Unit I

INTRODUCTION TO ECONOMICS

CONTENTS OF THIS UNIT

1. Meaning of Micro and Macro economics
2. Economy and economic problem
3. Central problems of an economy. What to produce, how to produce and for whom to
produce
4. Concepts of production possibility curve and opportunity cost

INTRODUCTION

Economics is a social science which studies the economic activities of the people. It studies the
way in which society chooses to use the limited resources to produce goods and services and
distribute them among people.
Scope of Economics:
It analyses the behavior of an individual under the branch of economics called micro economics
and the behavior of the society as a whole under the branch macroeconomics.

MICRO AND MACRO ECONOMICS

Micro economics: The word micro has been derived from Greek word Mikros meaning small.
Micro economics deals with small segments of the society. Micro economics is defined as the
study of behavior of individual decision making units, such as consumers, resource owners and
firms. It is also known as price theory.

It is the study of how individual economic units firms, households and industries make
economic decisions that is choices.

Macroeconomics: The word Macro is derived from the Greek word means makros which
means large. It looks at aggregates in the economy. It is concerned with the level of prices (in
the aggregate), the level of employment, the level and the determinants of total national
income. It is concerned with the overall performance of the economy.

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Difference between Micro and Macro economics

S NO Micro economics Macro economics

1 It studies the individual units It deals with aggregate economic unit
2 It deals with the determination of It deals with the determination of
price level and output in general price level and national output in
individual markets the country.

3 It aims at optimal allocation of It aims at determination of aggregate

resources output national income price level and
employment level in the economy
4 It assumes that macro variables It assumes that micro economic
remain constant. Example it is variables remain constant, Example it is
assumed that aggregate output is assumed that distribution of income
given while we are studying remains constant when we are studying
determination of output and the level of output in the economy
price of an individual firm or
industry
5 Examples: Individual demand, Aggregate demand aggregate supply and
supply and per capita income National income etc

WHAT IS AN ECONOMY
Meaning of the term Economy
In Economics, the word economy refers to production activities of well-defined area or region.
The term Indian economy includes collection of firms, shops, farms, banks, schools, colleges,
internet, public, military, theatres, roads etc. In short it includes any activity concerning
production of goods and services.
Production is carried out with the help of factors of production. These factors of production
earn income in the form of wages, interest rent and profit. Thus, economy refers to

It is a system spread over a particular area that reveals the nature and level of economic
activities in that area. In other words, it is a system where people earn a living.

Types of economies
1. Capitalist economy or free market economy
2. Socialist economy or centrally planned economy
3. Mixed economy

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 Basis Capitalistic Socialistic Mixed Economy
Control of economic Market forces By government Both by market
activities forces and
government
Motive Profit motive Welfare motive Both profit and
maximization of
social welfare
Ownership of Private Government Both private and
resources public
Determination of Market forces Government Both government
prices determine the prices and market forces

Basic problems of an economy

Factors of production such as land, labor, capital and entrepreneurship are referred to as
resources. These resources are never sufficient to satisfy human wants. The people have to
choose in using the available resources.
Thus, economics studies about
Making a choice in the presence of scarcity. Human wants are unlimited but resources to
satisfy them are limited. So, we are faced with the choice problem. Economics is concerned
with the study of human problems caused by scarcity of resources. Since resources are scarce
and human wants are unlimited people have to find ways and means to economize the
resources i.e. to use resources in the best possible manner.
Definition of scarcity
It is defined as the non-availability of adequate amount of resources to meet
the rising needs of consumers to satisfy their wants
Economics as defined by Lionell Robins
It is the science which studies human behavior as a relationship between ends
and scarce means which have alternative uses
The need for economizing resources
There is a need for economizing resources because human wants are
unlimited and means are limited with alternate uses.

The characteristics of resources

 Resources are scarce
 Resources can be put to alternative uses.

THE ECONOMIC PROBLEM AND WHY DOES IT ARISE

Meaning

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 The use and allocation of scarce resources for the production of goods
and services in a way that maximizes the satisfaction of human wants is
generally called the economic problem.
It is essentially a problem of choice arising from scarcity of resources.
Meaning of choice. It refers to the process of selection from limited
resources
Why does economic problem arise?
Human wants are unlimited
Resources are scarce and resources can be put to alternative uses
Scarcity is the essence of economic problem as if resources were not
scarce there would be no economic problem related to choice.
Economic problem is only due to choose. We can say that Scarcity and
choice go hand in hand. Scarcity implies limitation of a supply of
commodity in relation to its demand. In other words, there is excess
demand over available supply. Similarly, resources are scarce and they are
not sufficient enough to satisfy all human wants. This compels us to make
choice among the alternative uses of scarce resources. Thus, scarcity and
choice go together.

