ECON F211

Principles of Economics

The lecture slides are intended for both

section I and section II

2017

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 Scarcity: Our resources are limited

At a certain point of time, we have fixed

resources:
natural - land, water, fossil fuel,
# of people
# of factories
# of schools

Implication?
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 Implication of limited resources:

We can produce limited number of things (goods

/ services) with the limited available resources

Thus at a given point of time, we have fixed/limited

- quantity of food
- number of houses
- quantity of medicines..

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 Basic Problem
We have only limited resources

But our wants, i.e. our desires for the

produced goods/services are unlimited

We would like to have

more and better food, housing, education, .
more and better of practically everything
Exception?
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 Given limited resources and unlimited
wants

Individuals (and society) are forced to pick

some activities and reject others

Consequently, Scarcity implies that we

must make Choices
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Economics: The Study of Choice
Choices are made by
- Individuals
- Group of individuals / Society

- Examples?

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Example 1: choice of an individual

A student wants to have

Better grades: allocate more time to study
More relaxation: allocate more time to entertainment /
social networking.

Problem: Scarce resource

Due to scarce time, student has to choose only

certain amount of hours on FB
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Example 2: Choice made by society

Car factory needs land

Agricultural production also needs land

Problem: Scarce resource

The fact that land is scarce means that society must

make choices concerning its use.

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 PRINCIPLE #1:
PEOPLE FACE TRADEOFFS
To get one thing that we like, we usually
have to give up another thing that we
(also) like.

Making decisions requires trading off one

goal against another

i.e. if one goal is satisfied, the other goal(s)

must be sacrificed/ traded off 9
 Refer to Example1:
Student facing trade off
The student must decide how to allocate her most
valuable resourcetime.

She can spend a given amount of time studying

economics;
or
She can spend the given amount of time on social
networking

For every hour she studies Economics, she gives up

(trades off) an hour of social networking

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 Example 2:
Household facing trade offs
parents decide how to spend their family
income.

They can use family income on food,

clothing, a family vacation, or they can save
some amount for retirement or childrens
higher education.

When they choose to spend on one of these

good/service, they have less amount to
spend on some other good/service
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 Example 3:
Trade-off faced by society

Environmental Laws that require firms to reduce pollution

raise their cost of production (why?)

Because of the higher costs, these firms end up earning less

profits, paying lower wages, charging higher prices, etc.

Thus, while pollution regulations give us the benefit of a

cleaner environment and improved health;

These regulations may lead to higher production costs for

firms, thereby reducing the incomes of the firms owners,
workers, and customers.

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 We have understood that individuals and
societies face trade-offs.

logical question - Given that individuals face

trade-offs, how are choices made?
Need Economics

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 Economics is the study of

how society allocates its scarce resources

how people choose among the alternatives

available to them.

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 Economics is a social science

It is social because it involves people and

their behavior /choices

It is a science because it uses scientific

approach in the investigation of choices.

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 In most societies, resources are allocated
through the combined actions of millions of
people (consumers) and firms (producers).

Economists therefore study how people and

firms make their decisions/choices, given the
limited resources that they face

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 Key Take Away Points
Resources are scarce

Given the scarcity of resources, individuals

and societies must decide on how to
use/allocate resources

Economics is about the allocation of

scarce resources
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 What have we learnt so far
Resources are scarce/limited
Human desires are unlimited
Individual decision maker/ society must
make choices
While making choices, tradeoffs are
recognized
Given the tradeoffs, how are choices
made?
Role of Economics
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 People face different alternatives / courses of
actions

How to choose one particular alternative?

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 Each alternative/action has benefits and costs

Choice decision requires comparing the costs

and benefits of alternative courses of action.

Therefore we need to understand how to

measure costs and benefits of our actions

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 PRINCIPLE #2:
THE COST OF SOMETHING IS WHAT
YOU GIVE UP TO GET IT

cost of pizza=Rs 500

cost of visiting dentist = Rs 300

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 In many cases, the cost of some action is not
obvious

Example:
Consider the decision whether to attend college.

The benefit is intellectual enrichment and better

job opportunities.

But what is the cost? 22

 Cost of college education
Add up the expenditure on tuition, books,
hostel and other fees for a particular year

Does this total truly represent what you

give up to spend a year in college?

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 problem with this calculation of costs:

it ignores the largest cost of going to college

your time.

When you spend a year in college you cannot

spend that time working at a job (what kind of
job?)

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 For most students, the wages given up to
attend college are the largest single
cost of their education

By spending a year in college, a student

loses the opportunity of getting wages
(possibly low skilled job)

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 Opportunity Cost
Economists think of opportunity costs of an
action/choice

Opportunity cost of an action is the value of the

best alternative forgone while taking an action/
making any choice.

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 Examples
What is the cost of POE textbook? Rs 500
What is the opportunity cost of buying POE Textbook?

If you choose to spend Rs 500 on POE Text book,

then you have chosen to give up the benefits of
spending that amount on a pizza or a movie ticket or.

If watching a movie is most valuable of those

alternatives,
then the opportunity cost of the book is the value of the
enjoyment from the movie.

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 What is your opportunity cost of attending
POE lectures?

the value of the best alternative use of

your time
Watching movie
Enjoying leisure
POM lectures

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 Economics is about allocation of scarce
resources
Decide on production
Decide on consumption

Who makes these decisions?

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 Important decision makers in
Economics
Consumer

Consumes goods (eg. food) and services (eg. education)

Has limited income

Decisions
Spend the limited income on goods and services
OR ?
Tradeoffs?

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 Consumers maximize their well being by
purchasing more of some goods (eg.
snacks) and less of some other goods (eg.
vegetables)

i.e. consumers make trade off between

snacks and vegetables

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Q. Some consumers spend the limited income
on goods and services OR save. What is the
trade-off in this case?

