SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH AND ENTREPRENEURSHIP EDUCATION

SIMSREE PRE-INDUCTION ASSIGNMENT Economics

SIMSREE 2013-15

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Table of Contents
MICROECONOMICS ................................................................................................................3 DEMAND ................................................................................................................................. 3 DIRECT DEMAND AND DERIVED DEMAND ............................................................................... 3 TYPES OF GOODS ................................................................................................................4 Complementary goods ........................................................................................................... 4 Substitute goods ..................................................................................................................... 5 Normal goods ......................................................................................................................... 5 Inferior goods ......................................................................................................................... 5 Giffen goods ............................................................................................................................ 5 Snob or Veblen goods............................................................................................................. 5 DETERMINANTS OF DEMAND........................................................................................... 5 ELASTICITY........................................................................................................................... 7 Price elasticity of demand ..................................................................................................... 7 Cross-Price Elasticity ............................................................................................................. 8 Income Elasticity.................................................................................................................... 9 SUPPLY ..................................................................................................................................9 DETERMINANTS OF SUPPLY ............................................................................................ 10 ELASTICITY OF SUPPLY ..................................................................................................... 11 EQUILIBRIUM ..................................................................................................................... 11 MACROECONOMICS............................................................................................................. 13 GROSS DOMESTIC PRODUCT (GDP) ........................................................................................ 13 ECONOMIC POLICIES: ............................................................................................................ 14 SOME OTHER TERMINOLOGIES: .................................................................................. 18

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The field of economics is broken down into two distinct areas of study: Microeconomics and Macroeconomics.

MICROECONOMICS
Microeconomics is that branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets. Demand Demand: It is defined as an individuals desire to buy a particular product backed by his/her willingness and ability to purchase that product, at a given price. Note: In case the individual has the desire as well as the willingness to pay the current price but he/she lacks the ability to do so, then a demand does not occur. E.g.: A Middle Income household may desire a luxurious car, but that household may lack the ability and so the desire remains only a desire and does not translate into demand for that product. Direct Demand and Derived Demand Direct Demand is for consumption goods. They are for those goods and services that directly satisfy an individual consumers desire. For example: Automobiles Derived Demand is generally for intermediate goods. It is the demand for the goods used by the producers to manufacture consumption goods. For example: demand for steel (intermediate good) is derived from the demand for automobiles (final goods). If demand for automobiles increases, demand for steel will increase.

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Law of Demand: All other things remaining unchanged, the quantity of goods demanded increases when its price decreases and vice versa. This relationship can be shown by a demand schedule and a demand graph given below: Demand Schedule: Prices and quantity demanded normally move in opposite directions. Prices 4 8 12 16 20 Quantity 30 25 15 10 6

Demand Curve: A curve showing the relationship between the price of a good and the quantity demanded.

Price

DD

Quantity

TYPES OF GOODS Complementary goods are a pair of goods consumed together. As the price of one goes up, the demand for the other falls. Example- car and petrol (when price of petrol increases, demand for cars will decrease)

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Substitute goods are alternatives to each other. As the price of one goes up the demand for the other also goes up. Example Pepsi and Coke (when Pepsi price increases, demand for coke will increase as people will switch from Pepsi to Coke) Normal goods are those goods whose demand goes up when the consumers income increases. Example: television, air- conditioners Inferior goods are those goods whose demand falls when the consumers income increases. Example: kerosene (as income increases more people start using LPG and so the demand for kerosene decreases) Giffen goods are those goods whose demand moves in same direction as price. Thus Giffen goods are goods which people, paradoxically, consume more as the price rises. Example: Inferior staple foods: If the price of these inferior staples increases, then poor income groups wont have spare money to buy other food stuffs to satisfy their hunger thus they will have to buy more of these inferior staples. Hence as the price of this inferior quality food rises paradoxically its demand also rises. Note: There exists no Giffen good currently in the world. Snob or Veblen goods are those goods whose demand falls when price falls. Veblen goods are a group of commodities for which people's preference for buying those increases as their price increases, as greater price confers greater status. Example: Mercedes, BMW (Mercedes and BMW are seen as a status symbol) DETERMINANTS OF DEMAND When price changes quantity demanded will also change. There will be a movement along the same demand curve. When factors other than price changes, demand curve will shift to the left or to the right. These are the determinants of the demand curve: 1. Income: An increase in a persons income will lead to an increase in demand (shift demand curve to the right), a decrease will lead to a decrease in demand for normal

