Economics by Bhawani Nandan Prasad

1. 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

2. • 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.

3. 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.

4. 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.

5. 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.

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

7. 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.

8. 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 * yq]
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

9. 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.

10. 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

11. 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)

12. 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.

13. 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

15. 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

16. 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 hisher 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.

17. 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.

18. • 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

19. • 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

20. 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

21. Income distribution