02 10 Principles

There's always Trade-offs¶

Refers to the fact that when picking an option, you're always giving up on something else; ie there is always an opportunity cost

It is due to scarcity of resources; every resource is finite; nothing comes free

Eg: when i want to study, i'm giving up sleep

Real Cost¶

Cost of something is what you sacrifice to get it Real Cost = relative price = opportunity cost

It's not just monetary cost

Rational people think at Margin¶

Rationality: making a decision considering all possibilities to obtain best outcome with minimal input and losses.

Marginality: making decisions considering incremental benefits/costs associated with an action; not at total benefit/cost

marginal profit (net benefit) = marginal benefit - marginal cost Proceed incrementing production as long as marginal net benefit \(\ge\) 0

People respond to incentives¶

Incentive: instrument to induce an individual to act/react tool to change behavior

Subsidies = +ve incentive Taxes = -ve incentive

Trade benefits everyone¶

1. Reduces cost of production through specialization Specialists require lower resources for production, because they are really good at it; hence they can increase output
2. Both parties gain a greater variety of goods and services

Overall trade gains depends on

1. choice set
2. cost minimization

Individual gains depends on

1. Terms of trade basically means the exchange rate
2. Bargaining power
3. nature of the product (Shelf life / perishability) The one with the greater shelf life product will have greater bargaining power because they don't have to sell in a hurry
4. elasticity of demand

Benefits of scale¶

You get larger benefits with lower costs if you focus on specialization at large scale

Larger systems are more productive per unit input

The average cost reduces when the volume of production increases

eg: college mess cooking $$ \text{Cost}(y) = y^\alpha $$ Where \(y =\) output quantity

Benefits of scale exists if \(\alpha < 1\)

Elasticity of demand¶

Elastic demand¶

Demand for commodity is highly sensitive to income of consumers

eg: smartphones

Inelastic demand¶

Demand for commodity is nearly independent of income of consumers.

Eg: coffee, rice, food Even if someone gets richer, they won't be eating more food

Markets are usually good¶

Economic Systems¶

An economic system is an arrangement of economic activity

Functions of Market¶

1. organizing economic activity

2. determining the price supply reflects the availability/abundance of the commodity demand reflects the willingness for purchasing commodity price for a product without a market(demand/supply) for it is undefined

3. Signaling and allocation of resources

Not all market signals are pure market signals Distortion of market signal: when govt creates policies to change pricing in a free market Eg: subsidies

Government¶

Govt can help improve market outcomes

1. Protect property rights

2. Generate efficient outcomes, such as prevent

   1. Monopoly

   2. Tragedy of Commons for CPR(Common Property Resources)

      For community resources(like fishing ponds, forests), the govt comes in to prevent over-utilization of the resources; supports sustainability

3. Market failure

   1. Market fails when it comes to non-excludable commodity
   2. Govt interferes in fields where private investors are not interested

   Examples

   • national defence
   • community services
   • landscapes
   • fresh air

4. Promote equality/equity

   1. prevention of trade of whatever is socially harmful (alcohol, drugs)
   2. keeps market's obsession with efficiency at the expensive of equity in check
   3. reduces economic inequality

5. Socially desirable outcomes

Monopoly¶

private monopoly: unfair situation for consumers where there is only a sole producer of a product natural monopoly: situation where there is a single producer (like govt), but not necessarily bad; eg: Railways

monopoly can be addressed through govt subsidies for the monopoly the monopoly company will tend to increase output to attain the new maximum marginal net benefit hence, the level of optimal output will be greater after subsidies than without it, and hence the producers increase the supply this will reduce the price and benefit the consumers

Excludability¶

Excludable¶

possible to exclude whoever did not pay for it

Eg: netflix subscription

Non-excludable commodity¶

where it is impossible to exclude those who did not pay for it

eg: national defence, community parks

Efficiency vs Equity¶

There is always a conflict b/w efficiency vs equity.

Efficiency¶

optimization to maximize output with minimum input

Equity¶

Morals

upholding social norms, benefitting society/the world

Rivalry of consumption¶

Rivalled consumption¶

When the consumption of a product makes it unavailable for consumption for others

Non-rivalled consumption¶

When the availability of a product is independent of its consumption

That's one of the best things of digital revolution: it has enabled non-rivalry

Eg: national defence, fresh air, lighthouses, netflix subscription

Goods¶

Something that generates pleasure

You pay for it

Bads¶

generates displeasure

you receive payment

Standard of living¶

Standard of living of a country depends on its production level

Measures for standard of living

• for individuals comparing real personal income
• for countries
  • comparing real GDP shows the employment opportunities in the country
  • comparing real GNP (Gross National Product) shows the status of citizens of the country
  • per capita income and output per capita income \(= \frac{income}{population}\), per capita output \(= \frac{output}{population}\) shows the average contribution of people; doesn't show income inequality though

