Chapter-One

Review of Some Basic Economic Concepts

1.1. Brief Definitions

This chapter begins with examining what the science of economics is about.
The subject matter of economics has grown so wide and vast that it is
difficult to define it in a nutshell. Nonetheless, from time to time, economists
have attempted to define economics. The various definitions can be
categorized in to three of the wealth, the welfare and the scarcity definitions
discussed below.

The wealth definition, pioneered by Adam Smith in his work “an enquiry in to
the nature and causes of the wealth of nations”, puts economics as a science
of wealth that enquires in to the factors that determine wealth of a country
and its growth. It emphasizes the production, distribution and expansion of
material wealth resulted from productive labor as the subject matter of
economics. The wealth definition unduly limited the scope of economics that
it neglected the immaterial services such as health, education,
administration and arts from the definition of wealth and thus ignored their
role for economic growth.

The welfare definition (by Alfred Marshal), in contrast, considers economics

as the study of mankind in the ordinary business of life closely connected
with material welfare. It deals with wealth implying that it studies man’s
action in earning and spending wealth. Thus, wealth here is studied not as an
end but as a means to the end of promoting human welfare. This definition
again leaves immaterial services and ends out of the scope of economics.

The scarcity definition (by Robbins) regards economics as a science which

studies human behavior as a relationship between unlimited ends and scarce
resources with alternative uses. It studies human action regarding how he
Compiled by micro team
Microeconomics I Page 1
satisfies his wants (all goods and services) with scarce resources. This
definition leaves macroeconomic issues such as determination of national
income and employment, and the theory of economic growth and
development untouched that are the major concerns of modern
microeconomics.

Furthermore, professor Hennery smith has recently defined economics as

“the study of how in a
-civilized society one obtains the share of what other people have produced
and of how the total product of society changes and is determined.”
Although this recent definition explicitly embraces the crucial issues of
distribution of income, determination of income and employment and theory
of economic growth, it excludes the problems of pricing and resource
allocation.

In conclusion, the whole subject matter of economics can hardly be

inclusively put in few words. Being started with the wealth aspect of Smith,
its scope has remarkably grown touching new and varied issues owning to
the dynamic economy that economic theories lay on. Accordingly, existing
economic theories might not work anymore or may be inadequate to
comprehend the constant changes. Economics can instead be better
described by spelling out the problems economists raise as J.Viner stated it
that economics is what economists do. Economists deal with various issues
like pricing and resource allocation, distribution of national income,
determination of employment and income, general price level and theory of
economic growth and development.

1.2. Microeconomics and Macroeconomics

The modern view divides the subject matter of economics in to

microeconomics and macroeconomics. The term microeconomics is derived
from the Greek word mikros to mean ‘small’ and macroeconomics from

Compiled by micro team

Microeconomics I Page 2
makros meaning ‘large’. Microeconomics deals with the analysis of small
individual units such as individual consumers, individual firms, and small
groups of individual units like industries and markets. In particular, it
analyses the theory of product pricing that include theories of demand and
production and cost; theory of factor pricing and theory of economic welfare.
Microeconomics also deals with some aggregates relating to a particular
product, industry or particular market with regard to price, output or
employment generation.

On the other side, macroeconomics analyses the economy as a whole and its
large aggregates such as national output and income, aggregate
employment, aggregate consumption, aggregate investment and the general
price level of the economy. The theories of distribution and growth in
national output are studied in macroeconomics. It thus analyses and
establishes the functional relationship between these large aggregates.
Unlike microeconomics, aggregates and sub-aggregates in macroeconomics
relates to the whole economy with a great deal of products, markets and
industries.

But it is vital to note that micro and macro-economics are interdependent.

Macroeconomic theories are derived from theories of individual behavior.
The theories of aggregate consumption and investment are based on the
behaviors of entrepreneurs and consumers. Likewise, some macroeconomic
issues like profits and rates of interest are determined from macroeconomic
theory.

1.3. The Fundamental Economic Fact- Scarcity

Economics especially deals with the achievement and use of material

requirements to satisfy human wants. But human wants are without limit.
Most of us, for instance, want more or better food and clothing, better
education or health care, good houses and new television sets. Economists

Compiled by micro team

Microeconomics I Page 3
say human wants are unlimited due to the facts that some human wants are
recurring and others are hierarchal. The same needs reappear after being
satisfied and needs emerge with higher order ones. For example, the need to
eat recurs within a certain interval. Likewise, once you attain your Bachelor
degree, you aspire to get better education like a master degree and then
PhD.