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goods. Goods whose demand varies inversely with income are called inferior goods. 2. Consumer Preferences: Favorable change leads to an increase in demand, unfavorable change lead to a decrease. 3. Number of Buyers: More buyers lead to an increase in demand; fewer buyers lead to decrease. 4. Price of related goods: a. Substitute goods (those that can be used to replace each other): If the price of a good increases the demand for its substitute good increases. Example: price of Pepsi rises, the demand for Coke would increase. b. Complementary goods (those that can be used together): If the price of a good increases the demand for its complement good also increases. Example: if the price of petrol rises, the demand for automobiles will decrease. 5. Expectation of future: a. Future price: Consumers current demand will increase if they expect higher future prices; their demand will decrease if they expect lower future prices. b. Future income: Consumers current demand will increase if they expect higher future income; their demand will decrease if they expect lower future income.

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Shift along the demand curve Demand curve shifts due to due to change in price of the goodfactors other than price of the good

Shift along the supply curve Supply curve shifts due to due to change in price ofthe goodfactors other than price of the good ELASTICITY It is a measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable. Price elasticity of demand: The Sensitivity of the quantity demanded to changes in price is called price elasticity of demand denoted by Ep

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Ep =% change in quantity demanded = Q/Q % change in price P/P If Ep = o then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes the demand curve will be vertical. Example: Life-saving drugs (people will continue to buy them irrespective of the increase in price) If Ep is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price. Example: Salt, bread If Ep = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to be unitary elastic. A 15% rise in price would lead to a 15% contraction in demand. If Ep> 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For Example a 20% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is 1.5. Example: Foreign travel by low-cost airlines. Cross-Price Elasticity It is a measure of the responsiveness of the demand for a good with respect to changes in the price of a related good; the percentage change in the quantity demanded of one good divided by the percentage change in the price of a related good. The cross-price elasticity is positive whenever goods are substitutes. Example: Increase in price of coca cola will increase the demand for Pepsi. The cross-price elasticity is negative whenever goods are complements.

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Example: Increase in the price of petrol will reduce the demand for petrol cars.

Income Elasticity A measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income. The income elasticity is positive whenever the good is a normal good. Example: Fruits (Income increases by which demand for fruits also increases) The income elasticity is negative whenever the good is an inferior good. Demand falls as income rises. Typically inferior goods or services tend to be products where there are superior goods available. Example: Demand for bid is decrease as income increases since people now can afford cigarettes. SUPPLY Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. Law of Supply states that all other factors remaining unchanged the supply of good increases as its price increases. This can be shown by a supply schedule and a supply curve. Supply schedule: There exists a positive relation between quantity and price Price 1 5 8 13 20 Quantity 2 10 15 25 35

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SUPPLY CURVE Price SS

Quantity

DETERMINANTS OF SUPPLY When price changes quantity supplied will change. That is a movement along the same supply curve. When factors other than price change, supply curve will shift. Here are some determinants of the supply curve. 1. Production cost Since most private companies goal is profit maximization. Higher production cost will lower profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate, government regulation and taxes, etc. 2. Technology Technological improvements help reduce production cost and increase profit, thus stimulate higher supply. 3. Number of sellers More sellers in the market increase the market supply. 4. Expectation for future prices If producers expect future price to be higher, they will try to hold on to their inventories and offer the products to the buyers in the future, thus they can capture the higher price.

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ELASTICITY OF SUPPLY Price Elasticity of Supply: The responsiveness of supply to changes in prices is called Price elasticity of supply Es = Percentage change in quantity supplied / Percentage change in price Availability of raw materials: Example, availability may cap the amount of gold that can be produced in a country regardless of price. Length and complexity of production: It also depends on the complexity of the production process. Mobility of factors: If the factors of production are easily available and if a producer producing one good can switch their resources and put it towards the creation of a product in demand, then it can be said that the Es is relatively elastic. The inverse applies to this, to make it relatively inelastic. Time to respond: The more time a producer has to respond to price changes the more elastic the supply. Excess capacity: A producer who has unused capacity can (and will) quickly respond to price changes in his market assuming that variable factors are readily available. Inventory: A producer who has a supply of goods or available storage capacity can quickly increase supply to market EQUILIBRIUM Equilibrium = perfect balance in supply and demand. It determines market output and price. At prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price)

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At price > equilibrium level: excess supply Equilibrium price is market clearing price: no excess demand or excess supply Any price above the equilibrium causes an excess supply and any price below the equilibrium causes a shortage. The market if uncontrolled will automatically arrive at the equilibrium price at which supply equals demand.

