Webinar on Economics Basics by IIM Rohtak for Admissions-2014
Webinar : Economics
For CAT 2013 Call Getters
A webinar by PR Cell, IIM Rohtak for Preparation
for WAT-PI process, Admissions-2014
• 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
Economics and its Scope
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.
It is the branch of economics that examines the functioning of
individual industries and the behavior of individual decisionmaking units—that is, business firms and households.
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
• 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.
• Collection of buyers and sellers that, through their actual or
potential interactions, determine the price of a product or set of
• 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.
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.
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
The Market Mechanism
• Tendency in a free market for price to change until the market
• Equilibrium (or market clearing) price :
Price that equates the quantity supplied to the quantity
• 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
• At the lower price P2, there
is a shortage, so price is bid
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
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
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.
Linear Demand 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
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
Arc Elasticity of Demand
● arc elasticity of demand Price elasticity calculated over a range of
Effects of government intervention –
• 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
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
• 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.
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.
• 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
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 anotherThe 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
• 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
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
• For example, when deciding whether to produce additional output, a
firm considers only the additional (or marginal cost), not the sunk
• Returns to scale
– Increasing returns to scale
– Constant returns to scale
– Decreasing return to scale
• Economies and Diseconomies of scale
• Consumer Surplus
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 is the use of
expenditure to influence
• An increase or decrease in
has a direct impact on the
AD as it leads to increased
or decreased demand for
goods and services in the
• 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
• 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
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
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
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
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.
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
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.