Business Economics for Public Sector

Mcconnell & Brue 17th edition & Microeconomics by Pindyck/Daniel Rubinfeld

Mohsin Mushtaq Chandna

13 Lectures 10 AM -1.15AM

Definition
It is the Social Science concerned with the efficient use of scarce resources to achieve the maximum satisfaction of economic wants.
Lets focus on key phrases in this definition Social Science, Scarce Resources, Maximum Satisfaction and Economic Wants

Scarce Resources
The resources are scarce and therefore the goods and services produced using these resources are also scarce. There is no such thing as free lunch, some body pays for it Since we use scarce resources therefore they must be used in most productive manner i:e Best use. Every single use means it foregoes another possible use Opportunity Cost of not going for 2nd best option

Utility

An economic term referring to the total satisfaction received from consuming a good or service in a rational manner It is an abstract concept rather than concrete Utility is hard to measure but it can be determined indirectly with consumer behavior Utility increases with wealth but at a decreasing rate. Marginal utility is the additional satisfaction derived from each extra unit of consumption

Rational Behavior
It means same person may make different choices under different circumstances Choices will vary greatly among individuals and also change as costs and benefits change Rational self interest is different from selfish behavior. Choices reflect the pursuit of self interest and are rational but they are based on differing preferences and circumstances

Economic Wants
Wants are different from Needs which are necessary for survival like food shelter Want is something which a person likes to have needs have high priority wants have low Some foods are needs but some may be wants as well as needs Ice cream is want but milk is need

Marginalism
Economics involves lot of marginal analysis like marginal utility marginal cost marginal benefits For instance a gain of additional utility by consumption of one more drink is corresponded with additional cost Some times we consume too much of a good which means its marginal costs outweigh marginal benefits so we are sacrificing goods which are more valuable at the margins-the place where we consider very last unit of each. And hence the concept of marginalization

Economic Methodology
Observation of raw facts or data collection Formulation of a hypothesis Testing of Hypothesis Acceptance, rejection or modification of it Continued testing of hypothesis. If favorable hypothesis evolves into theory and a well tested and widely accepted theory leads to law. The process of deriving theories and principles is called theoretical economics

Figure 1.1 The relationship between facts, Theories, and Policies in Economics.

Policy Economics Theoretical Economics

Theories

Facts

Some Terminologies
Generalizations: Economic theories, laws and principles are generalizations relating to economy and its behavior. They are imprecise because economic facts are diverse and no two individuals and institutions act in the same way. These principles are expressed as tendencies of typical consumer, worker or business firm. Although some consumers or firms may not be following these trends yet on average overall economy follows these trends.

Some Terminologies
Ceteris Paribus or Other things being equal assumption means that other variables except those under consideration are held constant for a particular analysis. Abstractions: economic theories or principles are abstractions or simplifications that omit irrelevant facts. This is simplifying the matters and avoids cluttering.

Policy Economics
It recognizes that theories and data can be used to formulate polices. Economic theories provide basis for economic policy. The typical steps in creation of economic policy are Stating the goal Determine policy option Implement and evaluate the selected policy

ECONOMIC POLICY
STATE THE GOAL POLICY OPTIONS
IMPLEMENT & EVALUATE

Economic Goals
May be economic growth, economic efficiency, full employment, equitable distribution of income and balance of trade etc These goals may be complementary, mutually exclusive or even conflict with each other. Full employment may reduce poverty and income inequalities but higher taxation may discourage entrepreneurs and may therefore have trade offs. When goals conflict societies prioritize objectives.

Macroeconomics
Macroeconomics examines the economy or its basic subdivisions as a whole such as government, business sectors or households. So households are considered as if lumped together. It deals with economic measures such as total income, total output, total employment, aggregate expenditures and general level of prices in analyzing various economic problems.

