ECONOMICS QUICK REVISION NOTES FOR CPT “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups”--Henry Hazlitt
Shandar Ahmed 20-Nov-14
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PREFACE Dear students, It has been a wonderful experience teaching you all. I know that you all are working very hard, preparing for the final battle and I believe that each one of you would prove yourselves beyond everyone’s expectations. Just remember that every examination is designed to test your presence of mind along with your knowledge about the respective subjects. Strategy should be your biggest weapon. I hope that you all are working on the strategies that I had presented you with, in the class i.e. to solve as many MCQs as possible. Solving MCQs will help you tremendously when it comes to time management and accuracy, that reading alone can never impart. I have prepared this Last Minute Quick Revision Notes to help you consolidate all the ideas that we have already discussed in the class. It will help you revise both Micro and Macro economics in under two hours. I suggest you, to please keep this revision note handy while solving MCQs and readily refer to it over and over again. This process will help you retain facts, data and concepts. Remember, it all starts with “Believing”. Believe in yourself and the world will be at your feet. I am available to you till the day of your examination, so please feel free to contact me in case of queries related to the subject. My blessings will always follow you. ALL THE BEST Shandar Ahmed
[email protected] +91 9990740183
MICRO ECONOMICS Chapter 1 Introduction to Micro Economics The word Economics is derived from Greek word “OIKONOMIA” which means “HOUSEHOLD”. Economics answer to the problem faced by mankind due to: 1) Unlimited Wants; 2) Scarce resources; 3) Alternate use of Resources.
Central Economic problems is to answer: 1) What to produce and how much to produce? 2) How to produce? 3) For whom to produce? 4) What provisions should be made for future generations (Sustainable Development)?
Adam Smith: Economics is an inquiry into the nature and causes of wealth of the nation. He is considered as the father of Modern Economics. J.B.Say: Science which deals with wealth. Alfred Marshall: Economics is the study of Mankind in the ordinary business of life. Lord Robbins: Economics is a science which studies human behaviour as a relationship between unlimited ends, and scarce means which have alternative uses. A.C.Pigou: The range of our inquiry becomes restricted to that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money. Paul A. Samuelson: He defines economic growth in terms of Dynamic Growth and development. Jacob Viner: He said “Economics is what Economist does”. Henry Smith: Economics is the study of how civilized society obtains the share of what other people have produced and of how the total product of society changes and is determined. Economics is Pragmatic or Positive Analysis but it is not Practical Science A pragmatic analysis is only concerned about the fact of the matter and defines “What is”. A Normative analysis passes “Value Judgment” or gives “Opinions” or “Prescribes”; It states “What ought to be”. Deductive Method: Logic proceeds from General to Particular (DGP) Inductive Method: Logic proceeds from Particular to General (IPG) Both Deductive and Inductive Models are complementary to each other Under Micro Economics we study: 1) Theory of Price or Product Pricing; 2) Theory of Consumer Behaviour; 3) Theory of factor Pricing; 4) Theory of Study of a single firm.
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Under Macro Economics we study: 1) 2) 3) 4) 5) 6)
Theory of National Income and Output; Theory of Unemployement; Theory of Money Supply; Theory of General Price Level (Inflation); Theory of Economic growth and development; Theory of International Trade.
Both Macro Economics and Micro Economics are complementary to each other. The Word Macro is derived from Greek ‘MAKROS’ means Large
PRODUCTION POSSIBILITY CURVE Production Possibility Curve is also known as Production Possibility Frontier or Production Transformation Curve. It is Downward Sloping or Negatively Sloped It is based on the fundamental premise of scarcity of resources It is CONCAVE to the origin because of increasing OPPORTUNITY COST It will be a STRAIGHT LINE if opportunity cost is CONSTANT It will be CONVEX if Opportunity cost is Decreasing If an economy produces on the PPC curve then it can be said that that there is no unemployement/full employement/no underemployement. It is a productively efficient point. A point outside PPC is not possible with the current resources A point inside PPC curve means underemployement/less than full employement/unemployement There will be an Inward/Leftward shift in the PPC due to natural calamity like earthquakes, floods, etc. There will be a Rightward/Outward shift in PPC due to improvement in technology, increase in population, greater capital formation, discovery of new resources. Movement along the PPC is known as “Trade Off”.
