Unit-1

Basic Concept and Principles

Definition and Nature of Economics:

Economics is a social science that focuses on the production, distribution, and consumption of
goods and services, and analyzes the choices that individuals, businesses, governments, and
nations make to allocate resources.

 Economics is the study of how people allocate scarce resources for production,
distribution, and consumption, both individually and collectively.
 The two branches of economics are microeconomics and macroeconomics.
 Economics focuses on efficiency in production and exchange.
 Gross Domestic Product (GDP) and the Consumer Price Index (CPI) are widely used
economic indicators.

Microeconomics
 Microeconomics studies how individual consumers and firms make decisions to allocate
resources. Whether a single person, a household, or a business, economists may analyze
how these entities respond to changes in price and why they demand what they do at
particular price levels.
 Microeconomics analyzes how and why goods are valued differently, how individuals
make financial decisions, and how they trade, coordinate, and cooperate.
 Within the dynamics of supply and demand, the costs of producing goods and services,
and how labor is divided and allocated, microeconomics studies how businesses are
organized and how individuals approach uncertainty and risk in their decision-making.
Macroeconomics
 Macroeconomics is the branch of economics that studies the behavior and performance
of an economy as a whole. Its primary focus is the recurrent economic cycles and broad
economic growth and development.
 It focuses on foreign trade, government fiscal and monetary policy, unemployment rates,
the level of inflation, interest rates, the growth of total production output, and business
cycles that result in expansions, booms, recessions, and depressions.
 Using aggregate indicators, economists use macroeconomic models to help formulate
economic policies and strategies.

Nature and Scope of Economics

While classical theorists offer a relatively narrower scope, neoclassical theorists suggest that
economics has broad nature and scope.

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 Nature of Economics

It is divided into two fields with respect to nature – Science and Arts. Though divided into these
two fields, it is considered a part of both.

Economics as an Art

Art is a field that dwells on the means of expression and application of any skills, whether
creative, pragmatic, or emotional. Art exists all around us, and it takes a great mind to appreciate
art. Like any other art form, economics requires a great deal of imagination; however, the
imagination has to be in the context of reality and cannot be a fleeting idea.

Furthermore, economics is goal-oriented. It states the means to achieve an end; similar is the
case with arts. For instance, Arts tells us the ‘how to’ part of anything. Economics also states
theories that discuss the ‘how to’ part of an end goal. Therefore, arts and economics deal with the
practical application of book-based knowledge. Both bring life to the theories.

Economics as a Science

Science determines the cause and effect relationship. It is quantifiable and uses a proven
apparatus to predict the desired results. It is based on experimentation. Economics has all these
qualities; it establishes a strong cause and effect relationship for the consumption of goods and
services between demand and supply.

Moreover, it can be measured or quantified in graphs and charts and, more importantly, money.
It uses its own methods to forecast the end result. Hence, economics is a science and can be of
two types:

 Positive: It is based on cause and effect relationship between variables and lays down the facts.
 Normative: It is based on value judgements and is to do with ‘how’ things should be.

Hence, economics as a science deals with the theory and the principles; economics as an art deals
with the application and execution.

Scope of Economics

Scope refers to the extent to which something deals with or the extent to which something is
concerned. Consumption of goods and services is the most basic way to define its scope.
However, in reality, the scope of economics is much more than the regular consumption of goods
and services. It can be distinguished as follows:

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Microeconomics

Micro refers to small; it is the study of individual units of consumption of goods and services as
well as that of production and much more. It is concerned with one single household, office,
industry or market.

Moreover, concepts such as product pricing and consumer or firm behaviour are a part of it.
Various types of markets are also studied under this. Hence, the consumption of goods and
services and the behaviour responsible for it is a part of microeconomics.

Macroeconomics

Macro means large; it is the study of the overall production and consumption of goods and
services. It is concerned with national income, GDP, GNP or gross national product. Concepts
such as macro-level business cycles, national budget, unemployment and money supply are a
part of macroeconomics.

Conclusion

The nature and scope of economics are thus much more than the mere consumption of goods and
services. Economics covers all the central issues faced by society and is thus regarded as a social
science. Hence, economics is a subject that can pave the way for many enlightening thoughts.