Microeconomics
It looks at specific economic units or very small segment of the economy Microscopic Here we talk of an individual industry firm or household Eg: Price of specific products, no of workers employed in a firm, income and production processes of a firm etc

Normative v/s Positive approach

In Microeconomics positive rather than normative models are used which means how things are rather than how they should be. An example of positive statement may be income inequality has increased during the past decade while a normative statement may be the government should tax the rich to decrease income inequality

Normative v/s Positive approach

Positive Economics focuses on facts and cause and effect relationship Positive economics avoids value judgment and aims at conducting scientific analysis Policy Economics, on the other hand, involves normative economics which incorporates value judgment: How economy should be and what policies should be adopted to achieve that goal. It talks of desirability

Principles of Macroeconomics
Principle 1: people face tradeoffs. To get one thing we give up another. Principle 2: cost of something is what u give up to get it: or Opportunity cost Principle 3: Rational people think at the margin, they compare costs and benefits at the margins Principle 4: People respond to incentives: they change their decisions when marginal benfits exceed marginal costs

Principles of Macroeconomics
Principle 5: Trade can make every one better off. Competition results in gains from trade as people specialize Principle 6: Markets are a good way to organize economic activity. Adam Smiths invisible hand Principle 7: Governments can, sometimes, improve market outcomes. When market fail to allocate resources efficiently, governments can intervene to promote efficiency and equity. Pls note here externality and market power

Principles of Macroeconomics
Principle 8: the standard of living depends on a countrys production. It can be measured in terms of personal incomes or market value of a nations production Principle 9: prices rise when the governments print too much money. Large quantity of money decreases value of the currency Society faces a short run tradeoff between inflation and unemployment. When prices go up unemployment goes down: only in short run !!!

Pitfalls to Sound Reasoning

Biases: some people have biases like most of us have about foreign debt etc Loaded Terminologies: Like high profits are termed as Obscene, low prices as exploitative, government is bunch of mindless bureaucrats and government regulations as socialists. Misperception of definitions like investment is construed as purchase of bonds instead of purchase of capital assets like plant and machinery

Pitfalls to Sound Reasoning

Fallacy of composition which means what is correct for an individual is not true for whole. Example: A bumper crop is good for an individual farmer but not for all of them as prices will go down. Causation Fallacy: Post hoc and correlation v/s causation. Post hoc occurs because event A precedes event B which make people to believe that B was caused by A. In other words after this therefore because of this fallacy

Pitfalls to Sound Reasoning

Correlation v/s Causation: Correlation between 2 events means that they are associated in some systematic way. For instance if X and Y also then it doesnt necessarily mean that Y has increased because X increased. It could be coincidental or dependant on a 3rd factor. Economic Example, income and higher education Proverbial Example Old Womans Cock

Graphs
Its the time to look at graphs. In a graph we have 2 axis, X and Y. Have u ever thought which variable should be taken on X and which variable u take on Y?

Graphs
Its the time to look at graphs. In a graph we have 2 axis, X and Y. Have u ever thought which variable should be taken on X and which variable u take on Y? Independent variable on X and Dependent on Y To draw a line we need two points of X variable which have their corresponding Y Values

Graphs
Now lets think about the slope of the line What is the Slope: Its Rise over Run What is the equation of the line:

Graphs
What is the Slope: Its Rise over Run What is the equation of the line: Y=mX+C

Graphs
Income per week $0 100 200 300 400 Consumption per week $ 50 100 150 200 250

So Which variable should we take on X-Axis and which variable should we take on Y. Income is independent variable so goes on X and Consumption is dependant variable and hence goes on Y.

Graphs
So what is the slope of the line and equation of this line Begin by taking 2 points say 100, 100 and 50, 0 Rise over Run means distance between 2 vertical points and 2 horizontal points So 100-50 = 50/100 or 0.5 100-0 So the slope of this line is 0.5 Positive Slope means when X increases Y also increases

Graphs
Now what is the line equation As I mentioned it is Y=mX+C where m=slope and C is a constant. So lets find out the equation for this line To do this we need only one point of X and Y So lets take 200, 150 (x, y) Now 150 = 0.5 * 200 + C Or 150 = 100 + C or C = 150 100 or C = 50 (See graph even when X=0 the person still spends 50 and it is constant

$400

C = 50 + .5Y
CONSUMPTION

300 CONSUMPTION (C)

e
200

d c

100

a
0

b
100 200 INCOME (Y) 300 400

Graphs
Relationship between ticket price & attendance
Ticket Price (in $) 50 40
30 20 10 0

