Overview

First Principles of
Economics
Introduction to Economics

The Road Not Taken

TWO roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;
1.

Then took the other, as just as fair

The Necessity of Choice: Frost

Onewhomanagesahousehold

Economy

Economics

analyses and provides

answers to basic fundamental question of
scarcity
Scarcity arises out of two basic
fundamental facts of life
a)Wants unlimited
b) Economic Resources limited
Three questions
A) What to produce
B) How to produce
C) For whom to produce

What is the Economic

Problem?

The ECONOMIC PROBLEM is the problem of

allocating resources efficiently

to achieve objectives
while satisfying constraints, such as

scarcity
requirement
feasibility

Economic Analysis are important to

a variety of public and private
sector activities. For e.g.
1. analysing costs and benefits of a project, or
a scheme,
2. Pricing strategy of a product
3. user fees (price) for public parks, water, toll
road,
4. designing scholarship program,
5. causes of unemployment, inflation,
6. tax rate from revenue and equity point

1.

EFFICIENCY
2. EQUITY

CRITERIA FOR EVALUATING

THESE DECISIONS

Formalizing

economic behaviour into some

model
Two types
Operational or Internal Use
(Microeconomics)
Environmental or External
(Macroeconomics)

Economic Tools

Three

Groups of Principles
Individual Choice 4 principles
Interactions between Economic Agents
Economic Interactions at large

12 Principles

How

People Make Decisions

How People Interact
How Economy as a Whole Works

Principles of Economics

Resources

are Scarce
The Real Cost of Something is what you
must give up to get it: Opportunity Cost
Decisions at Margin
Exploit opportunities to be better off

Individual Choice

Decision

making is a process of making

optimal tradeoffs because resources are
scarce
Cost versus quality
Employee versus customer
Etc.

How

to make the optimal tradeoff?

There

is no free lunch.

1. Tradeoffs

I shall be telling this with a sigh

Somewhere ages and ages hence:
Two roads diverged in a wood, and I
I took the one less traveled by,
And that has made all the difference.

Most decisions not all or nothing

Should I watch the second half of the Uruguay Italy game
or should I study?
Should Apple ship out 300,000 more ipods?
Marginal means incremental, or additional
Marginal benefit - individual
Marginal revenue - firm
Marginal cost
So optimal tradeoff involves equalizing marginal
benefit/revenue and marginal cost

2. Optimal tradeoff: Decision at the

Margin

How much? is a decision at the margin.

You make a trade-off when you compare the costs with the

benefits of doing something.

Decisions about whether to do a bit more or a bit less of an
activity are marginal decisions.

Marginal Analysis
Making trade-offs at the margin: comparing the

costs and benefits of doing a little bit more of an

activity versus doing a little bit less.
The study of such decisions is known as
marginal analysis.
Ex.: Hiring one more worker, studying one more
hour, eating one more cookie, buying one more CD

3. The real cost of something is what you

must give up to get it.
The real cost of an item is its opportunity cost: what

you must give up in order to get it.

Opportunity cost is crucial to understanding individual
choice:
Ex.: The cost of attending the economics class is
what you must give up to be in the classroom during
the lecture.
Sleep? Watching TV? Rock climbing? Work?
All costs are ultimately opportunity costs.

Opportunity Cost
I WOULD RATHER BE SURFING THE
INTERNET.
In fact, everybody thinks about opportunity cost.
The bumper stickers that say:
I would rather be .{fishing, golfing, swimming,
etc} are referring to the opportunity cost.
It is all about what you have to forgo to obtain your
choice.
https://www.youtube.com/watch?
v=yw6wB7haSu8&ebc=ANyPxKqEjG1ipVOuFno8hWD
ULU8W1kCsdOQ_YHrmZO4fF6jc6bAVKAHqoNDVGM
To7HUrzExpo3DIZz25jkdhHg71n2euGnQRhw