Types of Market/Economy In an Open Economy there is no restriction on Export and Import A Command Economy is system where the government, rather than the free market, determines what goods should be produced, how much should be produced and the price at which it must be sold A Socialist Economy is an economic system based on State ownership of capital. It is an economic system which is heavily regulated and controlled by the government. A Planned Economy is an economic system in which decisions regarding production and investment are embodied in a plan formulated by a Central Authority i.e. Government A Market Economy (Capitalist Economy) also widely known as a "free market economy", is one in which goods are bought and sold and prices are determined by the interplay of Demand and Supply. In Market Economy there is Consumer Sovereignty. Note: Command economy, Planned economy, Socialist economy have very similar characteristics.
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CHAPTER 2 Theory of Demand and Supply Law of demand states that the quantity demanded and the price of a commodity are inversely related, other things remaining constant (Ceteris paribus). Demand is quantities of goods and services that consumers are willing and able to purchase at a particular price during a period of time. Demand is a Qualitative concept and not Quantitative Price of a good and Quantity demanded are Inversely proportional/Negatively related/Indirect relationship Complementary Goods: Inverse Relationship/ Indirect/ Negative relationship between Quantity and Price. Substitute Goods : Direct/Positive Relationship between Quantity and Price Income Increases---- Demand for Normal Goods (e =1) and Luxury Goods (e > 1) increases and vice-versa Income Increases----Demand for Inferior goods decreases and vice-versa Income Increases---- Demand for necessities remain inelastic in the beginning and then it becomes Perfectly Inelastic Positive change in tastes and preferences-----Increases Demand Negative change in tastes and preferences----Decreases Demand Increase in future expected rise in price---- Increases demand during current times Fall in future expected price----- Decreases demand during current times When Price of any good decreases----- Real Income of Consumers Increases and vice versa Exceptions to the Law of Demand: 1) Conspicuous/Veblen/Prestigious goods----Price increases and Quantity demanded also increases 2) Giffen Goods (Some inferior goods)---- Price increases Quantity demanded also increases 3) Speculative Goods: Even if price rises, quantity demanded rises Market Demand is a Horizontal Summation of Individual demand curves PRICE EFFECT = SUBSTITUTION EFFECT + INCOME EFECT (The reason why demand curve slopes downward) Expansion and Contraction in demand happens due to change in Price alone (called as change in Quantity demanded). In Expansion and Contraction the slope of demand curve does not change. Increase and decrease in demand happens due to factors other than price, like Income, change in price of substitute or complementary goods, change in taste and preferences etc. (termed as change in demand) In increase or decrease in demand the slope of demand curve changes (dd curve shifts leftward or rightward) Elasticity is the responsiveness in quantity demanded due to change in factors affecting demand Price Elasticity measures change in quantity demanded as a result of change in price Income Elasticity measures change in demand due to change in income of individuals Cross Elasticity measures change in demand due to change in price of Substitute and Complementary goods. In case of e= ∞ (Perfectly Elastic demand) the demand curve is a Horizontal Straight line, parallel to X-axis and touching the Y-axis. In case of e = 0 (Perfectly Inelastic demand) the demand curve is a Vertical line, parallel to Y-axis and touching the X- axis Methods to Measure Elasticity: 1) Proportional Method: % change in quantity demanded = Q0 – Q1 % change in price Q0 Compiled by Shandar Ahmed
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__P0__ P0 - P1
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2) Total Outlay or Expenditure Method: E= 1 ----Change in price does not affect total expenditure E>1 ---- Rise in Price leads to fall in total Expenditure and vice-versa E< 1 ----Rise in price leads to rise in total Expenditure and vice-versa 3) Point Elasticity or Geometric Method: Elasticity = Lower segment of the demand curve Upper segment of the demand curve 4) Arc Method: Elasticity = Q0-Q1 X P0+P1 Q0+Q1 P0-P1 When the change in quantity demanded is very less, we can measure this change on a single point on the demand curve----- in such a case we use Point Elasticity Method When the change in quantity demanded is large due to a big change in price, we have to measure this change over an Arc on the demand curve, between two points---- in such a case we use Arc Elasticity Method. Please Note: The numerical problem, when asked to solve using Point Method, Proportionate Method Formula should be applied Other Factors affecting Elasticity Demand: 1) Availability of Substitutes: If close substitutes are available------ Demand is Elastic and vice-versa 2) Greater proportion of income spent on any good----- Greater would be Elasticity and vice-versa 3) Normal goods have elastic demand and necessities have inelastic demand 4) More number of uses of a commodity---- more will be its elasticity and vice-versa 5) In the long time period demand will be more elastic and vice-versa 6) In case the consumer is addicted to any good---- demand will be inelastic 7) Tied goods will have inelastic demand 8) Goods in the high price range and low price range will have inelastic demand and normal goods will have elastic demand