Attendance (in thousands) 0 4

8 12 16 20

Now lets take Attendance on X Axis and Ticket Price on Y Axis. What is Slope and Equation of the line

$50

a
b

P=50-2.5Q

40

TICKET PRICE (P)

30

20

d
e f
4 8 12 16 20 ATTENDANCE IN THOUSANDS (Q)

10 0

The Economizing Problem

Two fundamental problems Societys economic wants i:e economic wants of its citizens and institutions are unlimited and insatiable Economic resources- the means of producing goods and services- are scarce or limited

Unlimited Wants
Consumers use goods to get utility. Utilities vary widely from necessities to luxuries- food shelter clothing to racing cars and yachts. Services also provide utility such as 5 star services and security etc. Institutions are not much different in this regard. Pvt institutions want factories to work efficiently while Government institutions strive to provide services like high ways law & Order etc

SCARCE RESOURCES
ECONOMIC RESOURCES PROPERTY RESOURCES LAND CAPITAL HUMAN RESOURCES LABOR

SCARCE RESOURCES
ECONOMIC RESOURCES PROPERTY RESOURCES LAND CAPITAL

Also known as the

Input Factors of HUMAN RESOURCES Production LABOR

ENTREPRENEURIAL ABILITY

Scarce Resources
Economic resources include Land, Labor, Capital and Entrepreneurship. Entrepreneurial ability is also a scarce resource because as he takes risk, combines resources and takes strategic decisions to produce goods and services to make profits. These 4 resources land, labor, capital and entrepreneurial ability are called factors of production

ENTREPRENEURIAL ABILITY

Takes The Initiative Makes Strategic Business Decisions Innovator The Risk Bearer

Employment and Efficiency

Since economics focuses on best use of scarce resources therefore it aims at ensuring best efficiency. This presupposes 2 aspects, full employment and full production. Full employment means those who can be legally employed like no child labor. Full production means all resources are best utilized to provide maximum satisfaction or out put. If not so then they are under utilized.

Allocative Efficiency
Allocative efficiency is least cost production of a particular mix of goods most wanted by society. This means apportionment of limited resources in such a way that society obtains the mix which it wants the most. At this point Price = MC The point of maximum allocative efficiency is achieved in perfect competition at the point where MR=MC and MC=AR=P

Productive Efficiency
Productive efficiency or technical efficiency occurs when the economy produces a mix of goods at the lowest possible cost given other goods. Its called Production Possibility Frontier. This is attained when firms produce at the bottom of their Average Cost Curves. Perfectly competitive firms also achieve this in the long run as they produce at P=MC and this happens to be tangent to the lowest point of AC curve

Production Possibilities Model

4 simplifying assumptions 1. Full employment and productive efficiency, 100% utilization of resources at least cost 2. Fixed Resources: Factors of production are in fixed supply though can be reallocated. 3. Fixed Technology: in the short run the methods of production cant be changed. 4. Two goods: As discussed earlier the society produces 2 goods or services only

Production Possibilities Model

Type of Product Pizzas (in hundred thousands) Robots (in thousands) A 0 10 B 1 9 C 2 7 D 3 4 E 4 0

In the above table Pizzas are depicted as consumer goods while robots are presented as capital investment. So by picking A society chooses to forego current consumption and concentrates on capital goods which are futuristic. Less now more later

Production Possibilities Curve

In this case pizza is on X-axis and robots on Y-axis Each point on the curve represents some maximum possible output or production frontier Points lying inside the curve represent less than maximum utilization of resources or inefficiency Points on the right side of curve show greater output and require extra resources to produce Rate of change of pizza to robots or vice versa depicts Law of Increasing Opportunity Cost

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

in table form
PIZZA
(in hundred thousands)

0 10

1 9

2 7

3 4

4 0

ROBOTS

graphical form
(thousands)

(in thousands)

Robots

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

Limited Resources means a limited output... At any point in time, a full-employment, fullproduction economy must sacrifice some of product X to obtain more of product Y.

