
Economic analysis is based on certain presupposition

about human behavior

Tries to understand why the world is what it is
Example (propositions enabling Law of Demand):

People prefer more to fewer; people seek to maximize welfare by making reasonable and consistent choices

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Developing Economic Theories

The real world of economic is very complex, therefore,

economists turn to theory

A theory is a set of abstractions about the real world Economic theories are simplified models abstracted

from the complexity of the real world

Tries to explain observed behavior and make

predictions about the future

Assumption of Ceteris paribus (other things remain the

same)
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Positive and Normative Economics

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Positive Economics
The scientific study of what is, what was and what

will be the economic relationships

Explanation and prediction (deals with actual

observed phenomena); can be proven right or wrong.

Example:
The inflation rate rises when the money supply is increased What will be the impact of an import quota on foreign cars?

What will be the impact of an increase in the excise tax on petroleum products?

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Normative Economics
What ought to be (deals with opinions and

recommendations); reflects value judgments.

Normative statements reflect subjective values. They

cannot be proved true or false.

Example: The inflation rate should be lower.

The two can be hard to disentangle.

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Common Mistakes
Pitfalls to Avoid in Economic Thinking

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Three Pitfalls
Violation of the ceteris paribus condition.
Ceteris paribus is a Latin term meaning other things constant.
When describing the effect of a change, the outcome may be influenced by changes in other things.

Association is not causation.

Statistical association alone cannot establish causation.

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Three Pitfalls
Fallacy of composition
The fallacy of composition is the erroneous view that what is true for the individual (or the part) is also be true for the group (or the whole). Microeconomics focuses on narrowly defined units, while macroeconomics is focused on highly aggregated units.
One must beware of the fallacy of composition when shifting from micro-to macro-units.

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Microeconomics and Macroeconomics

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Microeconomics and Macroeconomics

Microeconomics is the study of economics at the level

of the individual economic entity Examples: the behavior of individual consumer, individual firm, etc.
Macroeconomics deals with the sum of the behaviour

of all economic entities together (the economy as a whole or about economic aggregates)

Examples: Study of national income (GDP), employment, Inflation (price level), etc.
T.J. Joseph 26

Micro Vs. Macro

Microeconomics

Studies the economy at the level of individual consumers, workers, firms, goods, and markets
Macroeconomics

Studies the economy at the aggregate level, at the level of the economy as a whole.

Examines total consumer behavior, total employment, total production, total sales, etc.
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The Production Possibilities Curve

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Basic Concepts
Opportunity cost: the value of the highest-valued

alternative that must be forgone when a choice is made

Marginalization (Marginal benefits and costs): the

benefits and (opportunity) costs associated with one additional unit of the good.

Decision Making
Decision-making is the main job of management It involves evaluating various alternatives and

choosing the best among them

Decision making is done at the margin

Decision makers evaluate a fixed array of alternatives.
Decision makers compare the marginal costs to marginal benefits to determine the best alternative This is economic decision making.

Production Possibilities Curve

Production Possibilities Curve (PPC) is used to

illustrate the tradeoffs facing a society

PPC shows the maximum quantity of goods and

services that can be produced using limited resources to the fullest extent possible
PPC shows that more of one type of good can be

produced only by reducing the quantity of other types of goods that are produced

Production Possibilities
Defense Goods
Only defense goods produced

Defense
A1 B1 C1 D1 200 175 130 70 0 130 200

Non-defense
0 75 125 150 160 25 75

200 175 150 125

Underutilized (Inefficient)

A1

G1 B1

E1 F1 G1

F1

C1

Efficient Combinations

100 75 0
D1 E1
Only nondefense goods produced

25 50 75 100 125 150

Nondefense Goods

Growth
The PPC moves outward (growth occurs) as the result of: Increased labour resources Larger labor force Change in labor force participation

Chance in labor-leisure decision

Improved technology (innovation) Expansion of capital stock An improvement in the rules (laws, institutions, and policies) of the economy

A Shift of the PPC

Defense Non-defense 0 75 120 150 160 165

225 A2
Defense Goods

A2

225 200 175 130 70 0

200 175 150

A1

B2 B1 C2

B2 C2 D2 E2 F2

C1

125 100 75 0 25
D1

D2

E2
F2
Nondefense Goods

E1

50 75 100 125 150

Marginal Opportunity Cost

The shape of the PPC illustrates the relative cost of

moving productive resources from one activity to another.

The marginal opportunity cost is the amount of one

good or service that must be given up to obtain one additional unit of another good or service.
The PPC bows outward because there are ever-

increasing marginal opportunity costs to the production of any good.

Marginal Costs
To increase its production of nondefense goods, society is must give up ever-increasing amounts of defense goods..

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Questions for Thought

The government should provide goods such as health care, education, and highways because it can provide them free. -- Is this true or false?

Questions for Thought

1. Which of the following are positive economic statements and which are normative?
(a) The speed limit should be lowered to 55 miles per hour on interstate highways to reduce the number of deaths and accidents (b) Higher gasoline prices cause the quantity of gasoline that consumers buy to increase. (c) A comparison of costs and benefits should not be used to assess environmental regulations. (d) Taxes on alcohol result in less drinking and driving.

Questions for Thought

1. Suppose Amy is a doctor who has records that need to be entered. Doing this work herself would take 10 hours per week. She is contemplating hiring an assistant could do the same work in 40 hours. If Amy can make $80 per hour seeing patients, should she hire the assistant at $10 an hour? 2. Do you make the food that you consume and the clothing you wear for your self? Would modern living standards be possible without trade?

References
1. Chapter 1 in Dominic Salvatore (2009), Principles of Microeconomics, 5th edition, Oxford Publications. 2. Chapters 1 and 2 in William Boyes and Michael Melvin (2009), Textbook of Economics, 6th edition, Biztantra publications.