Supply Law of Supply states that, holding all other factors constant, an increase in price results in an increase in quantity supplied and vice versa i.e. there is a direct or positive relationship between price and quantity supplied, holding all other factors constant (Ceteris paribus). Supply is------Amount of goods and services that producers are “willing to offer” to market at various Prices during a period of time. It is also a Qualitative Concept Both Demand and Supply are Flow concept. Price and Quantity supplied have Direct/Positive relationship. Determinants of Supply: 1) Price of the Product: Direct/Positive relationship 2) Price of Related goods: Indirect relationship/Negative relationship (It implies, that, if the price of “Y” rises, the supply of “X” will fall because suppliers will shift towards more of supply of “Y”. 3) Factors of Production: Indirect/Inverse relation between cost of production and Supply (Cost increases supply decreases and vice versa) Compiled by Shandar Ahmed
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4) Taxes: Indirect/ Inverse relation between taxes and Supply (tax increases supply decreases and vice versa) 5) Subsidy: Direct/positive relationship (Subsidy increases Supply increases and vice versa) 6) Technology: Improved technology increases supply as cost of production decreases. 7) Since Supply of perishable goods cannot be increased in the short run, thus their supply is perfectly inelastic. Expansion and Contraction in Supply happens due to change in Price alone (this change is known as ‘Change in Quantity supplied’) In case of Expansion or Contraction----the slope of supply curve does not change Increases and Decrease in Supply happens due to change in factors other than price (this change is known as “change in supply”). In case of Increase or Decrease----- there is a change in the slope of supply curve i.e. the supply curve shifts either Rightwards (in case of Increase in supply) and Leftwards (in case of Decrease in supply) Methods to Measure Elasticity: 1) Proportional method: Elasticity= : % change in quantity supplied = Q0 – Q1 X P0___ % change in price Q0 P0 - P1 2) Arc Method: Elasticity = Q0-Q1 X P0+P1 Q0+Q1 P0-P1 3) Point Method: Elasticity
=
dq dp
X
p q
[Differentiation of quantity(q) w.r.t Price (p)]
In case of Horizontal Supply curve (Parallel to X-Axis)----- Supply is Perfectly Elastic (E= Infinity) In case of Vertical Supply curve (Parallel to Y-Axis)------- Supply is Perfectly Inelastic (E=0) When demand curve shifts Rightward-----Supply remaining the same----Both Price and supply increases and vice versa When supply curve shifts Rightward------- Demand remaining the same -----Price decreases but supply increases and vice versa When both demand and supply curve shift by the same amount, quantity may increase or decrease as the case may be, but the price remains same.
Theory of Consumer Behaviour Marginal Utility Analysis was given by Alfred Marshall Utility is the want satisfying power of a commodity Two theories comes under Marginal Utility Analysis: 1) Law of Diminishing Marginal Utility 2) Law of Equi-Marginal Utility Law of Diminishing Marginal Utility states that, as one consumes more of any commodity the satisfaction that he/she derives from the consumption of one additional unit (Marginal Utility) goes on diminishing. Marginal Utility Analysis is based on Cardinal Principle (something that can be measured and quantified in numerical terms or monetary terms) When TU increases------ MU diminishes, but remains positive. When TU is Maximum------ MU is Zero When TU starts to fall (diminishes)------------ MU becomes Negative Consumer Surplus(given by Alfred Marshall) = MU – Price OR TU – (MU X No. of Units consumed) Consumer is at Equilibrium when : MU = Price MU curve is also many a times referred to as ‘Demand Curve’ Compiled by Shandar Ahmed
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Indifference Curve Analysis (given by Hicks and Allen) Indifference Curve is based on Ordinal concept, meaning utility cannot be measured in numerical terms but can be ranked and compared. It is based on consumer preferences and thus considered to be a superior utility analysis. Indifference curve is also known as ISO-Utility Curve Every point on the Indifference curve gives the same level of satisfaction Indifference curve is CONVEX to the origin because Marginal Rate of Substitution (MRS) is decreasing MRS is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility (satisfaction). Indifference Curve is a Downward Sloping curve (Negatively Sloped) If MRS is constant-------- Indifference curve will be a STRAIGHT LINE (it happens when two goods are PERFECT SUBSTITUTES) When two goods are PERFECT COMPLEMENTARY goods ---------- MRS will consist of two straight lines which will be RIGHT ANGLED or “L” shaped. Important Properties of Indifference Curve: 1) It slopes Downward to the right i.e. negatively sloped 2) Two Indifference Curve will never intersect each other (due to different levels of satisfaction) 3) Indifference Curve is always Convex to the Origin due to falling MRS 4) A higher Indifference Curve will represent higher level of satisfaction and vice versa 5) Indifference Curve will never touch either X-axis or Y-axis. An Indifference Map depicts complete picture of consumer’s tastes and preferences.