In contrast, the productive resources such as land and other natural

resources, skilled labor, raw materials, capital equipments and
entrepreneurship are limited in supply. Land resource includes land and
other natural resources while labor refers to the physical or mental effort of
people. Capital represents the set of goods produced for use in the
production other goods but not for direct consumption. Entrepreneur ability
again is the sprite and effort to start, organize and run business. These
resources are scarce since total amount of demand for them is greater than total supply at zero
price level. These scarce resources result in scarce amount of goods and
services.

Thus, human wants for goods and services remain ahead of resources and
capacity to produce. This gives rise to the problem of how to use scarce
resources to achieve maximum possible fulfillment generally called ‘the
fundamental economic problem’. This problem of scarcity of resources
relative to wants bases all economic problems and unanimously faces
individuals, the society and all economic systems. Scarcity justifies existence
of economics as a scientific study that otherwise would have been
unnecessary. The problem can be felt well in poor countries where a lot of
people live at a bare subsistence level. However, the developed countries
also face the problem of scarcity despite the enormous rise in the
possession of goods and service because their present wants exceed their
increased resources and capacity to produce.

Compiled by micro team

Microeconomics I Page 4
The problem of scarcity of resources to satisfy human wants leads to the
basic economic problem of choice as to what goods and services should be
produced, how they should be produced , and for whom should they be
produced. Hence, an economy has to solve these central economic problems
if it is to meet its purpose. These problems are explained in some detail
below.

a. What to produce

Scarcity implies the society cannot have all the goods and services that it
would like to have. This in turn compels to decide which goods and in what
quantities are to be produced. The society would have to choose what
consumer and capital goods and what amounts of consumer and capital
goods should be produced. In particular, the society faces a range of goods
and services such as cars, schools, houses, nuclear bombs, rice, machinery,
lipsticks, and haircuts and must determine what amount of each chosen
good or service should be produced.

b. How to produce

This economic problem implies what combination of resources (production

technology) should be utilized to get the best out of the resources. Usually,
there exist various alternative techniques of producing a commodity and the
society has to opt among the alternative production techniques involving
various degrees of capital and labor intensity that result in the most efficient
outcome.

c. For whom to produce

Goods and services cannot be produced in sufficient quantities to satisfy all

wants of all the people due to scarcity of resources. This requires the society
to decide how the national output is to be distributed. It can be considered
as sharing of national ‘Teff’ among the people constituting a society. In a

Compiled by micro team

Microeconomics I Page 5
free market economy, the problem of who should get and how much of the
national output depends on money income. Greater money income implies
greater purchase of amount of goods and services and greater inequality in
money incomes leads to greater inequalities in the distribution of national
output.

Having explained the central economic problems, let’s proceed with how
actually these problems are solved. There are two main methods of the
market (price) mechanism and economic planning to solve the central
problems. In the former, the free play of the forces of demand and supply
decide what and how much, how and for whom should be produced. The
demand for and supply of goods, services and factors of Production
determine the price, quantity and distribution of inputs and goods and
services among individuals of the society. In the later, the central planning
authority decides what, how and for whom should be produced. In such an
economy, capital and property are collectively owned, government organizes
production and consumers lose freedom of consumption.

It is worth noting that no country in the world today solves the central
problems through unfettered market mechanism. Governments in present
capitalist countries intervene in the economy and play an active role in the
production, distribution and investment decisions. Besides, governments
interfere through the adoption of proper monetary and fiscal policies and
direct controls. Thus, the coexistence of market mechanism and government
interference gives rise to a mixed economic system.

1.4. Production Possibility Curve (PPC)

The nature of the basic economic problems discussed above can better be
understood with the help of a vital economic tool referred to as production
possibility curve (frontier). PPC represents graphically alternative production
possibilities facing an economy given its resource and current level of

Compiled by micro team

Microeconomics I Page 6
technology. An economy indeed faces the decision of what and how much of
several different goods and services to produce and how resources should be
allocated among different possible goods and services. But in order to
simplify the analysis, it is assumed that two goods-wheat and cloth-are to be
produced.

The analysis of the central economic problems using the PPC is based on the
assumptions of:

a. Fixed amount of productive resources and alternative uses of these

resources
b. Full employment and full use of existing production capacity
c. A given level of technology and a short period of analysis considered
d. Only two goods and some factors are better adapted to certain uses
than others

The table below shows a hypothetical economy with various production

possibilities between cloth and wheat for a given amount of productive
resources and technology.

