UNIT

01 Introduction to Economics

Names of Sub-Units

Meaning, Nature and Scope, Microeconomics and Macroeconomics, Twin principles of scarcity- trade-
offs, Economic system, Economic Issues, Economic Principles- Opportunity cost, Incremental and
Marginal Principle, Time Perspective, Discounting Principles- Production Possibility curve, Objectives
of Firms, Interface between Business and Economy

Overview
This unit discusses the definition, subject matter, nature and scope of economics. It differentiates
between microeconomics and macroeconomics. It explains various economic concepts and tools
involved in business decision making. It also discusses some of the important economic principles such
as discounting principle, opportunity costs, the importance of time element and marginal analysis
and incremental analysis.

Learning Objectives

In this unit, you will learn to:

 Explain the meaning, nature and scope of economics
 Discuss the central problems in economics
 Distinguish between microeconomics and macroeconomics
 Describe various economic concepts and tools involved in business decision making
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Learning Outcomes

At the end of this unit, you would:

 Gain an understanding of the nature and subject matter of economics
 Analyse the difference between microeconomics and macroeconomics
 Apply the subject matter of economics to real-world situations
 Assess the various economic concepts and tools for their utility in business decision-making

Pre-Unit Preparatory Material

 https://icmai.in/upload/Students/Syllabus-2012/Study_Material_New/Foundation-Paper1.pdf

1.1 INTRODUCTION
The subject of Economics is of tremendous importance and interest to the business world. Economics is
a fascinating study which explores the problems in the real world and offers meaningful solutions. The
central problem of economics relates to the scarcity of resources and their optimal allocation among
the unlimited human wants. Economics is the mother of all social sciences and has found applications
in every field of human activity, including agriculture, health, financial markets, health, labor,
macroeconomics, international trade, public economics, and industrial organisation, among others.
Therefore, it has been aptly said that economics is what economists do. It provides critical concepts and
tools which are highly useful in solving business problems.

1.2 MEANING OF ECONOMICS

Economics is concerned with the study of the real world. It studies human behavior in response to
prices, costs, and profits, among others. Economics is concerned with the optimal allocation of scarce
resources for the satisfaction of human wants. Human beings have unlimited wants, but the means to
satisfy these wants are limited. How economic agents optimally allocate these scarce resources among
unlimited wants is the subject matter of Economics. This involves making a choice of more important
wants over less important wants.
For instance, if you have only ` 100 in your pocket, and if you have to make a choice between buying an
Economics text book or watching a movie, you would as a rational consumer prefer to buy the textbook
rather than watch a movie since this is important for passing the exam and thereby will help you in your
career. Therefore, Economics is a science of scarcity and choice.
Since human wants are limited and resources are scarce, to acquire these resources, an effort is
required. Efforts will result in fulfilment of want and therefore satisfaction. However, new wants come
up, which again require effort and satisfaction. Wants are not only unlimited, but they are competing
and complementary to each other. For instance, in the above example, the desire to acquire a textbook
was competing with your need to watch a movie. Also, after acquiring a textbook, you also need to buy a
notebook, pen, pencil, and other items to make notes. So, all these are complementary goods.

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Wants

Satisfaction Efforts

Figure 1: Economics – Science of Scarcity

1.2.1 Nature and Scope

The nature of Economics is that it’s both positive and normative. A positive science explains the things
as they – what is. But it does not make an ethical judgement about whether it’s morally correct or wrong.
A normative science, on the other hand, passes a moral judgement about an economic decision – what
ought to be, and its effect on the welfare of the society. For instance, as a positive science Economics tells
us that the liquor and beverages industry is generating an annual revenue of $35 billion. It however,
does not tell us if that is good or bad.
As a normative science Economics passes a judgement and says that as more people get addicted to
liquor it will result in ill health, diseases, premature death, loss of productivity and many more families
being reduced to a state of poverty since the main breadwinner dies due to alcohol addiction. So, it
says in the long-run the health costs for the individuals and the society could go up and the welfare of
the country itself could be adversely impacted. For instance, if Economists calculate that the costs of
addiction in terms of health costs, productivity, insurance, and poverty are ten times more than the
revenue foregone to the industry and the government, it may advise the government to ban liquor
consumption.

1.3 MICROECONOMICS AND MACROECONOMICS

The word micro is derived from the Greek word mikros meaning small. Microeconomics is a branch of
economics that is concerned with the behavior of individual consumers, firms, industries, commodities
and prices. It studies how decisions made by economic agents affect the prices of goods and services.
The main objective of microeconomics is to maximise utility and minimise cost. It is also known as the
price theory. It studies an individual consumer, producer, particular firm, particular industry and so on.
It assumes the rational behaviour of economic agents.