Flow chart showing the reasons for economic problem

Unlimited wants Scarce resources

for goods and services Limited possibility of
production of goods and
services

Choice allocation of resources among goods and services to achieve

maximum satisfaction

CENTRAL PROBLEMS OF AN ECONOMY

MEANING OF CENTRAL PROBLEM

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Economics deals with the way society chooses to use its limited resources, which have
alternative uses to produce goods and services and distribute them among different groups.
The compulsion of making choices before societies is referred to as central problems. The word
central in this context refers to common to all societies. The problem of choice exists in all
societies. Because resources are scarce every economy faces the problem of choice. It is the
problem related to the allocation of resources to alternate uses.
Three aspects of the central problems
The society has to make a choice as to what goods and services are to be produced in what
quantities. The problem is described as what to produce.
The society has to make a choice as to by what method or technique should be adopted to
produce goods and services. In order to do so it involves choice of inputs. The problem is
referred to as How to produce.
The way the society chooses to distribute the produced goods and services according to
different income group in the society is referred to as for whom to produce

Therefore, the three central problems are

1. What to produce and in what quantities
2. How to produce
3. For whom to produce.
1 WHAT TO PRODUCE AND IN WHAT QUANTITIES
Since resources are scarce we are faced with the problem of what to produce. An economy has
to make a choice between consumption goods wheat shoes sugar etc and capital goods
(machines, trucks, etc).
Let us assume that the economy needs to produce wheat and machines. If the economy
decides to produce more of machines it is bound to reduce the production of wheat. After
deciding which good to be produced society has to decide the quantity of each good to be
produced? The reason is that resources used to produce wheat and machines are limited and
given. An economy cannot produce more of both wheat and machines. In economics, the
problem of what to produce is studied under price theory.
Example : The problem before the Finance Minister is Out of the given resources how much
to allocate to defense and how much to allocate civilian goods?

2. HOW TO PRODUCE:
It is the question of technique of production. Since resources are scarce an inefficient technique
of production, which would lead to wastage and high cost cannot be applied. A technique

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which would maximize output or minimize cost should be used. The two techniques available
are capital intensive and labor intensive. In labor intensive more of labor and less capital is used
and in capital intensive more of capital and less of labor is used. Every economy chooses that
technology which would minimize the cost
Example: The problem before the businessmen and the Planning commission is to employ
more labor or to employ more capital in production activities

4. FOR WHOM TO PRODUCE:

The problem relates to the distribution of income in the economy. It has two aspects.
1. Factoral distribution of income - it relates to income share of different factors of production
namely rent ,wages, interest and profit.
2. Inter personal distribution of income – it relates to income share of individuals and
household in the society.
Broadly every economy has two sections of the society the rich and the poor. Social justice is
promoted if more goods are produced for the poor. It would reduce inequality but at the same
time would reduce the profits of the producers. Low profits will mean low investment , low
GDP growth. Thus, there is a problem of choice social equality or GDP growth.

Positive and Normative Economics

Positive Economics deals with economic issues related to past, present or future. It deals with
such economic situations which can be studied by using facts and figures.

Normative Economics deals with what ought to be. It deals with opinions of the economists
related to economic issues or economic problems. Opinions often involve judgements.

Difference between Positive and Normative economics

Positive economics Normative economics
Deals with economic issues related to Deals with opinions of the economists
past present of future related to economic issues or economic
problems
Statements of positive economics relate Statements of normative economics
to what was, what is and what would be relate to what ought to be
Statements of positive economics are not These statements cannot be termed as
necessarily the statements of truth. true or false. These statements involves
These may be true or false opinions
Example somebody says population of Example somebody says old age pension
India is more than population of China it should be stopped. It is just an opinion
is a positive statement. This may or may

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 not be true. One can verify it
Positive economics does not involve value It involves value judgment
judgement

CONCEPTS OF OPPORTUNITY COST AND PRODUCTION POSSIBILITY FRONTIER

Economics is the study of making choice from the available alternatives. Resources can be put
to different uses. These uses may be taken as different opportunities. When one opportunity is
availed the other one is lost. For example, suppose on a given piece of land is equally fit for
production of rice, and wheat. Yield from cultivation of rice is Rs 10,000 and from wheat is Rs
9000. If the farmer decides to produce rice the opportunity cost of rice is Rs 9000 because it is
the value of the next best alternative activity. Opportunity cost is defined as the cost of the
foregone alternatives.
Using the above illustration, we can define opportunity cost as the value of the next best
alternative use.
Opportunity cost is defined as the value of the benefit that is foregone by choosing one
alternative rather than the other.

