1.

PRINCIPLES OF ECONOMICS AND

THINKING LIKE AN ECONOMIST

NILKANTH ATHALYE

REFERENCE BOOKS
1. ECONOMICS : Principles and Applications
by Mankiw ( Cengage Learning )
2. ECONOMICS : Special Indian Edition
by Samuelson & Nordhaus ( Mc Graw
Hill )

Definitions of Economics
Economics is a study of how societies ( national
and international ) manage their resources.
Economists study how people (and organizations,
which are essentially made up of people ) make
decisions ; how much they work, what they buy,
how much they save and how do they invest their
savings.
Economists also study the regulations of the
government and their policies which can affect the
behavior of people and organizations.

What does Economics Guide?

1. What to produce
2. How much to produce
3. For whom to produce

Some Noteworthy Economists

1.
2.
3.
4.
5.

Adam Smith ( 1776 )

T. R. Malthus ( 1798 )
Karl Marx ( 1867 )
J. M. Keynes ( 1936 )
Modern Mainstream Economists.

Principles of Economics
(A) How people make decisions

1. People face trade-offs. ( Sacrificing something to

get something , since resources are scarce)
2. Cost of something is what you give up to get it.
( The opportunity cost of an item is what you
give up to get that item. No free lunches )
3. Rational people think at the margin.
(Comparison of marginal costs and marginal
benefits )
4. People respond to incentives ( and disincentives
like taxes )

Principles of Economics
(B) How people interact

1. Trade can make everyone better off. (Specialization in

what one does best.)
2. Markets are usually a good way to organize economic
activities. ( In a market economy, millions of firms and
households decide and not only one central planner :
This is what is called the invisible hand.) .
3. Governments can sometimes improve market
outcomes. (Markets work only if property rights are
enforced and protected. The invisible hand may not
ensure distribution of prosperity equally)
Externalities like pollution.

Principles of Economics
( C ) How economy as a whole works.

1. A countrys standard of living depends on its ability to

produce Goods and Services. (Productivity of its
workers )
2. Prices rise when the government prints too much
money. ( growth in money supply causes inflation)
3. Societies face a short-run Trade -off between
Inflation and Unemployment. (Increase in money
supply increases the demand for goods and services,
which causes producers to hire more people and
produce more. Thus unemployment is reduced, but
prices go up.)

Economist as a scientist
Economists devise theories, collect data and then analyze
the data in an attempt to verify or refute their theories.
While observing, economists have to make do with
whatever the world happens to give them, as they can
not recreate an economy in a lab.
Economists make assumptions to simplify the complex
world and make it easier to understand . This helps to
focus on the essence of the problem.
Economists also use models to learn about the world.
This simplifies the reality to improve our understanding
of it.

THE CIRCULAR FLOW MODEL

1. Goods and Services produced by a Firm are
bought by Households, who in turn, supply
Labor, Land and Capital to the Firms, as input
Factors of Production.
2. Wages, Rent and Profits of the Firms go back
to the Households, in the form if their Income,
which in turn goes to buy the Goods and
Services sold by the Firm, constituting the
Firms Revenue.

PRODUCTION POSSIBILITIES FRONTIER

Given the Economys resources (which are not
unlimited), the economy can produce any
combination of products on or inside the frontier,
not beyond it.
This is feasible because people tend to trade off.
Also the cost of producing one item is the
opportunity cost of not producing another item.
The PPF curve is bowed outwards because of the
diminishing marginal utility of any item.
Technological advance can shift the PPF outwards.

MACRO & MICRO ECONOMICS

1. Macroeconomics is the study of economy-wide /
country-wide phenomena. ( effect of borrowing by
the central government, growth rate of the economy,
changes in the rate of unemployment, regulatory
policies of the government etc.)
2. Microeconomics is the study of how Households and
Firms make decisions and how they interact in
specific markets. (Effect of competition on a
company, rent control laws affecting availability of
housing in a city, increase in household consumption
because of lower prices etc. )

Diminishing Returns
1. Diminishing Marginal Returns.
2. Diminishing Marginal Utility.
3. Diminishing Marginal Productivity.