4. Core issues in an economy
What to produce?
should the emphasis be on agriculture, manufacturing or services, or should it be on
health, manufacturing, or housing?
How to produce?
Labour-intensive, land-intensive, capital-intensive?
Whom to produce?
Should income distribution be evenly distributed?
Whether to produce for domestic territory or to have trade relations
5.
6. Economic System
An economic system is a mechanism with the help of which the
government plans and allocates accessible services, resources, and
commodities across the country.
Economic systems manage elements of production, combining
wealth, labor, physical resources, and business people.
An economic system incorporates many companies, agencies, objects,
models, and deciding procedures.
7. Types of Economic System
Capitalism
Socialistic Economy
Mixed Economy
8. Capitalist Economy
In a capitalist system, the products manufactured are divided among people, not
according to what they want but on the basis of purchasing power, which is the
ability to buy products and services.
This means an individual needs to have the money with him to buy goods and
services.
Low-cost housing for the underprivileged is much required but will not include
demand in the market because the needy do not have the buying power to back
the demand.
Therefore, the commodities will not be manufactured and provided as per market
forces
9. Socialist Economy
In a socialist society, the government determines what products are to
be manufactured in accordance with the requirements of the society.
It is believed that the government understands what is appropriate for
the citizens of the country.
Therefore, the passions of individual buyers are not given much
attention. The government concludes how products are to be created
and how the product should be disposed of.
In principle, sharing under socialism is assumed to be based on what
an individual needs and not what they can buy.
A socialist system does not have a separate estate because everything
is controlled by the government.
10. Mixed economy
Mixed systems have characteristics of both the command and the market economic
system.
For this purpose, mixed economic systems are also known as dual economic
systems.
However, there is no sincere method to determine a mixed system.
Sometimes, the word represents a market system beneath the strict administrative
control in certain sections of the economy
11. Economic Sector
Primary sector: It is that sector that relies on the environment for
any production or manufacturing. A few examples of the primary
sector are mining, farming, agriculture, fishing, etc.
Secondary sector: In this sector, the raw material is transferred to a
valuable product. A few examples are construction industries and
the manufacturing of steel, etc.
Tertiary sector: It is also known as the service sector, and it includes
the production and exchange of services. A few examples are
banking, insurance, transportation, communication, etc.
13. Opportunity Principle
By opportunity cost of a decision is meant the sacrifice of alternatives required by
that decision. If there are no sacrifices, there is no cost.
For instance, a person chooses to forgo his present lucrative job which offers him
Rs.100000 per month, and organize his own business.
The opportunity lost (earning Rs. 100,000) will be the opportunity cost of running
his own business.
14. Discounting
According to this principle, if a decision affects costs and revenues, in the long run, all those
costs and revenues must be discounted to present values before a valid comparison of
alternatives is possible.
This is essential because a rupee worth of money at a future date is not worth a rupee today.
Money actually has a time value. Discounting can be defined as a process used to transform
future dollars into an equivalent number of present dollars.
For instance, $1 invested today at 10% interest is equivalent to $1.10 next year.
15. Discounting
FV = PV*(1+r)t
Where FV is the future value (time at some future time), PV is the present value
(value at t0, r is the discount (interest) rate, and t is the time between the future
value and present value.
The present value formula is PV=FV/(1+r)t,
where you divide the future value FV by a factor of 1 + r for each period between
the present and future dates.
16. The Production Possibility Curve
The production possibility frontier is the graph, which
indicates the various production possibilities of two
commodities when resources are fixed.
The production of one commodity can only be increased by
sacrificing the production of the other commodity.
It is also called the production possibility curve or product
transformation curve.
17. Production Possibility Frontier
Assumptions and description
The state of technology is taken to be constant.
Since the production of one commodity can be increased only by
decreasing the production of the other commodity, production
possibility curve also measures the production efficiency of the
commodities. Hence, PPF assumes that all inputs are used
efficiently.
The production possibility frontier helps in deciding the
commodities most beneficial to society, but this response is limited
in itself as there is a choice between two commodities only.
There is only a choice between two commodities.
19. PPF or PPC explanation
The production possibility frontier shows us that there are limits to
production, so an economy, to achieve efficiency, must decide what
combination of goods and services can and should be produced.
Let's turn to an example. Imagine an economy that can produce only two
things: wine and cotton.
According to the PPF, points A, B and C – all appearing on the PPF curve –
represent the most efficient use of resources by the economy.
20. For instance, producing 5 units of wine and 5 units of cotton (point B) is just as
desirable as producing 3 units of wine and 7 units of cotton.
Point X represents an inefficient use of resources, while point Y represents the
that the economy simply cannot attain with its present levels of resources.