PRODUCTION POSSIBILITY CURVE/PRODUCTION POSSIBILITY FRONTIER

The compulsion of making choices and the opportunity cost of choosing an alternative can be
explained with the aid of graphical technique.
This concept is based on the following assumptions
 The amount of productive resources is fixed
 There is no change in technology
 All the resources are fully and efficiently employed
 All resources are not equally efficient in the production of all goods.

PPC SCHEDULE (table number 1)

Production Cloth Wheat

possibilities (in thousand (in thousand
metres) quintals)
A 0 15

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 B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

The economy can produce maximum either 5 thousand metres of cloth or 15 thousand quintals
of wheat or any combination of the 2 goods like B, C D E etc. The economy has to choose out of
these possibilities

Commodity A
Definition of Production possibility curve
A PPC is a curve showing all possible combinations of two goods that can be produced by
making full use of given resources and technology in an economy
The economy can produce some combination on PP frontier only if resources are fully and
efficiently employed. It will produce somewhere below PP curve if some resources are
unemployed or inefficiently employed. For example, there may be unused land and
unemployment in the country. Also remember that it cannot produce at any point above the PP
curve because field resources do not permit to do so. If resources increase PP frontier will shift
to the right.

Characteristics/Properties of the PPC

It slopes downwards to right.
It slopes downwards to right indicating that the economy has to forego some quantity of one
commodity to have more quantity of the other commodity.
It is concave to the origin.
A concave downward sloping curve has an increasing slope. The slope is the same as MRT. SO
concavity implies increasing MRT, an assumption on which the PP curve is based

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RATE OF SACRIFICE INCREASES WHY
The rate of sacrifice increases because no resource is equally efficient in production of all
goods. It means that resources which are efficient in production of Y are comparatively less
efficient in production of X.
In the beginning, we may find some resources which are equally efficient but as we go on
producing more and more of X it may be difficult to find equally efficient resources. Then there
is no option but to transfer only the less and less efficient or less and less productive resources.
It means to produce each additional unit of X we have to sacrifice the resources engaged in the
production of Y at an increasing rate.
Let us assume that only two goods are produced in an economy. Let these two goods be guns
and butter. Suppose if all the resources are engaged in the production of guns, there will be a
maximum amount of guns that can be produced per year. Let it be 15 units (one unit may be
taken as equal to 1000, or one lakh and so on). At the other extreme suppose all the resources
are employed in production of butter only. Let the maximum amount of butter that can be
produced is 5 units. These are the two extreme possibilities.
In between there are others if the resources are partly used for the production of guns and
partly for production of butter.
Possibilities Guns Butter MRT
A 15 0 -
B 14 1 1G:1B
C 12 2 2G:1B
D 9 3 3G:1B
E 5 4 4G:1B
F 0 5 5G:1B

MARGINAL RATE OF TRANSFORMATION

MRT is the ratio of units of one good sacrificed to produce one more unit of the other good.
For example, if production of two units of Y is sacrificed to obtain production of one unit of X
MRT equals 2Y:1X
Rate of sacrifice can also be explained in terms of marginal opportunity cost. In other words it
is defined as the addition to the cost in terms of number of units of a good sacrificed to produce
one more unit of the other good.
Both MRT and MOC convey the same meaning in the context of PP frontier.

Units of one good sacrificed

MRT= ------------------------------- =  guns/butter
More units of the other good produced

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 Can PP curve be a straight line?
Yes, if MRT is constant the PPC will be a straight line. It means that every time the society
requires to produce one more unit of good, the number of units of the other good to be
sacrificed is the same. It also means that each resource is equally efficient in production of all
the goods.

