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Economics: The Core Issues
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Scarcity : The core problem
Scarcity- Lack of enough resources to satisfy all
desired uses of those resources. Factors of Production: resources used to produce
goods and services.
1. Land- all natural resources
2. Labor- skills and abilities to produce goods
3. Capital-final goods produced for use in further
production
4. Entrepreneurship-assembling of resources toproduce new or improved products and technologies
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Core Issues
What to produce
how much of each commodity should be produced.should the emphasis be on agriculture,
manufacturing or services. Should it be on health,
education, defence, infrastructure or housing?
How to produce
different ways to produce goods but which
production method to use. labour intensive, land
intensive, capital intensive? ; Efficiency. For whom to produce
who is going to get the output produced? Should
everyone get an equal share?
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Opportunity Cost
- Cost of the next best alternative forgone.
- Helps us to understand the true cost of decisionmaking and in valuing different choices.
Suppose a machine can produce either X or Y .Theopportunity cost for producing a given quantity of X
is the quantity of Y, which the resource would have
produced.
If the machine can produce 10units of X and 20units of Y, then the opportunity cost of 1x is 2Y.
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Capital Goods
Consumer Goods
Yo
Xo
A
BY1
X1
Ym
Xm
Production Possibility Curve
- Alternative combinations of final goods and services
that could be produced in a given time period, with
all available resources and technology.
O
C
D
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Production possibility curve illustrates two essential
principles: scarce resources and opportunity cost.
All points on production possibility curve areefficient points of production.
Points inside the production possibility curve shows
inefficient utilisation of resources.
Points outside the production possibility curve are not
attainable with the current level of resources.
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Capital Goods
Consumer Goods
Yo
Xo
E
E1Y1
X1
Growth: Increasing Production Possibilities-if more resources or better technology becomes available. Theeconomic growth is shown by the outward shift of productionpossibility curve.
O
A
A1 B1
B
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Circular Flow of Income: Two Sector Model
- Flow of goods and services between households
(consumers) and firms (producers).
Assumptions
Only two sectors - households and firms
Households supply factor services to firms Firms hire factor services from households
Firms sell all the goods and services to households
Households spend all their income on goods an services
No government intervention and no foreign trade
Households are the owners of productive resource - land,
labour, capital and enterprise
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Product market and Factor market.
Real flow-involves flow of goods and services.
Monetary flow-flow of money payments and expenditure.
It can be derived from the two sector model that:
Total production of goods and services by firms = Total
consumption of goods and services by household sector.
Factor payments by firms = Factor incomes of householdsector.
Consumption expenditure of household sector = Income
of firm sector.
Hence, real flows of production and consumption of firms
and households = Monetary flows of income and
expenditure of firms and households.
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Circular Flow of Income with Financial System
Brings about the role of saving and investment.
Financial institutions are primarily intermediaries
between savers and investors, or lenders and
borrowers.
Financial institutions pay interest to the savers astheir funds are placed with them for a period of time
under a contract.
Firms pay dividend and interest for the sums they
have borrowed from the financial markets in the form
of shares, bonds and public deposits.
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Circular Flow of Income In a Three Sector Economy
Government purchases goods and services from firms
and labour services from households. Governmentcollects taxes from households and firms in order to
finance its expenditure.
The government makes transfer payments to thehouseholds in the form of social security,
scholarships, etc. It also gives subsidies to the firms
for various purposes.
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Circular Flow of Income In a Four Sector Economy
The domestic economy and the rest of the
world(foreign sector) are connected through inter
import and export of goods and services ultimately
decide what the domestic economy gains or loses in
the international trade. trade surplus- when there is excess of exports over
imports.
trade deficit- when there is excess of imports over
exports.
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The four-sector model of the economy demonstratesthe overall macro economic condition of income andoutput in the following identity:
Y C + I + G + (X M)
wherein,
Y = Income or outputC = Private consumption expenditure on consumer
goods
I= Investment expenditure by producing sectorsG = Government purchases
XM = Net exports (X = Exports, M = Imports)
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Definitions
Marginalism
Incrementalism
Opportunity principle
Discounting
Time perspective
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Marginalism
Marginal analysis is related to a unit change in
independent variable, say increase in costs as a result
of a unit change in output.
Marginal output of labour: output produced by the
last unit of labour Marginal cost of production: cost incurred for
producing an additional unit of output
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Profit of a firm using principle of
marginalism
Unitsofoutput(1)
TotalRevenue
(Rs)
(2)
Marginalrevenue (Rs)
(3)
Total
costs(Rs)
(4)
Marginalcost (Rs)
(5)
Totalprofits
(Rs)(6)=(2)-(4)
Averageprofit (Rs)(7)=(6) / (1)
Marginalprofits
(Rs)
(8)
1 20 - 15 5 5.0 -
2 40 20 29 14 11 5.5 6
3 60 20 42 13 18 6.0 7
4 80 20 52 10 28 7.0 10
5 100 20 65 13 35 7.0 7
6 120 20 81 16 39 6.5 4
7 140 20 101 20 39 5.6 0
8 160 20 125 24 35 4.4 -4
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Incrementalism
Incremental reasoning involves estimating the impact of
decision alternatives. Usually, changes occur in chunk rather than unit
changes.
Incrementalism is more general whereas marginalism is
more specific. Incremental costs :change in total costs as a result of
change in the level of output, investment etc.
Incremental revenue is a change in total revenue resultingfrom a change in the level of output, price etc.
While taking a decision, always incremental revenueshould always be greater than incremental costs
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Opportunity Principle
Cost of next best alternative foregone or the costexpressed in terms of the next best alternative
sacrificed.
Helps us view the true cost of decision making
Implies valuing different choices
Highest valued benefit that must be sacrificed as a
result of choosing an alternative.
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Discounting
The concept of discounting is based on the fact that arupee now is worth more than a rupee earned a yearafter.
Even if one is sure about future income, yet it has tobe discounted because to wait for future implies a
sacrifice for the present Suppose a sum of Rs 100 is due after one year. Let
the rate of interest be 10 percent. Then we candetermine the sum to be invested now so as to
produce the return (R) of Rs 100 at the end of theyear. The present value or the discounted values ofRs100 will then be V1= R
(1+i)n
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V1 = 100
1+0.10
= Rs.90.90 A present value of Rs100 due two years later would
be V1 = 100
(1+.10)2
= Rs.82.64
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Time perspective
Short run versus long run
Short run- at least one factor of production will be
kept constant
Long run- all factors are varied