A BUDGET LINE---- depicts combinations of TWO goods that a consumer can buy with his given money income. A point outside Budget line ----------- Shows Overspending A point inside Budget line ------------- Shows Under spending Any point anywhere on the Budget Line -------- Shows same amount of money spent.
Budget Line is a result of: 1) Price of Commodity “X” 2) Price of Commodity “Y” 3) Income of the consumer A consumer is at Equilibrium when he/she is deriving the maximum possible satisfaction. It happens when Price Line or budget Line is “Tangent” to the Highest Possible Indifference Curve i.e. Slope of Indifference Curve = Slope of Price Line or Budget Line Consumer Equilibrium: MUx = Px MUy Py
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CHAPTER- 3 Theory of Production and Cost Production is defined as creation or addition of utility. Man cannot create matter but can add or create utility Characteristics of Land: 1) It’s a free gift of nature; 2) It’s immobile 3) Its usefulness depends on human effort 4) It’s limited in supply, i.e. it perfectly inelastic (supply curve will be a vertical straight line) 5) It’s indestructible, meaning it cannot be destroyed Characteristics of Labour: 1) It’s directly connected with human effort; 2) It’s highly perishable, meaning one cannot store his/her labour; 3) It’s mobile, meaning it can migrate from one place to another; An entrepreneur is one who initiates any business; Innovation is the most important function of an entrepreneur as propounded by Joseph Alois Schumpeter. Production function----It’s the relationship between Physical INPUTS and Physical OUTPUT (where Output is a dependent variable and Inputs are Independent variable), Technology as an input is assumed constant Short Period Production Function---- At least one factor remains fixed while others are variable Long Period Production Function----- All factors vary in the same proportion. Time concept in Production Function was conceived by Alfred Marshal Cobb–Douglas Production function: 1) Q= K X La X C 1-a (Where; ‘K’ and ‘a’ are Positive Constants, ‘L’ stands for units of Labour and ‘C’ stands for amount of Capital) 2) It gives Constant Returns to Scale 3) It concludes that----- Labour consists of 3/4th and Capital consists of 1/4th in a Production function 4) The production function given by them is LINEAR and HOMOGENEOUS implying Constant Returns to Scale Average Product= Total Product / Units of Variable inputs (Q) Marginal product = Change in Total Product/ Change in Input (MP= TPn - TPn-1) Total Product is the Total Output Law of Variable Proportion: 1) Point of INFLECTION is a point on TP curve when MP is Maximum 2) Point of SATURATION is a point where TP is Maximum after which it starts falling 3) MP curve cuts AP curve from above, where AP is maximum (at this point AP=MP) 4) When AP is rising------ MP is rising initially and then it is falling (MP> AP) 5) When AP is falling----- MP is Falling (AP> MP) 6) When TP is rising-----MP and AP is rising initially and then they start to fall 7) When TP is Maximum, MP is Zero 8) When TP starts to fall, MP becomes negative 9) A firm must produce within Stage II (as it is optimally utilizing its fixed factors)
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The Long Run Production Function goes through 3 stages: 1) Increasing Returns to Scale (Output increases more than proportionate to the increase in Inputs) 2) Constant Returns to Scale (Output increases proportionate to the increase in Inputs) 3) Diminishing or Decreasing to Returns to Scale (Output increases less than proportionate to the increase in Inputs In case of Negative Returns to Scale, Output decreases when Input is increased (Marginal Product becomes Negative) Internal Economies of Scale affects a single firm External Economies of Scale affects a group of firms
ISO-Quant Curve It represent Equal Production Level, thus it is also known as Equal production curve It has all the characteristics of an Indifference Curve. It may be defined as a curve showing various combinations of two factors (Capital and Labour) that can produce a given level of output. It is based on the principle of Cardinality because the Output can be measured.
