Webinar : Economics For CAT 2013 Call Getters

IIM Rohtak Vivek Pandey Nishat Goel

A webinar by PR Cell, IIM Rohtak for Preparation for WAT-PI process, Admissions-2014

Session Agenda

• The objective of this session is to guide the participants on basics of Economics.

The principle of scarcity

• When we talk of scarcity within an economic context, it refers to limited resources, not a lack of riches. These resources are the inputs of production: land, labor and capital.

• People must make choices between different items because the resources necessary to fulfill their wants are limited. These decisions are made by giving up (trading off) one want to satisfy another.

Economics and its Scope

• Economics

It is the social science that studies how individuals, groups, and organizations (called economic actors, players, or agents), manage scarce resources, which have alternative uses, to achieve desirable ends.

• Microeconomics

It is the branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, business firms and households.

• Macroeconomics

It is the branch of economics that examines the economic behavior of aggregates— income, output, employment, and so on—on a national scale

Prices and Markets • Microeconomics describes how prices are determined.

• In a centrally planned economy, prices are set by the government.

• In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets—collections of buyers and sellers that together determine the price of a good.

Market

• Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products.

• Market Definition: Determination of the buyers, sellers, and range of products that should be included in a particular market.

• Extent of a market Boundaries of a market, both geographical and in terms of range of products produced and sold within it.

• Market definition is important for two reasons:

– A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future.

– Market definition can be important for public policy decisions.

Types of Markets

• Monopoly and monopolistic competition

• Monopsony

• Bilateral Monopoly

• Duopoly

• Oligopoly

• Cartel

• Oligopsony

• Perfectly competitive market

• Noncompetitive market

Classification of goods

Complementary goods: Complementary goods are one that are consumed together, e.g., hamburgers and French fries or IPods and IPod docking stations.

Substitute goods are alternatives to one another, e.g., a bicycle is a substitute for a car in transportation.

A normal good is one the consumption of which increases as income increases.

An inferior good is one the consumption of which decreases as income increases. Example cheap wine.

Basics of

Demand and Supply

The Demand Curve

• Relationship between the quantity of a good that consumers are willing to buy and the price of the good.

• We can write this relationship between quantity demanded and price as an equation:

• QD = QD(P)

The Demand Curve

• The demand curve is downward sloping, holding other things equal, consumers will want to purchase more of a good as its price goes down.

• The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods.

• A higher income level shifts the demand curve to the right (from D to D’).

The Supply Curve

• Relationship between the quantity of a good that producers

are willing to sell and the price of the good.

• We can write this relationship as an equation:

• QS = QS(P)

The Supply Curve

• The supply curve is upward sloping: The higher the price, the more firms are able and willing to produce and sell.

• If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right (from S to S’).

The Market Mechanism

• Tendency in a free market for price to change until the market clears.

• Equilibrium (or market clearing) price : Price that equates the quantity supplied to the quantity demanded.

• Surplus : Situation in which the quantity supplied exceeds the quantity demanded.

• Shortage : Situation in which the quantity demanded exceeds the quantity supplied.

The Market Mechanism

• The market clears at price P0 and quantity Q0.

• At the higher price P1, a surplus develops, so price falls.

• At the lower price P2, there is a shortage, so price is bid up.

Changes in Market Equilibrium

• New Equilibrium Following

Shift in Supply • New Equilibrium Following Shift in Demand

Changes in Market Equilibrium

• New Equilibrium Following Shifts in Supply and Demand

Elasticities of Demand and Supply

• Price elasticity of Demand :

Price elasticity of demand measures the responsiveness of

demand to changes in price for a particular good.

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Linear Demand Curve The price elasticity of demand

depends not only on the slope

of the demand curve but also

on the price and quantity.

The elasticity, therefore, varies

along the curve as price and

quantity change. Slope is

constant for this linear demand

curve.

Near the top, because price is

high and quantity is small, the

elasticity is large in magnitude.

The elasticity becomes smaller

as we move down the curve.