Table 1.1

Production possibility schedule

Production possibilities Cloth (in thousand meters) Wheat (in thousand

quintals)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

Compiled by micro team

Microeconomics I Page 7
The production possibilities A, B, C, D, E and F in the table above indicate the
combination of the amounts of cloth and wheat produced given the current
amount of resources and level of technology. For instance, production
possibility ‘A’ shows that 15 thousand quintals of wheat is produced if all the
given resources are employed for the production of wheat.

Y Y

    15 A B

Wheat 14 C H wheat

12 D

9 U E

5 PPC0
PPC2 PPC0 PPC1

0 1 2 3 4 5 F X
X

Cloth
cloth

Figure 1.1: Production possibility curve (frontier)

Figure1.2. Shift in PPC

With ‘B’, the economy can produce 14 thousand quintals of wheat and one
thousand meters of cloth and similar combinations can be formulated for the
other production possibilities above.

The alternative production possibilities can be illustrated graphically by

plotting the data in table 1.1. The curve AF is called the production possibility
curve (frontier) - PPC. Points on the PPC like A, B, C, D and F are technically
efficient in that the economy fully utilizes and employs its resources. The

Compiled by micro team

Microeconomics I Page 8
combined output of the two goods can neither lie at U where there exist
underutilization or underemployment nor at H which lies beyond the capacity
of the economy to produce. However, resource underutilization or
inefficiency due to unemployment, under-employment or the like could allow
production of more of the two or either of the two goods.

As we move from production possibility A to F, we give up some units of

wheat so as to have some more units of cloth and vice-versa. Some
resources are drawn away from wheat production and devoted to production
of cloth. Hence, it is always must to give up something of one good to obtain
some more of another with full-employment economy and full-use of
production capacity. This reveals that resource scarcity prevents an
economy from producing more of both goods.

Besides, as we move from A to B, B to C, C to D and further D to E and E to

F, the amount of wheat given up for having extra unit of cloth goes on
increasing. In particular, the cost of extra one thousand meters of cloth as
we move from A to B, B to C, C to D ,D to E and E to F is 1 thousand, 2
thousand, 3 thousand, 4 thousand and 5 thousand respectively. The
successive rise in the amount of wheat sacrificed in order to have one more
unit of cloth is called the principle of increasing opportunity cost and this
makes the PPC concave to the origin. The rise in opportunity cost (or
concavity of the PPC) is related the fact that economic resources are not
completely suited to alternative uses that a given resource is more suited to
the production of one good than another often called specificity of resources.
Opportunity cost here is defined as the ratio of the amount of good given up
to the amount of other good gained or the value of the next best alternative
sacrificed.

Despite the assumptions to draw the PPC, the change in the supply of
resources and change in technology in the long run shifts the PPC outward
such as from PPC0 to PPC1 or PPC2 in figure 1.2. Hence, the growth in

Compiled by micro team

Microeconomics I Page 9
economy due to change in capital, human or natural resource and
technology shifts the PPC outward while the deterioration in growth from
lower amount of productive resources and inferior technology shifts the
production possibility curve to the left.

It is worth noting that the movement from one PPC to another should be
distinguished from the movement from a point inside the PPC to a point on it.
Despite the increase in output in both cases, the former involves increase in
resources or productive capacity while the latter results in fuller employment
or efficient utilization of resources. Beside, the former is about theory of
economic growth where as the latter is associated to the short-run
macroeconomic theory.

1.5. Micro economic theory and the price system

1.5.1. the circular flow of economic activity

Micro economic theory –studies the economic behavior of individual decision

making units such as individual consumers (resource owners), and business
firms, and the operation of individual markets in a free enterprise economy.
Micro economics focuses attention on two broad categories’ of economic
units: Households and business firms and it examine the operation of two
types of markets; the market for goods and services & the market for
economic resources.

Resource market
Expenditure of firms’ income of resource owners

Flow of resources flow of resources

Firm Household

Compiled by micro team Product market

Microeconomics I Page 10
 Flow of goods and services goods and services

Revenue of firms’ consumption expenditure

Figure 1.4 the circular flow of economic activity.