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Macroeconomics
Macroeconomics, as the name suggests, studies the behavior of the aggregate economy. It examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product (GDP), inflation and price levels. Macroeconomics is a huge topic and hence this short write up tries to cover as much of it without going too much into details. Lets start with the GDP Gross domestic product (GDP) of a country refers to the market value of all the final goods and services produced within a country in a given period. There are 3 ways of calculating GDP of a country. 1) Market Price method In market price method we multiply each and every good and service produced in country with the price charged for it and adds it up to get GDP. 2) Factor cost method For producing goods and services firms need to pay wages to labour, interest for using capital to banks, rent for land to owner of land and profit to owners of company. The sum of all these expenses for each and every firm in the country also gives you the GDP. It is an indirect method of calculating GDP. 3) Expenditure method Here we look at different sources of demand for these products and services and equate it to GDP and then get an equation for GDP which serves as a basis to understand most topics of macroeconomics going forward. Gross Domestic Product = Consumption + Investment + Government Spending + Exports Imports

Y = C + I + G + X - M (eqn.1)

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C - Consumption Consumption is total personal consumption expenditure by all individual people of the country I - Investment Investment is aggregate spending by all the firms. Remember firms invest and not individuals. What is called as investing commonly (like I invested in stocks) is not considered in economics as investing. It is called as saving. Firms buying new machinery is called investing. G - Government Spending Government spending or government expenditure consists of government purchases. X- Exports Demand for products of a country in foreign countries. M- Imports Demand for some part of C, I and G can be fulfilled by imported products and thus it is reduced from GDP of this country. Economic Policies: In order to influence GDP of a country the factors at Right Hand Side of equation 1 can be adjusted or changed. This leads to different policies. 1) Fiscal Policy: If Government spending (G) is changed it is called as Fiscal Policy (done by the government). If government wants to increase GDP it will increase its spending by building roads, bridges , gardens and other such public utilities. Thus demand from government will boost the GDP. If it wants to slow down GDP growth then it can increase taxes thus decreasing GDP (its a disincentive to produce more). 2) Monetary policy: The term monetary policy is also known as RBIs credit policy or money management policy. It is basically the central banks view on what should be the

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supply of money in the economy and also in what direction the interest rates should move in the banking system. Such and many other questions related to the demand and supply of money in the economy is explained by the monetary policy. The objectives of a monetary policy are similar to the five year plans of our country. In a nutshell it is basically a plan to ensure growth and stability of the monetary system. The significance of the monetary policy is to attain the following objectives. 1. Rapid Economic Growth: It is an important objective as it can play a decisive role in the economic growth of the country. It influences the interest rates and thus has an impact on investments in the country. If the RBI adopts an easy credit policy, it would be doing so by reducing interest rates which in turn would improve the investment outlook in the country. This would in turn enhance the economic growth. However faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. 2. Exchange Rate Stability: Another important objective is maintaining the exchange rate of the home currency with respect to foreign currencies. If there is volatility in the exchange rate, then the international community loses confidence in the economy. So it is necessary for the monetary policy to maintain the stability in exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 3. Price Stability: The monetary policy is also supposed to keep the inflation of the country in check. Any economy can suffer both inflation and deflation both of which are harmful to the economy. So the RBI has to maintain a fair balance in ensuring that during recession it should adopt an easy money policy whereas during inflationary trend it should adopt a dear money policy 4. Balance of Payments (BOP) Equilibrium: Another key objective is to maintain the BOP equilibrium which most of the developing economies

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dont tend to have. The BOP has two aspects which are BOP surplus and BOP deficit. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. 5. Neutrality of Money: RBIs policy should regulate the supply of money. It is possible that the change in money supply causes disequilibrium and the monetary policy should neutralize it. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability.