Micro Economics

Microeconomics is the social science that studies the implications of incentives and decisions,
specifically about how those affect the utilization and distribution of resources. Microeconomics
shows how and why different goods have different values, how individuals and businesses
conduct and benefit from efficient production and exchange, and how individual’s best
coordinate and cooperate with one another. Generally speaking, microeconomics provides a
more complete and detailed understanding than macroeconomics.

 Microeconomics studies the decisions of individuals and firms to allocate resources of

production, exchange, and consumption.
 Microeconomics deals with prices and production in single markets and the interaction
between different markets but leaves the study of economy-wide aggregates to
macroeconomics.
 Microeconomists formulate various types of models based on logic and observed human
behavior and test the models against real-world observations.

Understanding Microeconomics

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Microeconomics is the study of what is likely to happen (tendencies) when individuals make
choices in response to changes in incentives, prices, resources, and/or methods of production.
Individual actors are often grouped into microeconomic subgroups, such as buyers, sellers, and
business owners. These groups create the supply and demand for resources, using money
and interest rates as a pricing mechanism for coordination.

The Uses of Microeconomics

Microeconomics can be applied in a positive or normative sense. Positive microeconomics

describes economic behavior and explains what to expect if certain conditions change. If a
manufacturer raises the prices of cars, positive microeconomics says consumers will tend to buy
fewer than before. If a major copper mine collapses in South America, the price of copper will
tend to increase, because supply is restricted. Positive microeconomics could help an investor
see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. Microeconomics
could also explain why a higher minimum wage might force The Wendy's Company to hire
fewer workers.

Method of Microeconomics

Microeconomic study historically has been performed according to general equilibrium theory,
developed by Léon Walras in Elements of Pure Economics (1874) and partial equilibrium
theory, introduced by Alfred Marshall in Principles of Economics (1890).1 The Marshallian and
Walrasian methods fall under the larger umbrella of neoclassical microeconomics. Neoclassical
economics focuses on how consumers and producers make rational choices to maximize their
economic well being, subject to the constraints of how much income and resources they have
available. Neoclassical economists make simplifying assumptions about markets—such as
perfect knowledge, infinite numbers of buyers and sellers, homogeneous goods, or static
variable relationships—in order to construct mathematical models of economic behavior.

These methods attempt to represent human behavior in functional mathematical language,

which allows economists to develop mathematically testable models of individual markets.
Neoclassicals believe in constructing measurable hypotheses about economic events, then using
empirical evidence to see which hypotheses work best. In this way, they follow in the “logical
positivism” or “logical empiricism” branch of philosophy. Microeconomics applies a range of
research methods, depending on the question being studied and the behaviors involved.

Basic Concepts of Microeconomics

The study of microeconomics involves several key concepts, including (but not limited to):

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  Incentives and behaviors: How people, as individuals or in firms, react to the situations
with which they are confronted.
 Utility theory: Consumers will choose to purchase and consume a combination of goods
that will maximize their happiness or “utility,” subject to the constraint of how much
income they have available to spend.
 Production theory: This is the study of production—or the process of converting inputs
into outputs. Producers seek to choose the combination of inputs and methods of
combining them that will minimize cost in order to maximize their profits.
 Price theory: Utility and production theory interact to produce the theory of supply and
demand, which determine prices in a competitive market. In a perfectly competitive
market, it concludes that the price demanded by consumers is the same supplied by
producers. That results in economic equilibrium.

Macro Economics

Macroeconomics is a branch of economics that studies how an overall economy—the markets,

businesses, consumers, and governments—behave. Macroeconomics examines economy-wide
phenomena such as inflation, price levels, rate of economic growth, national income, gross
domestic product (GDP), and changes in unemployment.

Some of the key questions addressed by macroeconomics include: What causes unemployment?
What causes inflation? What creates or stimulates economic growth? Macroeconomics attempts
to measure how well an economy is performing, understand what forces drive it, and project
how performance can improve.