Elasticities of Demand and Supply

Other Demand Elasticities

● income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income.

● cross-price elasticity of demand Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another.

Elasticities of Supply

● price elasticity of supply Percentage change in quantity supplied resulting from a 1-percent increase in price.

Elasticities of Demand and Supply

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a particular point on the demand curve.

Arc Elasticity of Demand

● arc elasticity of demand Price elasticity calculated over a range of prices.

Effects of government intervention – Price Control • Without price controls,

the market clears at the equilibrium price and quantity P0 and Q0

• If price is regulated to be no higher than Pmax, the quantity supplied falls to Q1, the quantity demanded increases to Q2, and a shortage develops.

The concept of Utility

• Total utility is the satisfaction of consuming a total quantity of a good or service.

• Marginal utility is the additional utility yielded by consuming one more unit of that good or service.

• Diminishing utility means that at some level of consumption an additional unit yields less satisfaction than the preceding unit.

• Equal marginal principle: Principle that utility is maximized when the consumer has equalized the marginal utility per rupee of expenditure across all goods

Indifference Curve

• Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction.

• For any level of utility say U’ = f (x, y) there is a locus of commodity combinations which graphically form an indifference curve. All combinations on that curve have the same level of utility meaning the consumer is ‘indifferent’ to any point on the curve. The indifference curve is also called a preference or utility curve.

Indifference Curve

• An Indifference Curve

The indifference curve U1 that passes through market basket A shows all baskets that give the consumer the same level of satisfaction as does market basket A; these include baskets B and D.

Our consumer prefers basket E, which lies above U1, to A, but prefers A to H or G, which lie below U1.

Indifference Map • Graph containing a set of indifference curves

showing the market baskets among which a consumer is indifferent.

An indifference map is a set of

indifference curves that

describes a person's

preferences.

Any market basket on

indifference curve U3, such as

basket A, is preferred to any

basket on curve U2 (e.g.,

basket B), which in turn is

preferred to any basket on

U1, such as D.

An Indifference Map

Marginal Rate of Substitution • Maximum amount of a good that a consumer is

willing to give up in order to obtain one additional unit of another good.

The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the

consumer’s marginal rate of

substitution (MRS) between two goods.

In this figure, the MRS between

clothing (C) and food (F) falls from 6

(between A and B) to 4 (between B

and D) to 2 (between D and E) to 1

(between E and G).

Convexity The decline in the MRS

reflects a diminishing marginal rate

of substitution. When the MRS

diminishes along an indifference

curve, the curve is convex.

Perfect Substitutes and Perfect Compliments

• Two goods for which the marginal rate of substitution of one for the other is a constant

• Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles.

Maximizing consumer satisfaction

• Satisfaction is maximized (given the budget constraint) at the point where

MRS = P1/P0

• Marginal benefit : Benefit from the consumption of one additional unit of a good.

• Marginal cost : Cost of one additional unit of a good

• Satisfaction is maximized when the marginal benefit—the benefit associated with the consumption of one additional unit of food—is equal to the marginal cost—the cost of the additional unit of food.

Some other concepts

• Opportunity cost is the best alternative that we forgo, or give up, when we make a choice or a decision.

• Opportunity costs arise because time and resources are scarce. Nearly all decisions involve trade-offs.

• Sunk costs are costs that cannot be avoided, regardless of what is done in the future, because they have already been incurred.

• Marginalism : In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.

• For example, when deciding whether to produce additional output, a firm considers only the additional (or marginal cost), not the sunk cost.

• Returns to scale

– Increasing returns to scale

– Constant returns to scale

– Decreasing return to scale

• Economies and Diseconomies of scale

• Consumer Surplus

Macroeconomics

Aggregate Demand and Supply

• Aggregate Demand: Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels.