Scope of
Microeconomics

Consumption Production Exchange Distribution Public Finance

Figure 2: Scope of Microeconomics

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The subject matter of microeconomics consists of

Microeconomic

Product Pricing Factor Pricing Welfare Economics

Rent
Demand Theory Supply Theory Wages

Interest

Profit

Figure 3: Subject Matter of Microeconomics

Macroeconomics, on the other hands, studies the economy as a whole. The word macro is derived from
the Greek word makros meaning large. It studies aggregates and averages. For instance, it studies Gross
Domestic Product (GDP), total production, total consumption, total market demand and supply, average
price level, per capita income and so on. At the same time, microeconomics studies individual trees
macroeconomics studies the whole forest.

Macroeconomics

Theory of National
Theory of Economic Theory of
Income and Theory of Price
Growth Distribution
Employment

Figure 4: Subject Matter of Macroeconomics

1.4 TWIN PRINCIPLES OF SCARCITY – TRADE-OFFS

As we already discussed, wants are unlimited but the resources to satisfy these wants are scarce.
Therefore, using those resources involves a decision about how to use them. For example, if a producer
has limited money to invest, he needs to make a decision about whether he will produce cement or steel.
That is because if he produces cement, he cannot produce steel and vice versa. That is, we have to make
a choice and there is a trade-off between one product or the other and one use or the other. Suppose, for
example, that you are a beverage manufacturer. To produce a beverage, you have to use some scarce
resources: packing material, bottles, machines and so on. If you choose to produce coffee, you cannot
produce tea and vice versa. Your scarce resources force you to make a choice and this involves a trade-
off between producing one product instead of the other.

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Similarly, consumers must choose between current consumption – current needs versus future
consumption – future needs. Since resources such as time, labor, and money are limited, they must
choose how to best allocate them by making tradeoffs.

1.5 ECONOMIC AND ECONOMIC ISSUES

The central problem of Economics is:
 What to produce?
 How to produce?
 How much to produce?

What to Produce
The first question is which commodities should be produced and in what quantities. The commodities
which do not enjoy demand from consumers and fetch remunerative prices in the market would not be
produced. Therefore, only those commodities which enjoy adequate demand and fetch remunerative
prices would be produced.
At the point of intersection of demand and supply curves, that is where the buyers and sellers agree to
buy and sell a given good at a certain price, equilibrium price and output for that good are determined
and markets are cleared.

How to Produce
This refers to which techniques of production should be used. There are two types of techniques:
a. labour-intensive technique which employs relatively more labour and less capital.
b. capital-intensive technique which employs more capital and less labour.
Which technique of production will be adopted depends on the prices of the factors of production. If
labour is cheap and capital is expensive, a labour-intensive technique of production would be used and
vice-versa.

For Whom to Produce

Commodities can be consumed only by those people who have more purchasing power. Price mechanism
determines the income of the factors of production and goods. Income here refers to purchasing power.
Thus, when the price of every commodity and every factor of production is determined, the decision can
be taken about whom to produce.

1.6 ECONOMIC PRINCIPLES – OPPORTUNITY COST

Opportunity Cost refers to the cost of the displaced alternative or the sacrificed alternative or the
foregone alternative. Since resources are scarce, we need to make a choice. Choice involves sacrificing
one use over the other. For instance, Adam Smith has said that if a hunter enters a forest and sees a bear
and deer at the same time, he can shoot only one animal because the other will run away. Therefore, the
opportunity cost of the deer is the bear and the opportunity cost of the bear is the deer.
Similarly, every economic agent needs to make a choice about foregoing one alternative versus the
other. For instance, as a student, if you had a limited budget of ` 1 lakh and you had a choice of pursuing

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either a masters in commerce or a diploma in computers, the opportunity costs of masters in commerce
is a diploma in computers and vice versa. You can either do a masters in commerce or a diploma in
computers. But you cannot do both with your limited budget and time. Which one you choose depends
on the factors considered about which will pay off in the long-run better than the other in terms of your
career choices.

1.7 INCREMENTAL AND MARGINAL PRINCIPLE

The incremental concept involves estimating the impact of the alternative decision on costs and
revenues. It emphasises the changes in total cost and the total revenue resulting from changes in prices,
products, procedures, investments or whichever other factors may be involved in the decisions. The two
basic components of incremental reasoning are:
1. Incremental cost
2. Incremental revenue.