 Macroeconomics is the branch of economics that deals with the structure, performance,
behavior, and decision-making of the whole, or aggregate, economy.
 The two main areas of macroeconomic research are long-term economic growth and
shorter-term business cycles.
 Macroeconomics in its modern form is often defined as starting with John Maynard
Keynes and his theories about market behavior and governmental policies in the 1930s;
several schools of thought have developed since.
 In contrast to macroeconomics, microeconomics is more focused on the influences on
and choices made by individual actors in the economy (people, companies, industries,
etc.).
As the term implies, macroeconomics is a field of study that analyzes an economy through a
wide lens. This includes looking at variables like unemployment, GDP, and inflation. In
addition, macroeconomists develop models explaining the relationships between these factors.

These models, and the forecasts they produce, are used by government entities to aid in
constructing and evaluating economic, monetary, and fiscal policy. Businesses use the models

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to set strategies in domestic and global markets, and investors use them to predict and plan for
movements in various asset classes.

Properly applied, economic theories can illuminate how economies function and the long-term
consequences of particular policies and decisions. Macroeconomic theory can also help
individual businesses and investors make better decisions through a more thorough
understanding of the effects of broad economic trends and policies on their own industries.

History of Macroeconomics

While the term "macroeconomics" is not all that old (going back to the 1940s), many of
macroeconomics's core concepts have been the study focus for much longer. Topics like
unemployment, prices, growth, and trade have concerned economists since the beginning of the
discipline in the 1700s. Elements of earlier work from Adam Smith and John Stuart
Mill addressed issues that would now be recognized as the domain of macroeconomics.

In its modern form, macroeconomics is often defined as starting with John Maynard Keynes and
his book The General Theory of Employment, Interest, and Money in 1936. Keynes explained
the fallout from the Great Depression when goods remained unsold, and workers were
unemployed.

Macroeconomics vs. Microeconomics

Macroeconomics differs from microeconomics, which focuses on smaller factors that affect
choices made by individuals and companies. Factors studied in both microeconomics and
macroeconomics typically influence one another.

A key distinction between micro- and macroeconomics is that macroeconomic aggregates can
sometimes behave in very different ways or even the opposite of similar microeconomic
variables. For example, Keynes referenced the so-called Paradox of Thrift, which argues that
individuals save money to build wealth (micro). However, when everyone tries to increase their
savings at once, it can contribute to a slowdown in the economy and less wealth in the aggregate
(macro). This is because there would be a reduction in spending, affecting business revenues
and lowering worker pay.

Meanwhile, microeconomics looks at economic tendencies, or what can happen when

individuals make certain choices. Individuals are typically classified into subgroups, such as
buyers, sellers, and business owners. These actors interact with each other according to the laws
of supply and demand for resources, using money and interest rates as pricing mechanisms for
coordination.

Limits of Macroeconomics

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It is also important to understand the limitations of economic theory. Theories are often created
in a vacuum and lack specific real-world details like taxation, regulation, and transaction costs.
The real world is also decidedly complicated and includes matters of social preference and
conscience that do not lend themselves to mathematical analysis.

Micro economic Theory Diagram

Managerial Economics

Managerial economics is a stream of management studies that emphasizes primarily on solving

business problems and decision-making by applying the theories and principles of
microeconomics and macroeconomics. It is a specialized stream dealing with an organization’s
internal issues using various economic tools. Economics is an indispensable part of any business.
This single concept derives all the business assumptions, forecasting, and investments.

Managerial economics and its relevance in business decisions

1- Useful in business organization

2- Helping in chalking out business policies
3- Help in business planning
4- Helpful in cost control
5- Useful in coordination of business activities
6- Useful in demand for casting
7- Helpful in profit planning and control
8- Helpful for business prediction
9- Helpful in price determination
10- Helpful in solution of business taxation problems
11- Gives the right decision
12- Maintains of cost
13- Distribute Profits
14- Measurement of the efficiency of the firm

Fundamental Principles of Managerial Economics – Incremental principle ,

Marginal principle, Opportunity cost principle, Discounting principle, Concept of
time perspective principle, Equi- marginal principle

Managerial Economics can be defined as amalgamation of economic theory with

business practices so as to ease decision-making and future planning by management.

Managerial economics is defined as the branch of economics which deals with the
application of various concepts, theories, methodologies of economics to solve practical
problems in business management. It is also reckoned as the amalgamation of economic

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theories and business practices to ease the process of decision making. Managerial economics is
also said to cover the gap between the problems of logic and problems of policy.

