Core Concepts

• Economics studies decision-making under scarcity, where unlimited wants meet limited resources, necessitating tradeoffs.
• Microeconomics focuses on the decisions of individual households and firms, while Macroeconomics examines economy-wide phenomena and government tradeoffs.
• Economists use simplified models (mathematical representations) to understand complex real-world interactions, acknowledging that models are abstractions ("wrong") but useful for isolating key forces.
• Sound economic decision-making relies on understanding opportunity cost (value of the forgone alternative), ignoring sunk costs (unrecoverable past expenses), and applying the marginal principle (comparing incremental benefits and costs).
• The model of demand and supply is a fundamental tool used to analyze behavior in markets, particularly perfectly competitive markets.

Key Term Definitions

• Economics: The study of how society manages its scarce resources; fundamentally, the study of decision-making in the presence of scarcity or tradeoffs.
• Scarcity: The limited nature of society's resources relative to unlimited wants.
• Tradeoff: The necessity of giving up one thing to obtain another due to scarcity.
• Microeconomics: The branch of economics that studies the behavior of individual economic units, such as households and firms, and their interactions in markets.
• Macroeconomics: The branch of economics that studies economy-wide phenomena, including inflation, unemployment, economic growth, and government policy.
• Model: A simplified mathematical representation of reality used to better understand real-world phenomena by focusing on key variables and relationships.
• Opportunity Cost: The value of the best alternative that must be forgone to undertake an activity or make a decision. Often an implicit, non-obvious cost.
• Sunk Cost: A cost that has already been incurred and cannot be recovered, regardless of future decisions.
• Marginal Principle: A decision-making heuristic stating that an activity should be increased as long as the marginal benefit is greater than or equal to the marginal cost.
• Market: A group of buyers and sellers of a particular good or service.
• Demand: The relationship between the price of a good and the quantity buyers are willing and able to purchase.
• Supply: The relationship between the price of a good and the quantity sellers are willing and able to sell.
• Efficiency: The property of society getting the maximum benefits from its scarce resources (maximizing the size of the economic pie).
• Equity: The property of distributing economic prosperity fairly among the members of society (how the economic pie is divided).

Scarcity and Tradeoffs

Scarcity and Tradeoffs - Definition

Scarcity refers to the fundamental economic problem of having seemingly infinite human wants in a world of limited resources. A tradeoff is the consequence of scarcity, requiring that choosing more of one thing necessitates having less of something else.

Scarcity and Tradeoffs - Key Insights

All economic decisions, whether by individuals, firms, or governments, involve navigating tradeoffs because resources (time, money, materials) are always limited relative to potential uses. Economics is essentially the study of these choices.

Scarcity and Tradeoffs - Examples

• A car manufacturer with limited microchips must decide which models receive the chips, trading off production of one model for another.
• A firm with a fixed advertising budget must choose which products to promote, trading off exposure for one product against another.

Efficiency versus Equity

Efficiency versus Equity - Definition

• Efficiency: Maximizing the total output or benefit generated from available scarce resources.
• Equity: Distributing the benefits generated by resources fairly or equally among society's members.

Efficiency versus Equity - Key Insights

There is often a conflict between efficiency and equity. Policies designed to increase equity (e.g., progressive taxes funding social programs) can sometimes reduce incentives for production, thereby potentially lowering overall efficiency. Understanding this tradeoff is crucial for policy analysis.

Efficiency versus Equity - Examples

• Implementing high taxes on businesses to fund unemployment benefits might enhance equity but could reduce firms' incentives to invest and expand (lowering efficiency).

Opportunity Cost

Opportunity Cost - Definition

The value of the next best alternative that is given up when making a choice. It represents the true cost of a decision.

Opportunity Cost - Key Insights

Opportunity costs are often implicit (not involving a direct cash outlay) and are frequently overlooked, leading to suboptimal decisions. Recognizing and quantifying opportunity cost is essential for accurate cost-benefit analysis.

Opportunity Cost - Examples

• Education: The opportunity cost of pursuing an online BBA includes the potential income forgone by not working during study time.
• Consumption: For affluent individuals during COVID lockdowns with limited spending options, the opportunity cost of money was low, making niche purchases (like "flights to nowhere") seem more appealing than they would be otherwise.
• Business Choice: A handyman choosing to open a shop must consider the forgone earnings from his handyman work as an opportunity cost of his time. Ignoring this led Ramesh to choose a less profitable option (shop profit Rs. 20,000 vs. inventory sale profit Rs. 10,000 + handyman income Rs. 15,000 = Rs. 25,000).

Sunk Cost

Sunk Cost - Definition

Costs that have already been incurred and cannot be recovered or changed by present or future decisions.

Sunk Cost - Key Insights

Sunk costs are irrelevant to future decision-making. Rational decisions should be based only on future costs and benefits. Considering sunk costs (the "sunk cost fallacy") often leads to irrational choices, like continuing a failing project to "justify" past investment.