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Q. Some consumers spend the limited income on goods and
services OR save. What is the trade-off in this case?

Consumers save in order to pay for future consumption like

healthcare, higher education of kids, etc.

Thus consumers are trading off current consumption for future

consumption

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 Labor/workers

What kind of trade-offs do workers face?

Most jobs and pay-scales depend on educational attainment and

accumulated skills

Consequently, workers decide whether to join workforce now

(immediate income) or get higher education and join workforce later

Trade off immediate income for future high income

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 Workers also face trade-offs in their choice
of employment

Some people choose to work in public sector

High job security but low income

Some choose to work in private sector

Low job security but higher income

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 Firms

Companies face limited resources

good quality raw material, production capacity,
financial resources

Given these constraints, company must decide

how much output to produce

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 Scarcity and the Fundamental
Economic Questions
Due to scarcity of resources, every economy faces
the following questions:

1. What should be produced?

2. How should goods and services be produced?
3. For whom should goods and services be
produced?

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 What should be produced?

Using the economys scarce resources to

produce one thing requires giving up
another.

Ex. Producing better elementary education

may require cutting back on health care
services.
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How should goods and services
be produced?

choices to be made in determining how

goods and services should be produced.

Should a firm employ skilled or unskilled

workers?

Should it produce in its own country or

should it use foreign plants?
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 For whom should goods and
services be produced?

If a good or service is produced, a

decision must be made about who will get
it.

A decision to have one person (or group)

receive a good or service usually means it
will not be available to someone else.
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 What did we learn so far
Scarcity and Choice

Individuals face scarcity and choice

Fixed income, time,
Economy as a whole face scarcity and choice
The total amount of resources in an economy: workers, land,
machinery, and factories are limited.

Implication: Thus, the economy cannot produce all the health care,
education, or entertainment that people want.

Implication: A choice must be made

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Rs 13000cr shaved off military weapons outlays

Running the military at its current strength itself is proving to be so

expensive that the government is left with little for the purchase of
new guns, war-ships and fighter planes to replace outdated
weapons

Q. Opportunity cost of maintaining current military strength?

Buying new weapons
Building new schools
Building new hospitals

What is the most valuable alternative foregone from the perspective of the
defense ministry?
 Government sanctioned Rs 7,566 crores for Delhi-Meerut
Expressway (2016)

What is the opportunity cost of building the expressway

X primary schools
Y Hospitals
Better law enforcement
 Thus Opportunity Cost is a measure of costs
expressed as value of best alternative given up

Opportunity cost need not be expressed in terms of

money
individual/society has to select the best alternative
Selection of best alternative can be subjective (i.e.
varies from person to person)
 Let us consider how to represent scarcity and choice for the whole
economy

The whole economy produces different kinds of outputs using all the
available inputs

Examples of output:
rice/wheat/phones/computers/services,.

Examples of input:
Labor, capital, land, ..
 Production Possibilities

To simplify things, let us suppose that

production in the economy can be divided
into two broad categories of outputs

Suppose the economy can produce either

x or y
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 Interpretations of x and y
Classic example: guns versus butter
Representing defense goods versus non-defense goods

Healthcare expenditure vs. education expenditure

Consumption Possibility
Investment vs. present consumption
future consumption vs. present consumption
 With a scarcity of resources, such as labor
and capital, a choice exists between
producing x vs. y

If the economy produces more of x, then it

must produce less of y.
 Production Possibilities Curve (PPC)
is a graphical representation of the
alternative combinations of goods and services
an economy can produce.

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In drawing a PPC, we shall assume

1. the economy chooses between production of

only two goods;

2. the inputs available to the economy are fixed;

3. the technology of production is also fixed

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 Constructing PPC of a
hypothetical economy
Combination A involves devoting all of the inputs to production of
iron
combination C means devoting all of the inputs to production of
cashew
combination B involves the production of both iron and cashews

These values are plotted in a production possibilities curve

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 Observations
1. The curve is a downward-sloping
Implication: If the economy produces more of x, then it must
produce less of y

The negative slope of the production possibilities curve reflects

the scarcity of resources, i.e. inputs.

Producing more cashews requires shifting resources (eg. ?) out

of iron production and thus producing less iron.

Producing more iron requires shifting labor from cashew fields,

thereby producing less cashews

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2. In the simplest version, we consider a linear
PPC:
Implication: there is a linear, negative
relationship between the production of the 2
products
The slope of PPC measures the rate at which
economy must give up iron production to
produce additional unit of cashew.
The economy must give up 2 units of iron in
order to produce an additional unit of cashew
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 Consider what would happen if the economy decides to produce 1
kg more cashew

The economy must forego the production of 2 kg of iron

Thus the opportunity cost of producing 1 kg cashew is 2 kg of iron

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 The absolute value of the slope of a PPC
measures the opportunity cost of an
additional unit of the good (on the
horizontal axis) measured in terms of the
quantity of the good (on the vertical axis)
that must be forgone.

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3. Neither x nor y is an independent or a
dependent variable in the PPC;
we could have assigned either one to the
vertical or to the horizontal axis

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Extension: Suppose we consider the
economies of 3 different states

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 How do we compare the opportunity costs of an additional unit of
cashew in the 3 states?

equals the absolute values of these slopes (that is, the amount of
iron that must be given up per kg of cashew).

The steeper the PPC, the greater the opportunity cost of an

additional unit of cashew.

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 Opportunity cost of producing cashew in State 1
= absolute value of slope of PPC =2

Opportunity cost of producing cashew in State 2 =1

Opportunity cost of producing cashew in State 3 =0.5

Thus the opportunity cost of cashews is least in State 3 and greatest

in State 1.

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