Managerial economics is used to find a rational solution to problems faced by firms. These
problems include issues around demand, cost, production, marketing, and it is used also for
future planning. The best thing about managerial economics is that it has a logical solution to
almost every problem that may arise during business management and that too by sticking to the
microeconomic policies of the firm.

1. Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the firm’s
objective of profit maximization, it leads to increase in profit, which is in either of two
scenarios-
o If total revenue increases more than total cost.
o If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other.
Marginal generally refers to small changes. Marginal revenue is change in total revenue per
unit change in output sold. Marginal cost refers to change in total costs per unit change in
output produced (While incremental cost refers to change in total costs due to change in total
output). The decision of a firm to change the price would depend upon the resulting
impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than
the marginal cost, then the firm should bring about the change in price.
Incremental analysis differs from marginal analysis only in that it analysis the change in the
firm's performance for a given managerial decision, whereas marginal analysis often is
generated by a change in outputs or inputs. Incremental analysis is generalization of
marginal concept. It refers to changes in cost and revenue due to a policy change. For
example - adding a new business, buying new inputs, processing products, etc. Change in
output due to change in process, product or investment is considered as incremental change.
Incremental principle states that a decision is profitable if revenue increases more than costs;
if costs reduce more than revenues; if increase in some revenues is more than decrease in
others; and if decrease in some costs is greater than increase in others.
2. Equi-marginal Principle
Marginal Utility is the utility derived from the additional unit of a commodity consumed.
The laws of equi-marginal utility states that a consumer will reach the stage of equilibrium
when the marginal utilities of various commodities he consumes are equal. According to the
modern economists, this law has been formulated in form of law of proportional marginal

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 utility. It states that the consumer will spend his money-income on different goods in such a
way that the marginal utility of each good is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the
technique of production which satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources in a manner which
equalizes the ratio of marginal returns and marginal costs of various use of resources in a
specific use.
3. Opportunity Cost Principle
By opportunity cost of a decision is meant the sacrifice of alternatives required by that
decision. If there are no sacrifices, there is no cost. According to Opportunity cost principle,
a firm can hire a factor of production if and only if that factor earns a reward in that
occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the minimum
price that would be necessary to retain a factor-service in it’s given use. It is also defined as
the cost of sacrificed alternatives. For instance, a person chooses to forgo his present
lucrative job which offers him Rs.50000 per month, and organizes his own business. The
opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own
business.
4. Time Perspective Principle
According to this principle, a manger/decision maker should give due emphasis, both to
short-term and long-term impact of his decisions, giving apt significance to the different
time periods before reaching any decision. Short-run refers to a time period in which some
factors are fixed while others are variable. The production can be increased by increasing the
quantity of variable factors. While long-run is a time period in which all factors of
production can become variable. Entry and exit of seller firms can take place easily. From
consumers point of view, short-run refers to a period in which they respond to the changes in
price, given the taste and preferences of the consumers, while long-run is a time period in
which the consumers have enough time to respond to price changes by varying their tastes
and preferences.
5. Discounting Principle
According to this principle, if a decision affects costs and revenues in long-run, all those
costs and revenues must be discounted to present values before valid comparison of
alternatives is possible. This is essential because a rupee worth of money at a future date is

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 not worth a rupee today. Money actually has time value. Discounting can be defined as a
process used to transform future dollars into an equivalent number of present dollars. For
instance, $1 invested today at 10% interest is equivalent to $1.10 next year.
FV = PV*(1+r)t
Where, FV is the future value (time at some future time), PV is the present value (value at t0,
r is the discount (interest) rate, and t is the time between the future value and present value.
6- Equi-marginal principle is one of the widely used concepts in managerial economics. This
principle is also known the principle of maximum satisfaction - by allocating available resource
to get optimum benefit . This principle provides a basis for maximum utilization of all the inputs
of a firm so as to maximize the profitability.

In the practical world, a person may purchase more then one commodity. Let us assume that a
consumer purchases two goods A and B. How does a consumer spend his fixed income in
purchasing two goods in order to maximize his total utility? The law of equi-marginal utility tells
us the way how a person maximizes his total utility.
7- Principle of time perspective:

“a decision by the firm should take into account of both short-run and long-run effects on
revenues and cost & maintain the right balance between the long run and short run.