Sunk Cost - Examples

• Entertainment: Money spent on a non-refundable movie ticket is sunk. Staying to watch a bad movie solely because the ticket was paid for is irrational; the cost is unrecoverable, and staying incurs the additional cost of wasted time and discomfort.
• Travel: When deciding between driving and taking a bus, fixed car costs like annual insurance or past interest payments are sunk. They should be ignored. Only variable costs (fuel, incremental maintenance) relevant to the specific trip should be compared to the bus fare. (Relevant car cost for 600km trip ≈ Rs 1320 vs. Bus fare Rs 1500).

Marginal Principle

Marginal Principle - Definition

The principle that rational decision-makers take an action if and only if the marginal benefit (MB) of the action is greater than or equal to the marginal cost (MC).

• Marginal Benefit (MB): The additional benefit arising from a one-unit increase in an activity.
• Marginal Cost (MC): The additional cost arising from a one-unit increase in an activity.

Marginal Principle - Key Insights

To maximize net benefit (total benefit - total cost), decisions should be made "at the margin." Comparing average benefits and costs can be misleading. The optimal level of an activity is reached when MB = MC.

• Consumers maximize utility where Marginal Utility ≥ Price.
• Firms maximize profit where Marginal Revenue ≥ Marginal Cost.

Marginal Principle - Examples

• Business Expansion (Rahul's Bookstores): Comparing average benefit (Rs. 140k) to average cost (Rs. 100k) suggested opening a 4th store was good. However, the marginal benefit of the 4th store (Rs. 50k) was less than its marginal cost (Rs. 100k). Applying the marginal principle correctly showed that opening the 4th store would decrease total profit, and the optimal number was 3 stores.

Marginal Principle - Formula

Decision Rule: Undertake one additional unit of activity if MB ≥ MC. Stop when MB < MC.

The Model of Demand and Supply

Markets

Markets - Definition

A setting where potential buyers and sellers interact to exchange a particular good or service.

Markets - Key Insights

Markets differ based on structure, primarily the number and size of buyers and sellers, and the uniformity of the product. This course initially focuses on perfectly competitive markets.

Comparisons (Types of Markets)

• Perfectly Competitive Market: Many small buyers and sellers, identical products, no single participant can influence price (price takers).
• Oligopoly: Few large sellers dominate the market.
• Monopoly: A single seller controls the market.

---

Demand

Demand - Definition

Quantity Demanded: The amount of a good buyers are willing and able to purchase at a specific price, ceteris paribus (holding other factors constant).

Demand - Key Insights

• Law of Demand: Quantity demanded decreases as price increases (inverse relationship), resulting in a downward-sloping demand curve.
• Movement along the Curve: Caused by a change in the good's own price.
• Shift of the Curve: Caused by a change in any determinant other than the good's own price (increase = rightward shift, decrease = leftward shift).
• Market Demand: The horizontal summation of individual demands at each price level.

Examples (Factors Shifting Demand)

• Income: Increase shifts demand right for normal goods, left for inferior goods.
• Prices of Related Goods:
  • Increase in substitute's price shifts demand right.
  • Increase in complement's price shifts demand left.
• Preferences/Tastes: Favorable change shifts demand right.
• Expectations: Expectation of future price increase shifts current demand right.
• Number of Buyers: Increase shifts market demand right.
• (Practice Problem Insight): A demand function like QX = f(Px, Py, I, ...) shows relationships. A positive coefficient on Py indicates X and Y are substitutes; a negative coefficient on I indicates X is an inferior good.

---

Supply

Supply - Definition

Quantity Supplied: The amount of a good sellers are willing and able to sell at a specific price, ceteris paribus.

Supply - Key Insights

• Law of Supply: Quantity supplied increases as price increases (positive relationship), resulting in an upward-sloping supply curve. Higher prices incentivize using more resources (potentially higher cost ones) for production.
• Movement along the Curve: Caused by a change in the good's own price.
• Shift of the Curve: Caused by a change in any determinant other than the good's own price (increase = rightward shift, decrease = leftward shift).
• Market Supply: The horizontal summation of individual supplies at each price level.

Examples (Factors Shifting Supply)

• Technology: Improvement shifts supply right.
• Prices of Inputs: Decrease shifts supply right; increase shifts supply left.
• Expectations: Expectation of future price decrease shifts current supply right; expectation of future price increase shifts current supply left (hoarding).
• (Practice Problem Insight): A supply function like Qsx = f(Px, Pi, ...) shows relationships. A negative coefficient on input price (Pi) reflects the principle that higher input costs reduce supply.

Conclusion

The fundamental economic problem of scarcity forces individuals and firms to make choices involving tradeoffs. Microeconomics provides a framework for analyzing these decisions using core concepts like opportunity cost (consider implicit costs), sunk cost (ignore past, unrecoverable costs), and the marginal principle (compare incremental benefits and costs). These individual decisions aggregate within markets, where the interplay of demand (buyer behavior) and supply (seller behavior) determines prices and quantities, a dynamic powerfully illustrated by the demand and supply model. Understanding these principles is crucial for informed decision-making in both personal and business contexts.