Concept of Total Revenue(TR), Average Revenue(AR) and Marginal Revenue(MR) TR= Price X Quantity AR= TR/Quantity
MR= Change in TR/Change in Output (Q) i.e. TPn - TPn-1
TR is an inverted “ U “ shaped curve Both AR and MR have Negative slope When MR= 0 ---------------- TR is Maximum When MR is Negative TR is falling MR = AR X e-1 e
When e>1-------MR is Positive and TR is rising When e=1 ------MR is Zero and TR is Maximum When e MC 2) When AC curve rises --- MC > AC 3) AC curve= MC curve when AC is minimum 4) MC curve cuts AC curve from below from its Minimum Point Cost Function is the mathematical relation between Cost and its various determinants. Cost is a Dependent Variable Independent Variables that affects costs are: Size of plant, size of output, time period, managerial efficiency, technology, labour etc. Long Run Average Cost Curve (LAC): 1) It is also known as Envelop Curve or Planning curve 2) It is made up of several Short Run Average Cost (SAC) curves 3) In the long run a firm will produce at a point where LAC and SAC (Short run Average Cost Curve) are minimum. 4) When LAC declines----- SAC is Tangent to the falling portion of the LAC curve; 5) When LAC is rising------ SAC is Tangent to the rising portion of the of the LAC curve 6) LAC decreases due to Increasing Returns to Scale 7) LAC rises due to Decreasing Returns to Scale 8) LAC is minimum -------- it is due to Constant Returns to Scale 9) If modern technology is used----- LAC will gradually become ‘Flat’ and it will become “ L” shaped.
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Chapter- 4 Price Determination in Different Markets PERFECT COMPETITION: 1) Many sellers and buyers 2) Product Homogeneity or no product differentiation 3) No price discrimination 4) Free entry and exit 5) Firm and industry are different 6) Demand curve is Perfectly elastic, i.e. horizontal and parallel to X-axis 7) AR=MR=P 8) MC curve cuts MR curve from below 9) If MR>MC; Increase output and if MC > MR, decrease output 10) One must always try to achieve MR = MC (also known as point of profit Maximization) 11) Firms in this market are ‘Price Takers’ 12) Firms in this type of market will only earn ‘Normal Profit’ Conditions for Profit and Loss: 1) AR > AC or ATC --------- Abnormal of Supernormal Profit 2) AR = AC or ATC --------- Normal Profit 3) AR < AC or ATC --------- Abnormal Loss NOTE: The above conditions for Profit is valid for any type of Competition Production or Shutdown decision to be taken by a firm in the short run: 1) P = AVC (Shutdown point). But the firm must continue production as it is able to fully recover at least its variable factors used in the production process. 2) P > AVC ------- The firm must continue producing as it is able to recover some of its fixed factors apart from its Variable factors 3) P < AVC -------- The firm must discontinue production or shutdown as it is not able to recover even its variable factors. MONOPOLY: 1) It means “Alone to sell” i.e. only one seller 2) Product Homogeneity or no product differentiation (Goods sold are identical) 3) Price Discrimination (it will depend on elasticity of demand) 4) No free entry for any player or competitor 5) No difference between firm and industry 6) Downward sloping and less elastic demand curve 7) Cross Elasticity of demand in Monopoly is always Zero (as there are no substitutes available) 8) A Monopolist will charge High price where demand is Inelastic and lower price where demand is Elastic 9) A Monopolist can determine either Price or Output and not both 10) A Monopolist is a Price maker (he will sell his products at a price determined by him and not by the market) 11) Pigou classified three degrees of price discrimination i.e.: First- a monopolist will take away all of consumer’s surplus; Second- a monopolist will take away only a part of consumers surplus and Compiled by Shandar Ahmed
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Third- price will vary in different markets due to various attributes like location or consumer segments. MONOPOLISTIC COMPETITION: 1) Large number of small sellers and buyers 2) Free entry and exit for other competing firms 3) Selling similar but not identical products, meaning there is some sort of ‘Product Differentiation’ 4) Very Close substitutes are available 5) It’s a “Non-Price Competition”. Advertisement plays a very important role 6) There is no Price Discrimination (Firms charge equal price for same goods) 7) Firm and Industry are Different 8) Both AR and MR curves are downward sloping, but AR is more elastic than MR 9) Demand for products sold in this type of market will be highly elastic (as large number of Substitutes are available) 10) Any firm under Monopolistic Competition has always “Excess Capacity” 11) Firms in this market are Price makers OLIGOPOLY: 1) There are very few players in the market (not more than 10 players) 2) When there are only TWO players, it is termed as “Duopoly” 3) In a “Pure Oligopoly” there is product homogeneity, meaning no product differentiation 4) Firms are dependent on each other’s reactions 5) It is also a “Non-price’ competition and so advertisements play great importance 6) The Demand curve is “KINKED” or there is “Indeterminateness” of demand curve (Price Rigidity) 7) Above the Kink Elasticity will be greater than one (e>1) and below the Kink it will be less than one (e