14 13 12 11 10 9 8 7 6 5 4 3 2 1

Unattainable
A B C D W

Robots (thousands)

Attainable but Inefficient

E 1 2 3 4 5 6 7

Attainable & Efficient

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES
Q 14
13 12 11 10 9 8 7 6 5 4 3 2 1

Unattainable LAW OF INCREASING A OPPORTUNITY COSTS B The amount of other C W products that must be forgone or sacrificed to D Attainable obtain 1 unit of a specific product is Attainablecalled the & Efficient opportunity cost of that but good. Inefficient
E

Notes...

Robots (thousands)

Pizzas (hundred thousands)

Law of Increasing Opportunity Cost

The opportunity cost, the value of foregone production, increases as the quantity of a good produced increases . It is explained as the slope of production possibilities curve. It analyzes the alternative combination of the two goods. It generates a distinctive convex shape, flat at the top and steep at the bottom.

Economic Rationale: LIOC

The sacrifice of one good increases (Robots) as we produce more of other good (Pizza). This is because economic resources are not completely adaptable to alternate uses. For instance land may be suitable for agriculture and not for mining. Similarly technology may be labor intensive and not capital intensive. This lack of perfect flexibility or interchangeability is the cause of Increasing Opportunity Cost

Economic Rationale contd

As we saw earlier economic activity like production or consumption should continue till marginal benefits exceed marginal costs. The optimal point of production therefore is where MC=MB See the graph and tell me why. To sum up Resources are being efficiently allocated to any product when marginal benefits and marginal costs of it are equal or MB=MC

PRODUCTION POSSIBILITIES
P

Allocative Efficiency: MB=MC

MC
MB=MC
10

Marginal Benefit & Cost

$15

MB
Quantity of Pizzas
1 2 3

Production Possibility Curve: recap

1. Scarcity of resources is implied by the area of unattainable combinations of output-lying on the right of the curve 2. Choice among outputs is reflected by the variety of attainable combinations along the curve 3. Opportunity cost is illustrated by the downward slope of the curve and 4. The law of increasing opportunity cost is implied by the concavity of the curve.

Q 14
13 12 11 10 9 8 7 6 5 4 3 2 1 1

Robots (thousands)

Unemployment & Underemployment Shown by Point U

U
More of either or both is possible

Pizzas (hundred thousands)

Q 14
13 12 11 10 9 8 7 6 5 4 3 2 1

A B

Economic Growth

Robots (thousands)

E 1 2 3 4 5 6 7 Pizzas (hundred thousands) 8

PRODUCTION POSSIBILITIES

Applications...

Unemployment and Productive Inefficiency Tradeoffs and Opportunity Costs Shifts in the Production Possibilities Curves

Economic Systems
Market systems or Capitalism or Command system or Communism. In Capitalism individual buyers and sellers interact resulting in competition. In pure capitalism Laissez Faire approach is dominant which means let it be means no government interference or control A planned economy relies exclusively on the central plan given by the government, even though there are few private productions and markets

ECONOMIC SYSTEMS
THE MARKET SYSTEM Pure Capitalism Laissez-faire
THE COMMAND SYSTEM Socialism Communism

CIRCULAR FLOW MODEL

RESOURCE MARKET

RESOURCES

INPUTS

BUSINESSES

HOUSEHOLDS

PRODUCT MARKET

CIRCULAR FLOW MODEL

$ COSTS
RESOURCE MARKET

$ INCOMES

RESOURCES

INPUTS

BUSINESSES

HOUSEHOLDS

GOODS & SERVICES

PRODUCT MARKET

GOODS & SERVICES

CIRCULAR FLOW MODEL

$ COSTS
RESOURCE MARKET

$ INCOMES

RESOURCES

INPUTS

BUSINESSES

HOUSEHOLDS

GOODS & SERVICES

PRODUCT MARKET

GOODS & SERVICES

CIRCULAR FLOW MODEL

$ COSTS
RESOURCE MARKET

$ INCOMES

RESOURCES

INPUTS

BUSINESSES

HOUSEHOLDS

GOODS & SERVICES

PRODUCT MARKET

GOODS & SERVICES

$ REVENUE

$ CONSUMPTION