As we can see, in order for this economy to produce more wine, it must give up
some of the resources it is currently using to produce cotton (point A).
21. Cont..
If the economy starts producing more cotton (represented by points B and C), it
would need to divert resources from making wine and, consequently, it will
produce less wine than it is producing at point A.
As the figure shows, by moving production from point A to B, the economy must
decrease wine production by a small amount in comparison to the increase in
cotton output. The forgone production of wine in order to increase the cotton
production is called the opportunity cost of cotton production.
If the economy starts producing more cotton (represented by points B and C), it
would need to divert resources from making wine and, consequently, it will
produce less wine than it is producing at point A.
22. Cont..
As the figure shows, by moving production from point A to B, the
economy must decrease wine production by a small amount in
comparison to the increase in cotton output.
However, if the economy moves from point B to C, wine output will be
significantly reduced while the increase in cotton will be quite small.
Keep in mind that A, B, and C all represent the most efficient allocation
of resources for the economy; the nation must decide how to achieve
the PPF and which combination to use.
If more wine is in demand, the cost of increasing its output is
proportional to the cost of decreasing cotton production. Markets play
an important role in telling the economy what the PPF ought to look
like.
23. Cont.…
Being at point X means that the country's resources are not being
used efficiently or, more specifically, that the country is not producing
enough cotton or wine given the potential of its resources.
On the other hand, point Y, as we mentioned above, represents an
output level that is currently unattainable by this economy.
But, if there were a change in technology while the level of land,
labour and capital remained the same, the time required to pick cotton
and grapes would be reduced.
Output would increase, and the PPF would be pushed outwards. A
new curve, represented in the figure below on which Y would fall,
would then represent the new efficient allocation of resources.
25. PPF or PPC Shifting
When the PPF shifts outwards, we can imply that there has been growth in an economy.
Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking due
to a failure in its allocation of resources and optimal production capability.
A shrinking economy could be a result of a decrease in supplies or a deficiency in
technology.
An economy can only be producing on the PPF curve in theory; in reality, economies
constantly struggle to reach an optimal production capacity.
And because scarcity forces an economy to forgo some choice in favour of others, the
slope of the PPF will always be negative; if production of product A increases then
production of product B will have to decrease accordingly.
26. Production Possibility Frontier
and opportunity cost
The opportunity cost is the cost of an alternative that must be forgone
in order to pursue a certain action.
An opportunity cost will usually arise whenever an economic agent
chooses between alternative ways of allocating scarce resources. The
opportunity cost of such a decision is the value of the next best
alternative use of scarce resources.
Opportunity cost can be illustrated by using production possibility
frontiers (PPFs) which provide a simple, yet powerful tool to illustrate
the effects of making an economic choice.
A PPF shows all the possible combinations of two goods, or two
options available at one point in time.
27. Production possibilities
Suppose any country’s economy, produces only two
goods - textbooks and computers.
When it uses all of its resources, it can produce five
million computers and fifty-five million textbooks.
In fact, it can produce all the following combinations
of computers and books (Table 1).
34. Marginal Principle
This principle states that a decision is said to be rational and sound if, given the firm’s objective of
profit maximization, it leads to an increase in profit, which is in either of two scenarios-
If total revenue increases more than total cost.
If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal
generally refers to small changes.
Marginal revenue is a change in total revenue per unit change in output sold.
Marginal cost refers to change in total costs per unit change in output produced (While incremental
cost refers to change in total costs due to change in total output).
The decision of a firm to change the price would depend upon the resulting impact/change in
marginal revenue and marginal cost.
If the marginal revenue is greater than the marginal cost, then the firm should bring about the
change in price.
35. Incremental Principle
Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's
performance for a given managerial decision, whereas marginal analysis often is generated by a
change in outputs or inputs.
Incremental analysis is generalization of marginal concept. It refers to changes in cost and revenue
due to a policy change.
For example - adding a new business, buying new inputs, processing products, etc. Change in
output due to change in process, product or investment is considered as incremental change.
Incremental principle states that a decision is profitable if revenue increases more than costs; if
costs reduce more than revenues;
if increase in some revenues is more than decrease in others;
and if decrease in some costs is greater than increase in others.
36. Time Perspective
According to this principle, a manager/decision maker should give due emphasis, both to
the short-term and long-term impact of his decisions, giving apt significance to the
different time periods before reaching any decision.
Short-run refers to a time period in which some factors are fixed while others are variable.
The production can be increased by increasing the number of variable factors.
While the long run is a time period in which all factors of production can become variable.
Entry and exit of seller firms can take place easily.
From a consumer’s point of view, the short-run refers to a period in which they respond to
the changes in price, given the taste and preferences of the consumers, while the long-run
is a time period in which the consumers have enough time to respond to price changes by
varying their tastes and preferences.