• It is made up of four basic components: AD = C + I + G + NX C - Consumption demand I - Investment Demand G - Government Expenditure NX - Net Exports

• Aggregate Supply: In economics, aggregate supply is the total supply of

goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a given price level in an economy

• The Government can intervene in the market through two types of policies:

• FISCAL POLICY

• MONETARY POLICY

Fiscal Policy

• Fiscal Policy is the use of government revenue(taxes) and expenditure to influence the economy.

• An increase or decrease in government expenditure has a direct impact on the AD as it leads to increased or decreased demand for goods and services in the economy.

• An increase or decrease in the taxes leads to a change in the disposable income of the people leading to a corresponding change in the expenditure of the people

Monetary Policy

• Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

• The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank.

• The primary way that the central bank can affect the monetary base is by open market operations, or by changing the reserve requirements.

• Open Market Operations: An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

• Reserve Requirements: The banks need to hold a fraction of all deposits that they receive with the central bank and with themselves. This is called the required reserve ratio of banks.

• The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with.

• There are two basic components of required reserve ratio that might

be changed to alter the amount of loanable funds available with the banks. These are:

• Statutory Liquidity Ratio(SLR): SLR specifies the fraction of deposits that the banks need to hold with themselves in order to maintain a certain minimum level of liquidity. This is determined by the central bank of the country.

• Cash Reserve Ratio(CRR): CRR is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.

Balance of Payments

• Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.

• The BOP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit.

• The two principal parts of the BOP accounts are the current account and the capital account.

• The current account is the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers.

• The Capital Account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world.

• The BOP identity assumes that any current account surplus will be balanced by a capital account deficit of equal size – or alternatively a current account deficit will be balanced by a corresponding capital account surplus.

• Current Account + Capital Account = 0

Types of Deficits • Primary Deficit: A primary deficit is the deficit which is derived after

deducting the interest payments component from the total deficit of any budget.

• Current Account Deficit: If an economy is running current account deficit, it is absorbing (absorption = domestic consumption + investment + government spending) more than that it is producing. This can only happen if some other economies are lending their savings to it (in the form of debt to or direct/ portfolio investment in the economy) or the economy is running down its foreign assets such as official foreign currency reserve

• Capital Account Deficit: A deficit in the capital account means money is flowing out the country, and it suggests the nation is increasing its ownership of foreign assets.

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

• Trade Deficit: It is defined as the excess of imports over exports of a country

Repo and Reverse Repo

• Repo Rate: The repo or repurchase rate is the interest charged by the RBI to banks when they approach it for short term loans.

• Reverse Repo: Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.

Exchange Rates

• An exchange rate between two currencies is the rate at which one currency will be exchanged for another.

• The depreciation of a country's currency refers to a decrease in the value of that country's currency. For example, if the value of rupee falls from Rs.50/$ to Rs.60/$.

• The appreciation of a country's currency refers to an increase in the value of that country's currency. For example, if the value of rupee increases from Rs.60/$ to Rs.50/$.

Effects of Currency Appreciation

• Exports more expensive The foreign price of Indian Exports will increase Europeans will find Indian exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of Indian exports.

• Imports are cheaper Indian consumers will find that Re.1 now buys a greater quantity of U.S. goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.

• Lower (X-M) With lower export demand and greater spending on imports, we would expect fall in domestic Aggregate Demand (AD), causing lower economic growth.

• Lower inflation An appreciation tends to cause lower inflation because: – import prices are cheaper. The cost of imported goods and raw

materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.

– Lower AD leads to lower demand pull inflation. – With export prices more expensive, manufacturers have greater

incentives to cut costs to try and remain competitive.

Effects of Currency Depreciation

• A depreciation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

• A depreciation means imports will become more expensive. This will reduce demand for imports.

• Higher economic growth. Therefore higher exports and lower imports will increase AD. Higher AD is likely to cause higher Real GDP and inflation.

• Inflation is likely to occur because: • Imports are more expensive causing cost push inflation. • AD is increasing causing demand pull inflation • With exports becoming cheaper manufacturers may have less

incentive to cut costs and become more efficient. Therefore over time costs may increase.

Q & A