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| Economics is the study of how society manages its scarce
resources.
| It studies:
| How people make decisions
| How much to work?
| What to buy?
| How much to save or invest?
| Where to invest their savings?
| How people interact with each other- buyers, sellers and
price.
| What forces affect the economy as a whole-GDP growth,
population rise, price rise etc.
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| PART 1:HOW PEOPLE MAKE DECISIONS
| PRINCIPLE 1:People face trade-offs
| Situations:
| 1.college job
| 2.guns vs butter
| 3.clean environment vs high income
| 4.efficiency vs equity
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| Cost vs. Benefit
| Opportunity Cost: Whatever must be given up to
obtain something else.
| Monetary vs. non-monetary cost
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| Rational people are those who systematically and
purposefully do the best they can to achieve their
objectives.
| Marginal changes are small incremental adjustments
to a plan of action.
| Compare marginal benefits with marginal costs before
taking any decision.
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| An incentive is something that induces a person to act.
| Decision areas:
| Cost of consumption goods
| Public Policy
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| Healthy competition is possible only if there is trade
between nations.
| Win-win situation
| Isolation is not an option for any nation as it cannot
produce all goods and services.
| Cost consideration
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| Market economy: An economy that allocates resources
through the decentralized decisions of many firms and
households as they interact In markets for goods and
services.
| Concept of Ǯinvisible handǯ by Adam Smith
| Prices drive economic activity
| Welfare of the society is a natural outcome.
| Government intervention can impede the market
economy mechanism
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| A clear definition of the role and scope of government
policy is required.
| Property rights should be enforced-the ability of an
individual to own and exercise control over scarce
resources.
| Market failure-a situation in which a market left to itself
fails to allocate resources efficiently.
| Externality-the impact of one persons actions on the well-
being of a bystander.
| Market power: the ability of a single market actor to have a
substantial influence on market prices.
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| Differences in living standards across countries.
| Productivity variations:the quantity of goods and
services produced from each hour of a workerǯs time.
| Relation between productivity and living standards.
| Its impact on public policy
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| Inflation: An increase in the overall level of prices in
the economy.
| Causes: growth in amount of nationǯs money leads to
fall in the value of money. Prices thus rise.
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| Increase in the supply of money leads to more

demand.
| Higher demand leads to higher prices immediately.
| Slowly there is an increase in production also.
| This leads to generation of more employment
opportunities in the short run.
| Thus inflation and unemployment move in opposite
directions.
| Government can control the extent of inflation or
unemployment through the use of public policy.



 



 

| The scientific method stresses on a systematic method
of doing things.
| Scientists are able to test their theories in a lab setting.
| However an economist cannot create an artificial lab
setting. He has to rely on the real world series of events
to arrive at a conclusion.
| Historical events serve as a basis for an economist. For
e.g. the impact of the different recessionary phases,
world wars and their impact, the oil crisis etc.


 
| Like a scientist an economist also relies on
assumptions to take decisions. This is only for
simplicity in understanding
| For example an economist assumes two countries and
two products to explain the theory of international
trade. The same model is then used for a number of
countries and products.
| The nature of assumptions also changes with time and
the happenings in the external environment.
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| An economic model is made up of diagrams and
equations to demonstrate the working of the economy.
| These models are also based on assumptions and omit
those factors which are not relevant for the economy.
| There are two models in economics:
| 1.The Circular Flow Diagram
| 2.The Production Possibilities Frontier


 


 

| The circular flow of income is an economic model

depicting how money flows through the economy. In
the most simple version, the economy is modeled as
consisting only of households and firms.
| Money flows to workers in the form of wages, and
money flows back to firms in exchange for products.
| This simplistic model suggests the old economic
adage, "Supply creates its own demand."
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33Ú
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| A curve depicting all maximum output possibilities for
two or more goods given a set of inputs (resources,
labor, etc.). The PPF assumes that all inputs are used
efficiently.
As indicated on the chart above, points A, B and C
represent the points at which production of Good A
and Good B is most efficient. Point X demonstrates the
point at which resources are not being used efficiently
in the production of both goods; point Y demonstrates
an output that is not attainable with the given inputs.
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| Microeconomics is the study of decisions that people
and businesses make regarding the allocation of
resources and prices of goods and services. This means
also taking into account taxes and regulations created
by governments.
| Microeconomics focuses on supply and demand and
other forces that determine the price levels seen in the
economy.
| For example, microeconomics would look at how a
specific company could maximize it's production and
capacity so it could lower prices and better compete in
its industry.
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| Macroeconomics, on the other hand, is the field of
economics that studies the behavior of the economy as
a whole and not just on specific companies, but entire
industries and economies.
| This looks at economy-wide phenomena, such as Gross
National Product (GDP) and how it is affected by
changes in unemployment, national income, rate of
growth, and price levels.
| For example, macroeconomics would look at how an
increase/decrease in net exports would affect a
nation's capital account or how GDP would be affected
by unemployment rate.

 



 
| While these two studies of economics appear to be different, they are
actually interdependent and complement one another since there are
many overlapping issues between the two fields. For example,
increased inflation (macro effect) would cause the price of raw
materials to increase for companies and in turn affect the end product's
price charged to the public.

The bottom line is that microeconomics takes a bottoms-up

approach to analyzing the economy while macroeconomics takes a top-
down approach.
| Regardless, both micro- and macroeconomics provide fundamental
tools for any finance professional and should be studied together in
order to fully understand how companies operate and earn
revenues and thus, how an entire economy is managed and sustained.
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| Living in isolation is no longer an option for any
nation.
| Specialization and trade: However one nation may be
able to specialize in the production of a particular
good or service.
| This has to be done keeping in mind the opportunity
cost of producing/trading in that good.


 

 

| The ability of a country, individual, company or region

to produce a good or service at a lower cost per
unit than the cost at which any other entity produces
that good or service.
|
Entities with absolute advantages can produce
something using a smaller number of inputs than
another party producing the same product. As such,
absolute advantage can reduce costs and boost profits.
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| The law of ˜
 
 refers to the ability of
a party (an individual, a firm, or a country) to produce a
particular good or service at a lower opportunity cost than
another party.
| It is the ability to produce a product with the highest
relative efficiency given all the other products that could be
produced.
| It can be contrasted with absolute advantage which refers
to the ability of a party to produce a particular good at a
lower absolute cost than another.
| Comparative advantage explains how trade can create value
for both parties even when one can produce all goods with
fewer resources than the other.
| The net benefits of such an outcome are called gains from
trade.



| §nit Labor Costs

Õ  

Britain 100 110

Portugal 90 80
| In the absence of transportation costs, it is efficient for
Britain to produce cloth, and Portugal to produce wine, as,
assuming that these trade at equal price (1 unit of cloth for 1
unit of wine) Britain can then obtain wine at a cost of 100
labor units by producing cloth and trading, rather than 110
units by producing the wine itself, and Portugal can obtain
cloth at a cost of 80 units by trade rather than 90 by
production.