RBI controls both these aspects through the monetary policy tools like CRR, SLR, repo rate and reverse repo rate. i) CRR (Cash Reserve Ratio) - Banks in India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks dont hold these as cash with themselves, but deposit such cash with Reserve Bank of India (RBI).This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus, when a banks deposits increase by Rs. 100, and if the cash reserve ratio is 6%, the banks will have to hold additional Rs. 6 with RBI and Bank will be able to use only Rs. 94 for investments and lending / credit purpose. Therefore higher the ratio, the lower is the amount that banks will be able to use for lending and investment. This power of RBI to reduce the lendable amount by increasing the CRR makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system.

ii)

SLR (Statutory Liquidity Ratio) - It indicates the minimum percentage of

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deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved securities to liabilities (deposits). iii) Repo (Repurchase) rate - Is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

iv)

Reverse Repo rate - Is the rate at which banks park their short-term excess cash with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI.

3) Trade policy: If Imports (M) and exports (X) are changed it is called as trade policy (generally by government as is the case with India or somebody that regulates trade). They can be changes by regulations in import or exports thus restricting them or the other way of giving subsidies or tax breaks thus encouraging them. Generally one is encouraged and the other discouraged at a point of time depending on what is to be achieved at that time. The Tradeoff Why doesnt the government keep spending a lot of money and the RBI adopts a monetary policy that encourages a lot of investment so that GDP grows at very fast rate? The reason is indiscriminate spending by government and huge investments by

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firms will increase the money supply in the country tremendously. This will cause inflation in the country wherein goods will become very costly and beyond the reach of common man. Hence increased GDP comes at the cost of high inflation. We have to keep inflation in check and this puts a limitation on GDP growth as well.

Some other terminologies: 1) Inflation: Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate: The inflation rate is the percentage change in the price level. Demand-pull inflation is inflation initiated by an increase in aggregate demand. Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

2) CPI- Consumer Price Index It is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living. It is sometimes referred to as "headline inflation." Core inflation: A measure of inflation that excludes certain items that face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. Core inflation is most often calculated by

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taking the Consumer Price Index (CPI) and excluding certain items from the index, usually energy and food products. 3) WPI- Wholesale Price Index It is an index that measures and tracks the changes in price of goods in the stages before the retail level. Wholesale price indexes (WPIs) report monthly to show the average price changes of goods sold in bulk, and they are a group of the indicators that follow growth in the economy. Although some countries still use the WPIs as a measure of inflation, many countries, including the United States, use the producer price index (PPI) instead. 4) Business cycle: It implies the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. At one time, business cycles were thought to be extremely regular, with predictable durations, but today they are widely believed to be irregular, varying in frequency, magnitude and duration.

5) Fiscal Deficit: When a government's total expenditures exceed the revenue that it generates (excluding money from borrowings).

6) Trade Deficit: It is an economic measure of a negative balance of trade in which a country's imports exceeds its exports. A trade deficit represents an outflow of domestic currency to foreign markets.

7) Current Account Deficit: It occurs when a country's total imports of goods, services and transfers are greater than the country's total export of goods, services and transfers. This situation

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makes a country a net debtor to the rest of the world. 8) What are leading, lagging, coincident indicators? An indicator is anything that can be used to predict future financial or economic trends. Popular indicators include unemployment rates, housing starts, inflationary indexes and consumer confidence. Official indicators must meet certain set criteria; there are three categories of indicators, classified according to the types of predictions they make. Leading indicators These types of indicators signal future events. Think of how the amber traffic light indicates the coming of the red light. In the world of finance, leading indicators work the same way but are less accurate than the street light. Bond yields are thought to be a good leading indicator of the stock market because bond traders anticipate and speculate trends in the economy (even though they aren't always right). Lagging indicators A lagging indicator is one that follows an event. Back to our traffic light Example: the amber light is a lagging indicator for the green light because amber trails green. The importance of a lagging indicator is its ability to confirm that a pattern is occurring or about to occur. Unemployment is one of the most popular lagging indicators. If the unemployment rate is rising, it indicates that the economy has been doing poorly. Coincident Indicator It is an economic factor that varies directly and simultaneously with the business cycle, thus indicating the current state of the economy.

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