Households and firms (businesses are the two major decision making units of
the economic system. Now let us use their interactions by using the circular
flow model). The inner loop shows the flow of economic resources from
households to business firms and the flow goods and services, from business
firms to households represents production flow. The outer loop shows the
flow of money incomes from business firms to households and the flow of
consumption expenditures from households to business firms, this
represents financial flow. However, the above model represents a closed and traditional
economy because:
a) It involves only two elements of the economic system, namely, the business firms and
household. But it excludes the other two major elements, the government and foreigners.
b) The households in the model spend all of their incomes on consumption and do not save.
c) Since there is no capital investment, the model–economy is a stagnated one; i.e. there is
no economic growth because the total product is consumed in the same period.
1.6 Methods of Economic Analysis

Every branch of knowledge derives hypotheses, generalizations, principles,

laws and theories. Each scientific study adopts a certain methodology to
develop these theories and generalizations. Every scientific theory is based
upon a set of assumptions called premises or postulates. From the
postulates, testable hypotheses are driven through the process of logical
reasoning. A hypothesis is then established as a scientific theory if its
predictions coincide with the direct observation of facts or through statistical
methods of interpretation. Hence, the crucial test of a theory is that whether
the explanations and predictions are consistent or not with empirical

Compiled by micro team

Microeconomics I Page 11
evidence. A distinction could be made between generalizations (laws) and
theories. Generalizations are statements of relationship between variables
with no explanation about the described relations. Theories, on the other
hand, provide an explanation of the sated relation that logically bases the
generalization.

Like other scientific studies, generalizations in economics are derived

through either the deductive or inductive methods.

1.6.1 Deductive method

The deductive method is an abstract, analytical or a priori approach that

involves the principal steps of:

a) Perception of the problem: a scientific theorist must have a clear idea of

the problem and identify the significant variables and interrelationships.
b) Precise definition of technical terms and making of assumptions: the
next step in the deductive approach is the precise definition of technical
terms and clear statement of the postulates. The postulates are based
on observations or retrospect and could be behavioral relating to
economic agents and variables or pertaining to the production
technology and resources availability. The actual economic world is quite
complex in which numerous factors play a part and act and interact.
Hence, we introduce premises to identify the most significant factors
having a bearing on the problem. Theories then are maps of the real
world economic phenomenon and not perfect pictures. The crucial test of
an economic theory is that whether the explanations and predictions are
consistent or not with empirical evidence or the facts in the real world.
c) Deducing hypothesis: then follows the deducing of a testable hypothesis
describing the relation between variables affecting a phenomenon from
the premises taken using logical reasoning. The logical deduction is

Compiled by micro team

Microeconomics I Page 12
 carried out with the aid of words, symbolic logic, graphic technique or
formal mathematics.
d) Testing of hypothesis: economics relies on uncontrolled experiences and
observations to verify hypothesis. The need to depend on uncontrolled
experiences raises the size of observations and complicates analysis and
interpretation. Despite this, there exist many well-established
generalizations in economics such as the laws of demand and supply.
Predictions by hypotheses may not accord with historical sequence of
events and forecasting of future events. The statistical (econometric)
method may be used to verify hypothesis. If the predictions by a certain
hypothesis are consistent with the direct observation of facts or result of
statistical methods, it stands established as a scientific theory otherwise
rejected. The rejection of a hypothesis implies an error either in logical
deduction or adoption of too unrealistic assumptions.
The deductive method has some merits that useful mathematical
techniques can be used; detailed collection and analysis of data may not
be required; and vital due to impracticability of controlled experiment.
However, it requires a high level competence in logic and theoretical
abstraction and advanced model with no application can be developed.

1.6.2 Inductive Method

The inductive (empirical) method derives theories based on experience or

observations. The experimentation, observation or econometric methods
can be used to derive economic principles. Experimentation has limited
application in economics in that the behavior of man is changeable and
unmanageable, man cannot tolerate experimentation and an economic
phenomenon is the result of multiplicity of factors. The steps involved in the
inductive approach include identification of the problem, defining technical
terms and variables, collection of data and doing preliminary thinking about
the possible functional relationship, processing of data and development of

Compiled by micro team

Microeconomics I Page 13
 a theory to reined and tested further. The method of induction should be
supported with theories developed by deductive logic, requires sufficient
data and good knowledge of statistical methods.

Despite the above distinction, the modern viewpoint is that both

approaches are needed for the proper development of scientific economic
theories. Modern economists first derive economic hypothesis through
deduction and utilize statistical methods to for empirical test.

1.7 Positive Economics and Normative Economics

It is worth distinguishing between normative and positive economics.

Positive economics is a body of systematized knowledge about what it is. It
describes theories and laws to explain observed economic phenomenon. In
the other hand, normative economics relates to what should the economic
phenomenon be. In positive microeconomics, we explain the determination
of relative prices and resource allocation while normative economics
emphasizes what should the relative prices and resources allocation look
like. Given the profit maximization assumption, positive economics states that monopolist will
fix a price which will equate marginal cost with marginal revenue but the question what price
should or ought to be fixed so that maximum social welfare is achieved lies within the purview
of normative economics.

Compiled by micro team

Microeconomics I Page 14