Name - BHAWANI NANDAN PRASAD

MBA IIM Calcutta

Economics

Economics is the study of how a society decides

– what gets produced

– how it gets produced

– who gets what

Economics is concerned with

• how scarce resources (labor, capital, and natural resources) are allocated in the

production process among competing uses

• how income generated in the production and sale of goods and services is

distributed among members of society

• how people allocate their income through spending, saving, borrowing, and

lending decisions

Economics can be divided into two branches

– Microeconomics

• the causes and consequences of individual decision-making units in a

particular market

– Macroeconomics

• the causes and effects resulting from the sum of decisions made by all

firms or households in many markets

Finance

Finance deals with the raising and using of money by individuals, firms, governments, and

foreign investors

– how individuals manage money

– how the financial system coordinates and channels the flow of funds from

lenders to borrowers

– how new funds may be created by financial intermediaries during the

borrowing process

Supply and Demand

A market consists of the buyers and sellers of a good or service: abstraction from any concept of specific

time and location of a market. The market demand schedule shows the amount of the commodity that

buyers are prepared to buy at different prices.

The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

The downward slopping demand curve obeys the law of demand : quantity demanded decreases as price

increases. It is obvious from even causal observation or introspection that demand depends on many

things. In general, the quantity demanded is expected to depend, in addition to the own price, on

incomes

tastes and preferences

prices of "related" commodities

change in number of buyers

expectations, etc.

A change in any of these other factors thus leads to a shift in the entire curve.

When we draw the demand curve, we are focusing only on the relationship between price and quantity

demanded. We can do this by assuming that "everything else: is being kept at certain levels.

A change in commodity's own price by itself can only represent a movement along the demand curve and

not a shift in the curve. However, a change in any of the "other things" will lead to a shift of the demand

curve.

The market supply schedule shows the amounts of the commodity that sellers are prepared to sell at

different prices. The supply curve is the graph of the relationship between the price of a good and the

quantity supplied. The law of supply say that the quantity supplied increases as price increases.

In general, the quantity supplied is expected to depend on

Own Price

Technological Knowledge

Input Prices

Alternative output price changes

Expectations etc.

A change in technology that allows the commodity to be produced more cheaply should shift the

supply curve downwards and to the right.

Equilibrium : The demand and supply curves intersect to determine the market equilibrium.

Surplus

When price > equilibrium price, then quantity supplied > quantity demanded. There is excess supply or a

surplus. Suppliers will lower the price to increase sales thereby moving toward equilibrium.

Shortage

When price < equilibrium price, then quantity demanded > the quantity supplied. There is excess demand

or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby

moving toward equilibrium.

Government interventions:

Sometimes Governments try to correct the existing pattern of income distribution. They often try to

achieve the results indirectly, by interfering with the market processes.

Market demand and Elasticity

Market demand curve can come in different shapes from very flat to very steep. In very flat demand

curve, a small change in price has a large effect on quantity demanded. In very steep curve, even a large

change in price does not affect quantity demanded too much.

Consider the market demand for a commodity, q. Let it depend on a factor y (which might be its own

price, or the price of a related good, or income). The elasticity of demand for q with respect to y is defined

as the percentage change in q that results from a % change in y.

^q = Q2 - Q1 and ^y = Y2 - Y1

Since percentage changes are pure numbers, the elasticity measure will always be a unit-free pure

number.

Elasticity of q with respect to y = [^q/q *100] divided by [^y/y * 100] = [^q\^y * y\q]

Therefore elasticity of quantity demanded can be with respect to :

- own price (price - elasticity of demand)

- any other price (cross price - elasticity)

- income (income elasticity)

1. Point - Elasticity measures

2. Arc - Elasticity measures

To get rid of this ambiguity, take an average of the values:

e = - [^q * (P2 + P1)\2] / [^p * (Q2 + Q1)\2] = .46

If the percentage change in q > the percentage change in p, then e > 1, and we have elastic demand.

If the percentage change in q = the percentage change in p, e=1 and we say that demand is unit elastic.

If the percentage change in q < the percentage change in p, so that e < 1, demand is said to be inelastic.

Special Cases

If (inverse) demand curve is a horizontal straight line parallel to the quantity axis, then the price

elasticity measure goes to infinity - demand is perfectly elastic.

If (inverse) demand curve is a vertical straight line, then e=0 and demand is said to be perfectly

inelastic.

Factors affecting price elasticity:

1.availability of substitutes

Larger the availability of close substitutes, the more elastic will demand be.

2. Time period : Product durability

Durable goods tend to be more price-elastic in the short run.

Suppose price of TV goes up by some amount (say 5%), purchase of TV drops (say 10%) : e=2

Overtime, as TV becomes old, people again buy TV in the longer run TV purchase go down by 8% =>

e=1.6

3. Time period : adjustment

Larger the time period, the higher the elasticity of demand. Suppose petrol prices go up, short run demand

falls somewhat because motorists drive less. In the long run, people switch to smaller more fuel-efficient

cars - quantity demanded will go down.

If demand is price elastic : Increasing price would reduce Total Revenue and reducing price would

increase Total Revenue.

If demand is price inelastic : Increasing price would increase Total revenue, Reducing price would reduce

Total revenue.

