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Principles of Economics
Foundation Course in Managerial Economics
In this course, we will be focusing on microeconomic theories. We will see how people make decisions and how choices are made in the economy. There are 10 principles of economics which Professor Greg Mankiw has beautifully laid down in his book, Principles of Economics. These principles are about how people make decisions and how different nations interact with each other based on these principles. The opportunity cost is basically the salary or the income that the student is foregoing by taking up the option of doing higher education. So, nothing comes for free in this world. The fourth principle is that people respond to incentives, which is true everywhere. These principles are going to guide us to understand how people interact with each other. One of the principles is trade can make everyone better off. We are getting cheaper products from other countries and other countries are being able to utilize the efficient production or the quality of production that we are able to offer. Markets are usually a good way to organize economic activity. There is a demand for a certain product, people are willing to pay a certain price for it and price acts as a signal in the market. So this is how the market resolves the problem of what gets produced in the market, but how does it do so? It does by the demand. Markets are usually a good but not always and when the markets fail, governments improve market outcomes. An activity is causing or affecting people or stakeholders who are not directly involved in this economic activity. This is where the government has to intervene in the market. Another example is public goods. Say for example keeping the air clean is a public good. Public good is something from which you can not exclude anyone. The economy depends on how efficiently the country is able to produce its limited resources. Price rise is basically inflation when the government prints too much money. Inflation happens when the economy is chasing too little goods and the prices of these goods go up. Society faces a tradeoff between inflation and unemployment. This course is on primarily microeconomics and we are calling it managerial economics. This is about decision making process of individuals or managers who are who need to understand how consumers make decisions. We are going to develop various models to try to understand the basic functioning of these markets.
Demand - Supply Framework
Foundation Course in Managerial Economics
Now, suppose that the price of ice cream falls from $5 to $4. In this situation, the quantity demanded of ice cream will rise from 20 cups to 24 cups. Why? Because the new price is lower than the previous price, consumers are now willing to purchase more ice cream at each transaction. As long as the price remains below the equilibrium quantity, the quantity demanded will continue to increase until the entire market is consumed. The quantity demanded of any good is determined by the price of the good, and other things remaining the same. When it is winter, I buy less or the temperature outside is colder, what is the day temperature outside like? So maybe weather is one of the other things that affects my demand for ice cream. An individual comes to the market which with their demand curve and all the demand gets. All the demand that aggregates in the market and we get something called the market demand curve. This is the law of demand and in the next module I am going to talk about the different determinants of demand.
Determinants of Demand
Foundation Course in Managerial Economics
The demand curve is a graphical representation of the relationship between price and quantity demanded of a particular good. Other things remaining the same, the higher the price of a good, the lower the quantity demanded. However, there are certain goods that have a higher demand as people's incomes increase. For example, if the price of ribbons goes up, the demand for printers will go down. Additionally, expectations play a role in demand; if people are expecting prices to rise, they will demand more of that good. Lastly, taste and preference also play a role in demand. If the price of an item changes, people's demand for that item will change along the demand curve. If the other factors affecting demand (such as the availability of the item) remain unchanged, the demand curve will shift to the right. If, on the other hand, the availability of the item changes, people's demand for that item will shift to the left.
Supply Curve, Determinants of Supply Curve
Foundation Course in Managerial Economics
We have started with the concept of perfectly competitive markets. We are trying to explain equilibrium in a perfectly competitive market. The intersection of demand and supply determines the market equilibrium. So in the next week we are going to talk about elasticities of demand, price elasticity and income elasticity. We will also see how changes in prices change demand and how they also help us understand various factors.
Elasticity of Demand and Supply
Foundation Course in Managerial Economics
The second week of the foundation course in managerial economics was focused on elasticity. We talked about what is elasticity, what price elasticity of demand is, and cross price elasticity. Elasticity tells us a lot about how revenue or expenditure is hoped to be produced in an industry. Price elasticity of demand reflects how much demand responds to changes in variables like price or income. How much demand resists an increase in price or how much distortion occurs when one of the determinants of demand changes is determined by the law of demand. In the example of an ice cream market, if the producer's costs are going up and they want to increase their price, it would make sense for them to do so if the increase in price is more than the percentage increase in quantity demanded. Elasticity is a measure of how responsive demand is to changes in price. When the price is increasing, quantity decreases, and when the price is decreasing, quantity increases. This is not to say that the producer is not going to increase the price- when I am calculating elasticity, I use the midpoint method to get a value that is independent of the point at which it is calculated. The value of elasticity varies depending on the point at which it is calculated, but in both cases, when the price is increasing or decreasing, elasticity will have the same value. This is how elasticity of demand concept is used in economics and in the next module, we will be looking at the relationship between the demand curves and the shapes of the demand curves. Additionally, we will be looking at how elasticity of demand depends on the determinants.