Disparities in standard of living is caused due to difference in productivity Productivity: amount of goods and services produced by a worker during an hour of work

i don’t exactly agree with this cuz women have a history of earning less for the same productivity

Income¶

Nominal income¶

monetary income

Real income¶

\(\frac{\text{nominal income}}{\text{average of prices of all goods and services bought}}\)

it reflects the quantity of goods and services you can buy

GDP & GNP¶

Gross Domestic Product¶

total value of final goods and services produced within the borders of a country (regardless of nationality)

From the consumer's perspective, it is the same as national income ie, sum of incomes of all individuals is mathematically = GDP

Gross National Product¶

total value of final goods and services produced only by the nationals/citizens of a country (regardless of location)

Nominal GDP & GNP¶

production quantity x prices of the current year

Real GDP & GNP¶

production quantity x prices of base year

Paradox of value¶

The paradox of value is the contradiction that, although water is more necessary than diamonds for survival, diamonds are costlier

Prices rise when govt prints excess money¶

4 functions of money

1. Facilitates trade prevents the need for coincidence of wants; ie money prevents the need for both parties to want to exchange products that they want from the other person
2. mode of deferred payment
3. unit of value
4. store of value

If you print money without them producing anything, money loses its value and inflation occurs However, if you print money due to increase in the country's output, then it's fine

When prices of commodity increases, value of money reduces

value of money \(\propto \frac{1}{\text{price of commodities} }\)

Inflation¶

Rate at which prices of commodities increase

happens when economy is doing well

upto 2-5% inflation is acceptable

Inflation Models¶

Taylor Rule¶

Inflation rate something

Money Supply¶

Inflation-Welfare Cost Relation¶

Micro Effects¶

Money-givers gain

Fixed income money-receivers lose eg: regular employees

Variable income money-receivers not affected business people, freelancers

Macro Effects¶

Imports increase: demand for domestic products decreases, as they are costlier Exports decrease: as other countries do not want a more expensive product

Hence, high inflation is not good

Cost-Push inflation¶

Prices increase due to increase in the cost for supply

• cost of production
• prices of raw materials
• oil prices (transportation)

for the name, think suppliers push the product to the consumers

Demand-pull inflation¶

Prices increase due to increase in demand

for the name, think consumers pull the product from the sellers

Structural inflation¶

The suppliers are not able to keep up with the demand due to lack of infrastructure; ie, demand increases and producers want to increase output, but aren't able to do so

idk point: Agricultural inflation affects non-agricultural sectors, as agricultural products are used as raw materials also, agricultural sector depends on the manufacturing sector and vice-versa

Deflation¶

Rate at which prices decreases

in other words, it is negative inflation

more dangerous than high inflation

Welfare Cost¶

The cost associated with any action that has macro-level consequences and affects entire society eg: taxes, interest rates have welfare costs associated with them

Inflation/Unemployment¶

Economy faces a short-run trade-off between inflation and unemployment

Short run: period where contracts cannot be renegotiated (monthly, quarterly) Lon run: a long period (annually) which contains multiple renegotiations of contracts

Unemployment¶

the fraction/proportion of people seeking jobs but cannot get

does not include people who aren't seeking jobs

Natural Rate¶

Unemployment rate which exists regardless of whatever we do

Depends on the country's

1. resources
2. technology
3. production capacity/no of factories
4. population/size of the country

Actual Rate¶

The current rate of unemployment

it fluctuates a lot

• during depression, actual > natural
• during boom, actual < natural

However, if you take the average of 20yrs or so, the average actual rate tends to the natural rate

Output¶

Potential output¶

predicted output an economy can ideally produce by using all its resources

Actual output¶

What an economy actually produces

Scenarios¶

• during recession, actual < potential
• during boom, actual > potential

Phases of economy¶

flowchart LR
Depression --> Recovery --> Boom --> Recession --> Depression

Phillips Curve Relation¶

• y-axis = inflation
• x-axis = unemployment

• \(\pi_t =\) Inflation
• \(\alpha =\) inflation when there is no unemploment
• \(\beta =\) cost for reducing unemployment by a unit
• \(U_t =\) actual rate of unemployment

This relation is only short-run for long run, whatever is the inflation, unemployment tends to natural unemployment the graph will be a straigth line parallel to the y-axis

During shortrun, the contracts for raw materials, employees is fixed but prices for commodity increases therefore, producers increase production to maximize profit (misperception by producers); this is done by increasing employees Unemployment rate decreases

Moreover, workers suffer money illusion (only focus on the nominal income increase; don’t realise that the real income is the same)

Then in the long run, few months later, the employees will renegotiate for higher wages; then the producers will hesitate as they no longer see the attraction for producing at such large volume and paying such wages; so they fire employees; therefore, the unemployment rate will increase again

Inflation, Employment, Output¶

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