BASIC ECONOMIC IDEAS & RESOURCE ALLOCATION

Scarcity, Choice and Opportunity Cost

The Fundamental Economic Problem: Unlimited Wants and limited Resources

Key terms:
Economic Problem: Limited nature of available resources and unlimited wants
Needs: Something essential to live
Wants: The demand of something less important than the demand for a need.
Scarcity: Limited nature of resources
Choice: need to make a decision about the possible alternative uses of scarce resources
Economic Agents: Individuals, Firms, Governments
Consumption: The process by which consumers satisfy their needs/wants
Production: The process of converting raw materials into finished goods
Factors of Production: Land, Labor, Capital, Enterprise > Rent, Wages, Interest, Profit

OPPORTUNITY COST
Definition: Cost of The next best alternative that is forgone
Purpose: Indicates the benefits that could be obtained by choosing the next best alternative
Application: It can be used to evaluate both consumption and production decision

RESOURCE ALLOCATION
3 Basic Economic Questions
What to produce?
How to produce?
For whom to be produced?

NORMATIVE & POSITIVE STATEMENTS

Normative: Statements based on value judgement

Value Judgement: reflection of particular values or beliefs rather than factual evidence

Positive: Statements based on scientific or factual evidences

CETERIS PARIBUS
All other factors are assumed to remain constant
We use ceteris paribus to observe economic laws

TIME PERIODS
Short Run
Long Run
Very Long Run

ECONOMIC SYSTEMS
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ECONOMIC SYSTEMS
Market Economic System - Capitalism
Command Economic System - Planned Economy - Socialism
Mixed Economic System

Market Economy: It is driven by market forces i.e. Demand & Supply. Basic resource allocation decisions are in
the control of private individuals and firms. There is no government intervention. It runs on the basis of price
mechanism solely. The only motive is profit maximization

Advantages:
Governments can focus elsewhere
High innovation
Consumer welfare
Maximization of consumer and producer surplus

Disadvantages:
Lack of public Goods
Merit Goods under consumed
Demerit Goods over consumed
Negative Externalities

Planned Economy: All the resource allocation decisions are taken by the government. No involvement from the
private individuals and firms.

Advantages:
Whole Society's interest is regarded
The state can decide what to produced and for whom
Price Stability
Lower unemployment
No wastage of resources on promotional activities

Disadvantages:
Bureaucracy
Firm Inefficiency
Economic Inefficiency
Poor quality of goods & services
Corruption

Mixed Economic System: Resource allocation decisions are taken partially both by government and private
sector. Private sector is allowed to maximize the profit while being in the legal framework. Governments
makes sure to minimize the demerit goods consumption. Public goods are there. Innovation is there.

Purpose: To combine the advantages of both planned and free economy and to minimize flaws of both

TRANSITIONAL ECONOMY
The process of changing from a planned economic system to a more mixed economic system

Issues of Transition:
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Issues of Transition:
Inflation
Industrial unrest
International trade side effects
Unemployment
Fall in output
Reduction in welfare services

PRODUCTION POSSIBILITY CURVES

(PPC)

Definition: It indicates different combinations of products that can be produced in an economy in a given period
of time

PPC's assumption: Assuming the existing resources and level of technology available

Capital Goods & Consumer Goods

PPS actually shows how much maximum possible output can be achieved

Constant Returns: Would theoretically suggest that the amount of production sacrificed by one product and
gained by another are same/constant. (It is incorrect)

Law of Diminishing Returns

As extra units of input are used in the production process increase in output will be successively smaller as more
inputs are added

Constant and Increasing opportunity cost

PPC isn't a straight line
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PPC isn't a straight line

Increasing opportunity cost: when the extra production of one good involves incrementing sacrifices of another

Reason: Different FOPs have different qualities

SHIFTS in PPC

Causes of right shift in PPC

Investment in technology
Introduction of new resources
Increase in supply of labor
Improved human capital
Improved management of resources
Encouragement of entrepreneurship
Immigration

Causes of left shift in PPC

Emigration
Reduced Labor supply
Reduction in financing educational initiatives

CLASSIFICATION OF GOODS AND SERVICES

Free Goods: non scarce goods which are available for free. No allocation needed. Has equal demand and supply.
No cost of consumption

Private Goods: relatively scarce thus need to be allocated through a mechanism. Also called economic goods
If available for one individual, other might not have it. Price is charged for the consumption. Excluded from
those not willing or unable to pay

Types: Merit Goods & Demerit Goods

Merit Goods: private goods that would likely be underproduced and under consumed in market economy
Because people may not be aware of the potential benefits of the product due to lack of perfect information.
Examples include education, libraries, health care etc.
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Examples include education, libraries, health care etc.

Merit Goods provision

Government have two choices: subsidize or provide free consumption
Example: education
Government always intervenes to encourage consumption and production of merit goods

Demerit Goods: private goods which would be overproduced and overconsumed in a market economy. Because
individuals may not be aware of the potential damages caused by the consumption of such products due to lack
of perfect information.
Examples include alcohol, cigarettes etc

Demerit goods discouragement

Government discourage the consumption through taxation may be
Elasticity of Demand of demerit goods: some demerit goods are inelastic in nature due to addiction
Government always intervenes to discourage consumption and production of demerit goods

Public goods: Non rival and non-excludable goods. Examples include police, street lights, national defense etc.
Non rival: if one person consumes it, it is still available for others to use
Non excludable: it is not possible to exclude any person from its use

Free rider problem

It is impossible to exclude individuals who have not paid for the product
Free Rider: person who has no incentive to pay for the use of public good because he can still use it without
paying
Due to this price cannot be charged for public goods usually.

Non-rejectability: certain public goods cannot be rejected. For example national defense, police. Though this is
not applied to all public goods. For example public education as consumers can avoid making use of provided
education

MARKET FAILURE
Since public goods are usually free so they cannot generate any sort of profit they are only provided by the
government and ignored by the private sector

Quasi-Public Goods
Impossible to distinguish between if it's a private good or a public good. They are blended between two types
of goods. Examples may include public transport, parks, roads etc. reason behind is that they may be accessible
but rivalrous and partially excludable

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