Determinants of Elasticity of Demand
Foundation Course in Managerial Economics
In the last module, we introduced the concept of elasticity of demand and saw how elasticity is calculated. Now, we will look at how responsiveness of demand to price changes varies across commodities. There are three main principles determining price elasticity: 1) the magnitude of the price change that is necessary to cause a change in demand (the responsiveness of demand to price changes); 2) the type of product; and 3) whether the good is a necessity or a luxury. Price elasticity is higher for luxuries than necessities, and it is higher in the short run than the long run. An example of a situation where price elasticity is high is when someone buys a five-star meal at a five-star restaurant. Another situation where price elasticity is high is when people are buying petrol in short run verses petrol in the long run. In the short run, it is not easy for people to adjust their demand because it depends on what kind of cars they are driving. Price elasticity of demand is higher in the long run than the short run. Flatter the demand curve larger the elasticity and steeper the demand curves more inelastic the demand is. Flatter the. demand curve is larger the. elasticity. and larger the curve is. If the price is very high people are going to respond quicker to a reduction in price. a perfectly inelastic demand curve means that there is no response of quantity to prices. flatter demand curve gives me a high elasticity of demand. On the other hand i if i have a this is a very steep demand curve. So flatter the demand curve larger the elasticity. So can one imagine such a demand curve in the market. Probably no. perfectly elasticity demand curve means that change in quantity is infinite if there is a little bit of change in price or on the other hand that price does not change. You are going to breathe in the exactly same amount of air no matter what the people are willing to consume. So at this price infinite amount of quantity can be sold in the market and there is no price change Imagine a huge agricultural products market where sellers are competing for buyers to sell their goods at the lowest possible price. This is a perfect competitive market, meaning that there are many buyers and one seller. If the seller offers a price that is less than the price of another seller, it is not possible to meet the demand. The slope of the demand curve is constant, but its elasticity (the degree to which demand changes with price) varies at different points on the curve. This is an illustration of something I said earlier: if you are on the higher end of the demand curve or the price is too high, your elasticity is probably too high.
Price elasticity of demand reflects how much demand responds to changes in variables like price or income. How much demand resists an increase in price or how much distortion occurs when one of the determinants of demand changes is determined by the law of demand. In the example of an ice cream market, if the producer's costs are going up and they want to increase their price, it would make sense for them to do so if the increase in price is more than the percentage increase in quantity demanded. Elasticity is a measure of how responsive demand is to changes in price. When the price is increasing, quantity decreases, and when the price is decreasing, quantity increases. This is not to say that the producer is not going to increase the price- when I am calculating elasticity, I use the midpoint method to get a value that is independent of the point at which it is calculated. The value of elasticity varies depending on the point at which it is calculated, but in both cases, when the price is increasing or decreasing, elasticity will have the same value. This is how elasticity of demand concept is used in economics and in the next module, we will be looking at the relationship between the demand curves and the shapes of the demand curves. Additionally, we will be looking at how elasticity of demand depends on the determinants.
Demand Supply & Government Policies
Foundation Course in Managerial Economics
We will be utilizing a few modules to understand different policies of the government. Exceptions where markets fail and we said that although market is usually a good way of doing things. But there could be situations where the market outcome is not desirable in the economy. Say for example, India is a very hugely populated economy with lots of people looking for jobs and very high level of poverty. In certain situations, the price quantity equilibrium that is reaching through the demand supply framework of the market is not a desirable outcome which is to us. So in such a situation, the government may intervene and in certain situations, the government may raise the price in some cases and may lower it in others. So basically, what we are saying is since a lot of outcome market outcome in the economy is not acceptable or desirable to society in general, the government can set a price floor or price ceiling through various means, say for example, by increasing the tax. That that eventually raises the price for a commodity. The
government's price that it setting is resulting in an output outcome of price and hence an outcome of purchased which is different from the price quantity equilibrium that a free market will arrive at. So in all these cases, market equilibrium is disrupted. will bring him above the price ceiling and so forth. so not only will the suppliers on the supply side be seeking prices above the ceiling but also those on the demand side who are not being supplied at the price they would like to be. so the result of having a price ceiling is that there is not much competition and so the prices are high. The demand and supply curves are flatter in the long run because people both buyers and sellers both groups of people get more time to adjust to the prices and they adjust their preferences. The demand curve is more elastic and the supply curve is also more elasticity. As a result, because of the same price ceiling, the shortage is going to increase. In the long run, suppliers will find it less attractive to supply electricity in the market, so basically they reduce their capacity and they are not too much interested to be in the supply in the production of electricity. On the other hand, since prices are too low of electricity consumers are going to adjust their demand and they will shift to more and more consumption of more electricity intensive consumption behaviour. Both demand is distorted and supply is controlled in the market. That is where lot of resources are wasted in the economy. Resources could have been put to production and that would have satisfied the demand of lot of people and lot of suppliers would be happy to sell it to the market at a slightly higher price but that is not happening. So in the next class we are going to talk about price floors.