PP SCHEDULE
Good X Good Y MRT = Y/X
0 10 -
1 8 2Y:1X
2 6 2Y:1X
3 4 2Y:1X
4 2 2Y:1X
5 0 2Y:1X

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GOOD Y

4
2

0 1 2 3 4 5
GOOD X

WHAT HAPPENS IF RESOURCES ARE NOT FULLY AND EFFICIENTLY USED/EMPLOYED

A PP frontier is drawn on the assumption that resources are fully utilized and efficiently
employed. If it is so production should take place on some point on the PP curve say at point
A or point B. If resources are underutilized production takes place within the PP frontier,
The economy is not producing goods and services to the full potential.

10 A
Good Y

10
 U

Good X 5

SHIFT OF THE PP FRONTIER

A1
Good Y

B B1
Good X
PPC will shift to the right if resources increase. More labor, more capital goods, better
technology, all mean more production of both the goods.
A PP curve is based on the assumption that resources remain unchanged. If resources increase,
the assumption is broken, and the existing PP curve is no longer valid. With increased
resources, there is a new PP curve to the right of the existing PP curve

WHEN TECHNOLOGY CHANGES

When technology changes more production of both goods can take place and so the PPC will
shift to the right. It leads to functioning or production of economy on higher scale of production
resulting in higher level of production of both the goods.

IF RESOURCES DECREASE

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 A1
Good y

B B1
Good X

It can shift to the left if resources decrease. It is a rare possibility but sometimes it may happen
due to fall in population, due to destruction of capital stock caused by large scale natural
calamities, war, etc.
The central problem of what to produce with the help PPC
The figure shows that if all the resources are used in the production of wheat you can produce
5 tons of wheat and corresponding to point D. On the other hand, if all the resources are used
in the production of cloth we can produce 15 bales of cloth corresponding to point A. All points
on the PPC indicate the amount of 2 goods that can be produced with the given resources. At
points B and C resources are fully utilized but if the production of one commodity is increased
then production of the other commodity has to be decreased. This is because of the scarcity of
resources. (Note: The schedule referred to is the first table number 1)

A
A B

C
Good y
Cloth (bales)

X
Good x (wheat) Tons

The problem of How to produce with the help of PPC.

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This problem relates to choice of technique of production. The figure shows how an economy
chooses a technique that makes optimum use of the available factors of production. As is
evident, point E is very much inside the PPC. It shows the use of inefficient technique. If
efficient technique is used, there will be more production of one commodity without sacrificing
the production of the other, as shown by points A and C. or there will be more production of
both the goods as shown by point B in relation to point E.

P A
B
cloth C Production possibility curve
E

O P
Wheat
PPC and for whom to produce
It is the problem of distribution of income. If distribution of income is in favour of the rich that
would generate more surplus for investment and PPC would shift to the right, but poorer
section of the society would suffer deprivation.
If a country focuses on growth without caring for equality, it may succeed in shifting from ab to
cd. However economic divide would rise which may lead to social unrest.

A
p c This indicates higher level of potential output when savings and
p a investment is high because distribution of income is in favour of
l
e the rich
s This indicates lower level of potential output when savings and
s b d investment is low because distribution of income is in favour of
wheat the poor

ROTATION OF THE PPC

If there is growth of technology taking place for only production of one good Y and not in the
production of the other good the PPC will not shift either to the right or to the left completely
but will rotate.

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 Good Y
A1

0 B
Good X

In the above figure, there is growth of technology taking place for only production of good y as
production of good Y has increased from OA to OA1 and production of X remains the same as
OB
If there is growth of technology taking place for only production of one good X and not in the
production of the other good y

A
Good y
Y

B B1
Good X

Examples of growth of resources

a) Supply of skilled labor like IT engineers has increased in India causing a rightward shift in the
PPC of IT software.
b) Discovery of oil reserves in gulf countries causing a rightward shift in the PPC of those
countries.
Example of underutilization of resources
Labor is underutilized (or less than fully utilized) in India. Mass unemployment in India proves
this point

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RECAP OF THE ENTIRE UNIT

Micro economics is the study of how individual economic units, firms, households and
industries make economic decisions that is choices
Macroeconomics is the study of behavior of the economic system as a whole.
Economy - It is a system spread over a particular area that reveals the nature and level of
economic activities in that area. In other words, it is a system where people earn a living.
Economic problem: It is essentially a problem of choice arising from scarcity of resources
The root cause of economic problem is scarcity
Scarcity The non-availability of adequate amount of resources to meet the rising needs of
consumers to satisfy their wants
Economic problem arises because
Human wants are unlimited
Resources are scarce
Resources can be put to alternative uses
Alternative use of resources means more than one use to which a resource can be put and
imply that resource can be used only for one purpose at a time.
What to produce means what goods and services to be produced and in what quantities.
How to produce means that what technique should be employed in producing goods and
services
For whom to produce means how should the goods and services so produced be distributed to
people.
Positive Economics relates to the study of economic issues which are subject to verification
Normative economics related to the study of economic issues which involve value judgement
which are debatable.
Opportunity cost is defined as the value of the benefit that is foregone by choosing one
alternative rather than the other.
A PPC is a curve showing all possible combinations of two goods that can be produced by
making full use of given resources and technology in an economy