Income-elasticity of Demand Em = (^q/^m) (M/Q)

In the case of a normal good, Em >0, while for an inferior good, it is <0. If 0 < Em < 1, then the good is

called a necessity, otherwise it is a luxury.

Cost theory

The opportunity cost of an action refers to the rupee value of the next best alternative forgone. Costs are

tied to actions, not things.

Accounting costs are derived from financial reports that mainly categorize explicit rupee payments. As a

result, accounting costs can miss out on some implicit or hidden costs. The major deficiency of the

conventional economic statement is that it does not provide revenues and costs of alternative actions.

Accounting profit = Total revenue - explicit costs

Economic profit = Total revenue - opportunity costs

Therefore, in economics, if we say that a firm is earning zero or negative profits, this does not mean that

its accounting profit is zero or negative. Even a positive accounting profit may hide the true cost of

resources being used by the firm.

If economic profit = 0, then firm is said to earn normal profit, means if a firm is to continue operations in

an industry, economic rationale demands that it earn revenue at least sufficient to cover the returns from

alternative uses of its resources.

If economic profit > 0, then the firm is making Supernormal profits, and resources are attracted into the

industry.

If economic profit < 0, the firm can earn more elsewhere, and it would want to exit from the industry.

Market structures

Economists distinguish between market structures on the basis of the extent of strategic interaction

between sellers in the market / industry.

Perfect Competition : Many Sellers

Oligopoly : Few Sellers

Monopoly : One Seller

Competition can afflict an industry like a cancer. Left undetected, Competition may intensify and spread,

threatening the survival of all but the hardiest competitors. Early detection of competition can help firms

avoid its worst consequences.

Firms can adopt the following strategies to make sure that these conditions do not hold together at the

same time :

Non-Price competition

Product differentiation

Creation of entry barriers

Collusion

Use of Proprietary information

Measuring economic success • GDP (gross domestic product)/GNI (gross

• national income)

o Annual growth rate

o Per capita GDP/GNI

• Price level:

o Inflation rate

• External balance:

o Trade deficit as % of GDP

o Current account deficit (CAD) as % of GDP

• Unemployment (and poverty) rates

Pricing theory

Consumer behavior

Anyone who purchases goods and services from the market and pays for them is a Consumer.

Ways in which consumers can be exploited in Market:

Weighing less than what the trades charge for

Charging more than max. retail price

Adulteration or defective goods

Misleading advertisements

Bills are not given for the commodities purchase

When a consumer becomes conscious of his\her rights, while purchasing goods/services they will be able

to discriminate and make choices. This calls for acquiring the knowledge and skill to become well

informed consumer.

Consumer can express their solidarity through following forums:

Consumer Movements

Consumer Protection Council

• Consumers want to get the combination of goods on the highest possible indifference

curve. However, the consumer must also end up on or below his budget constraint.

• Combining the indifference curve and the budget constraint determines the consumer’s

optimal choice.

• Consumer optimum occurs at the point where the highest indifference curve and the

budget constraint are tangent.

• The consumer chooses consumption of the two goods so that the marginal rate of

substitution equals the relative price.

• At the consumer’s optimum, the consumer’s valuation of the two goods equals the

market’s valuation.

• An increase in income shifts the budget constraint outward.

• The consumer is able to choose a better combination of goods on a higher

indifference curve.

Regulation

Fiscal Policy • Operates through changes in government expenditure and revenue

Expansionary Fiscal Policy

• Upward shift of the aggregate demand curve through: – Larger government expenditure on goods and services (G ↑) – Lower taxes on households (C ↑) – Etc • Output goes up not only due to the initial ↑ in expenditure but subsequent rounds of increases (recall multiplier)

Impact of Government expenditure

Fiscal Policy in Recession

• Increasing government expenditure was Keynes’ solution to the Great Depression

• Can play a very important role in recession/depression when investment demand is not

very sensitive to changes in the interest rate and monetary policy may not be very

effective

• Recall: Interest alone does not necessarily influence I - also important is the expected

rate of return Increasing government expenditure more effective than reducing taxes

• Keynes – even digging trenches and filling up would be good

• Multiplier impact – output will increase more than the original increase

In Open economy: Monetary policy changes

o Changes in interest rates

o Changes in foreign exchange rates

o Changes in net exports

Monetary Policy Instruments in India • Reserve requirements as % of NDTL (net demand and time liabilities)

• Cash reserve ratio (CRR) – cash balance with RBI

• Statutory liquidity ratio (SLR) – safe & liquid assets such as government securities,

cash, gold

• Bank rate:

– Dormant: Currently Bank Rate acts as the penal rate charged on banks for shortfalls in

meeting CRR/SLR

– Bank Rate is also used by several other organizations as a reference rate for indexation

purposes.

Open market operations:

– Outright OMO:

• Activated after Economic reforms with the development of an active government

securities market

– Liquidity adjustment facility (LAF):

• RBI sets two rates - repo and reverse repo and offers to buy securities or sell securities

respectively

• New marginal standing facility (MSF) at 1% above repo rate

– Market stabilization scheme (MSS):

• RBI permitted to issue treasury bills and dated securities for sterilization purposes

Problems of using monetary policy for controlling inflation

• Demand-pull/Cost-push

• Fix-price/Flex-price

• Wage-price spiral

• Stagflation

• Inflationary expectations

Antitrust Policy

Income distribution