Cars

at a toll bridge
Assumption of rationality
Behaviouraleconomics
Roleofethics

4. Entities respond to incentives

Gains

from Trade
Market moves towards equilibrium
Efficient use of Resources to achieve
societys goal
Markets lead to efficiency
Government intervention during Market
failure

Interactions

Economies

consist of individuals, firms,

families, countries, that interact with each
other
Interaction makes things interesting

Interaction Changes Things

Case 1: Boss better than secretary at decision

making, secretary better at typing, boss
focuses on decision making alone and lets
secretary focus on typing alone
Case 2: Boss better than secretary at both
typing and decision making but more better in
decision making, so focuses on decision making
alone and lets secretary focus on typing alone

5. Gains from trade

 MARKETS

AS A DEVICE TO RESOLVE THE THREE

BIG
ISSUES
MARKETS AS MECHANISM FOR COORDINATING
AND
RECONCILING INDIVIDUAL CHOICES IN A
MANNER THAT
PROVIDES ANSWERS TO THE THREE SOCIAL
DECISIONS

6. Markets organize economic

activity

 Markets

can lead to efficient outcomes, but there

are collective action failures
Blood donation
Traffic
Price wars

Markets need not lead to equity

Markets can fail on account of externalities
Smoking
Vaccinations

7. Government intervention is
sometimes necessary

Buyer

Seller

Factor markets

Firms

individuals

Goods markets

individuals

Firms

Do markets achieve efficiency ?

Do markets achieve equity?

Types of markets

Markets usually lead to efficiency.

The incentives built into a market economy already

ensure that resources are usually put to good use.

Opportunities to make people better off are not wasted.
Exceptions: market failure, the individual pursuit of selfinterest found in markets makes society worse off
the market outcome is inefficient.

Resources should be used as efficiently as

possible to achieve societys goals.
An economy is efficient if it takes all opportunities to

make some people better off without making other

people worse off.
Should economic policy makers always strive to
achieve economic efficiency?
Equity means that everyone gets his or her fair
share. Since people can disagree about whats fair,
equity isnt as well-defined a concept as efficiency.

Efficiency vs. Equity

Ex.: Handicapped-designated parking spaces in a

busy parking lot

A conflict between:
equity, making life fairer for handicapped people, and
efficiency, making sure that all opportunities to make
people better off have been fully exploited by never
letting parking spaces go unused.
How far should policy makers go in promoting equity
over efficiency?

When markets dont achieve efficiency, government intervention

can improve societys welfare.

Why do markets fail?

Individual actions have side effects not taken into

account by the market (externalities).

One party prevents mutually beneficial trades from
occurring in the attempt to capture a greater share of
resources for itself.
Some goods cannot be efficiently managed by
markets.
Ex.: Defence, Public Goods

Public

sector monopoly

railways
Both

public and private sector with

independent regulator
Telecommunications

Community

ownership

Alternatives to market mechanism

Econ without interaction

Econ with
interaction

More choice good

More choice can be

bad

Individual rationality leads to good There could be

collective outcomes
collective action
failure
Markets need to be unfettered

Markets need to be
designed

Impact of interaction

Principles for the

Aggregate Economy

One

Persons spending=Other persons

Income
Overall spending gets out of line with the
Economys Productive Capacity
Government policies can change spending

Economic Interactions at large

Pareto

efficiency: Cannot make anyone

better off without making someone else
worse off
Equity
Economists have focused on efficiency,
but by and large ignored equity
There is a large literature on market
failure, though

Goals of economics

The

study of the behaviour of individual

entities in a market economy
Consumers
Firms
Real estate
Banking
FMCG

Markets
Market failures

Microeconomics

study of the aggregate economy

Aggregate output
Aggregate employment
Inflation

Macroeconomics

Exports

and Imports
Capital flows FDI and FII
Exchange rate
Balance of Payments

International Economics

Divya:

Minimum wage laws cause

unemployment
Tara: The government should raise the
minimum wage
Positive statements are descriptive
Normative statements are prescriptive

Positive versus Normative

Analysis