Characteristics/Properties of the PPC

It slopes downward from left to right
It is concave to the origin.

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Assumptions of PPC
The amount of productive resources is fixed
There is no change in technology
All the resources are fully and efficiently employed
All resources are not equally efficient in the production of all goods.
MRT is defined as the ratio of number of units of a good sacrificed to produce one additional
unit of the other good
If MRT is constant PPC will be downward sloping straight line
If MRT increases PPC will be having a concave shape.
If resources are fully and efficiently utilized production will take place on the PPC.
If resources are unemployed or inefficiently utilized production takes place below the PPC.
If resources increase PPC shifts outwards
If resources decrease PPC shifts inwards
If technology advances PPC shifts outwards

MCQ
Choose the correct alternative in the following questions.

1. Micro economics deals with economic behavior of

a) Economic system b) economic entities that make up the system c) Country d) region of a
county

2. Which is macroeconomic variable?

a) Unemployment b) inflation c) income expenditure d) All of the above

3. Macroeconomics deals with a) pricing of the product b) Pricing of a factor of production

c) General Price level d) None of the above

4. Which of the following is not an example of Micro Economics?

a) Saving of an individual b) consumption of a household c) price level of a firm d) aggregate
demand of an economy

5. Study of micro economics is concerned with

a) Theory of demand b) determination of aggregates c) general price level d) both a and c

6. Micro economics is not concerned with

a) National income b) A firm c) a producer d) A consumer

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7. Macroeconomics generalizes
a) How economic decisions are taken? b) How economic decisions are taken by people
c) How economic decisions are taken by the industry d) How economic decisions are taken by
the government.

8. Macroeconomics deals with functions of

a) Government b) Central bank c) Policy Commission d) All of the above.

9. Economics is a branch of
a) Social science b) Science c) Psychology d) All of the above

10. The word economy stands for

a) Government intervention b) People C) Income earning activities of the people
d) All of the above

11. Economic problem in the context of a country is using resources

a) Fully b) Efficiently c) both fully and efficiently d) None of the above.

12. Economic problem arises because of

a) Unlimited wants b) unlimited resources c) both a and b d) Neither a nor b

13. Which one of the following is not an economic problem faced by the country?
a) Alternative use of resources b) unlimited wants c) Scarce wants d) limited resources.

14. The central problems are called central because these are faced by
a) all the consumers b) all the producers c) all the investors d) all the countries.
15. Economic problem is basically the problem of choice making
a) between inputs b) between output c) about distribution of output d) all of the above

16. The central problem of How to produce is basically the problem of deciding to undertake
poduction with the help of
a) Capital only b) Labour only c) both capital and labour d) how much of capital and labour
each

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17. Which of the following is related to the problem of whom to produce.
a) factor distribution of income b) inter personal distribution of income c) both a and b
d) none of the above

18. The government of India decided to produce 1000 million quintals of wheat this year. The
decision regarding quantity of production is a part of which central problem of the economy
a) what to produce b) how to produce c) for whom to produced) None of the above.

19. Positive economics involves statements which are

a) verifiable b) not verifiable c) may or may not be verifiable d) none of these.

20. A statement which does not offer any suggestio is known as

a) positive statement b) normative c) both a and b d) none of these

21. Normative science deals with

a) facts b) opinions c) both a and b d) none of these

22. Which of the following is not concerned with problem of choice

a) excessive income b) alternative use of resources c) unlimited wants d) limited resources

23. In which of the following situdation does scarcity arise

a) supply of resources > demnad for resources b) supply of resources< demand for
resoruces c) supply of resources = demand for resources d) none of these.

24. You have four alternatives to spend your spare time. The alternatives in order of preference
are take rest, play, watch television, and study. What is the opportunity cost of choosing the
best alternative?
a) Rest b) Play c) watch television d) Study

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