According to the principle of time perspective, a manger/decision maker should give due
emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the
different time periods before reaching any decision. Short-run refers to a time period in which
some factors are fixed while others are variable. The production can be increased by increasing
the quantity of variable factors.
Utility analysis

The economic utility of a good or service is important to understand because it directly

influences the demand, and therefore price, of that good or service. In practice, a consumer's
utility is usually impossible to measure or quantify. However, some economists believe that
they can indirectly estimate what is the utility of an economic good or service by employing
various models.

 Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a
service or good.
 Although the concept of utility is abstract, it is a useful way to explain how and why
consumers make their decisions.
 "Ordinal" utility refers to the concept of one good being more useful or desirable than
another.

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  "Cardinal" utility is the idea of measuring economic value through imaginary units,
known as "utils."
 Marginal utility is the utility gained by consuming an additional unit of a service or
good.
The utility definition in economics is derived from the concept of usefulness. An economic
good yields utility to the extent to which it's useful for satisfying a consumer’s want or
need. Various schools of thought differ as to how to model economic utility and measure the
usefulness of a good or service.
Utility in economics was first coined by the noted 18th-century Swiss mathematician Daniel
Bernoulli. Since then, economic theory has progressed, leading to various types of economic
utility.

Ordinal Utility

Early economists of the Spanish Scholastic tradition of the 1300s and 1400s described the
economic value of goods as deriving directly from this property of usefulness and based their
theories on prices and monetary exchanges.

This conception of utility was not quantified, but a qualitative property of an economic
good. Later economists, particularly those of the Austrian School, developed this idea into an
ordinal theory of utility, or the idea that individuals could order or rank the usefulness of
various discrete units of economic goods.

Austrian economist Carl Menger, in a discovery known as the marginal revolution, used this
type of framework to help him resolve the diamond-water paradox that had vexed many
previous economists. Because the first available units of any economic good will be put to the
most highly valued uses, and subsequent units go to lower-valued uses, this ordinal theory of
utility is useful for explaining the law of diminishing marginal utility and fundamental
economic laws of supply and demand.

Cardinal Utility

To Bernoulli and other economists, utility is modeled as a quantifiable or cardinal property of

the economic goods that a person consumes. To help with this quantitative measurement of
satisfaction, economists assume a unit known as a “util” to represent the amount of
psychological satisfaction a specific good or service generates for a subset of people in various
situations. The concept of a measurable util makes it possible to treat economic theory and
relationships using mathematical symbols and calculations.

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However, it separates the theory of economic utility from actual observation and experience,
since “utils” cannot actually be observed, measured, or compared between different economic
goods or between individuals.

If, for example, an individual judges that a piece of pizza will yield 10 utils and that a bowl of
pasta will yield 12 utils, that individual will know that eating the pasta will be more satisfying.
For the producers of pizza and pasta, knowing that the average bowl of pasta will yield two
additional utils will help them price pasta slightly higher than pizza.

Additionally, utils can decrease as the number of products or services consumed increases. The
first slice of pizza may yield 10 utils, but as more pizza is consumed, the utils may decrease as
people become full. This process will help consumers understand how to maximize their utility
by allocating their money between multiple types of goods and services as well as help
companies understand how to structure tiered pricing.

Total Utility

If utility in economics is cardinal and measurable, the total utility (TU) is defined as the sum of
the satisfaction that a person can receive from the consumption of all units of a specific product
or service. Using the example above, if a person can only consume three slices of pizza and the
first slice of pizza consumed yields ten utils, the second slice of pizza consumed yields eight
utils, and the third slice yields two utils, the total utility of pizza would be twenty utils.

Marginal Utility

Marginal utility (MU) is defined as the additional (cardinal) utility gained from the consumption
of one additional unit of a good or service or the additional (ordinal) use that a person has for an
additional unit.

Using the same example, if the economic utility of the first slice of pizza is ten utils and the
utility of the second slice is eight utils, the MU of eating the second slice is eight utils. If the
utility of a third slice is two utils, the MU of eating that third slice is two utils.

In ordinal utility terms, a person might eat the first slice of pizza, share the second slice with
their roommate, save the third slice for breakfast, and use the fourth slice as a doorstop.

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 Unit -2

Demand and Supply Analysis

Theory Of Demand

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