The incremental cost is defined as the change in total cost resulting from a particular decision.
Incremental revenue is the change in total revenue resulting from a particular decision.
The incremental principle is defined as follows:
A decision is a profitable one if
 Increase in revenue is more than increase in cost
 Decreases some costs to a greater extent than it increases others
 Increases some revenues more than it decreases others and
 Reduces cost more than revenues.

Suppose XYZ Company gets an order that will generate additional revenue of ` 5,000. The cost of
production from this order in rupees is:
Labour 2500
Materials 1,500
Overheads 800
Selling and administration expenses 700
Total cost is ` 5,500
Therefore, the order appears to be unprofitable. However, if the firm has some idle capacity it can utilize
that to produce for the order. This may result in more efficient use of existing labour and capital with
the same selling costs. In that case the total costs will now be:
Labour 2500
Materials 1500
Overheads 800
Total incremental cost 4,800

Incremental reasoning shows that the firm would earn a net profit of Rs 200 (Rs 5,000 – 4,800), though
initially it appeared to result in a loss of Rs 500. The order should be accepted.

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Marginal concept refers to the effect of an additional unit of good or service on revenues, costs and
profits.
Marginal revenue is the addition made to the revenue by selling one more unit of the commodity.
Marginal cost is the addition made to total cost by producing one more unit of the commodity.
Equilibrium is achieved at the margins. When marginal revenue is greater than the marginal cost, it
results in abnormal profits. When marginal cost is more than marginal revenue, it results in losses. At
the exact point where marginal cost is equal to marginal revenue, it denotes an equilibrium point for
the firm since it results in normal profits.

1.8 TIME PERSPECTIVE

Time perspective states that an economic agent should carefully assess the impact of his decision both
from the perspective of short run as well as long run. In economics, short run is defined as a period when
only the variable factor labor can be increased to increase production. Capital is fixed. On the other
hand, in the long run both capital as well as labor can be increased to increase production. Then the size
of the firm increases and it may reap economies of scale. Conversely, what appears to be a profitable
decision in the short run may turn out to be loss-making in the long run. Since decisions involve scarce
resources, time perspective should be carefully considered.

1.9 DISCOUNTING PRINCIPLES

This is one of the fundamental propositions of economic theory. It states that a rupee received today is
worth more than a rupee received tomorrow. This is because inflation can erode the purchasing power
of money so that the same rupee received tomorrow may buy less amount of goods and services.
Therefore, it becomes necessary for an investor or capitalist to discount the present value of expected
future profits to arrive at a decision on whether it is worth investing the money. The discounting rate
is usually the bank rate of interest which banks charge on their loans. If the present value of expected
future profits so discounted are greater than the initial investment, it’s worth investing the money.
Otherwise, it1could result in losses.n n
t
PV  2  ...  

(1  r)1 (1  r)2 
(1  r)n t 1 (1  r)t
t  TRt  TCt
n
Value of Firm  n
 
(1  r)

t
(1  r)t
t 1 t 1

Where  denotes the rate of return, n is no. of time periods, and r denotes discounting rate.
Let us look at an example to understand this better. Hari Babu plans to invest a total of ` 28,000 in the
business. He wants to understand if this investment is profitable. He discounts the future cash flows to
the present value by using the rate of return of 7%.
The discounted cash flows amount to ` 23,198. Therefore, it may not be profitable to invest in the
business. The logic here is that when investing capital, it must at least give us something equal to bank
deposit which is considered to be the safest asset.

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Otherwise, it’s not worth investing.

Table 1: Discounting Principle - Example

Years Rate of r Future cash flows Discount Factor Discounted cash flows
=1/(1+r)^n =cash flow * discount factor
1 7% 5500 0.93458 5140

2 7% 6500 0.87344 5677

3 7% 7000 0.81630 5714

4 7% 5000 0.76290 3814

5 7% 4000 0.71299 2852

Total 28000 23198

Production Possibility Curve

The concept of the production possibility curve was introduced by Prof. Paul A. Samuelson to explain the
economic problem of scarcity. Production Possibility Curve (PPC) is the locus of various combinations of
two commodities which can be produced with given level of resources and technology. The PPC Schedule
is given below.

Table 2: Production Possibility Curve

Production Possibilities Wheat (mt) Cloth (mt)

A 0 18

B 1 16

C 2 14

D 3 10

E 4 5

F 5 0

On the basis of above schedule, we plot all the coordinates of A, B, C, D, E and F, which show the various
combination of two goods, wheat and cloth which can be produced in the following diagram.
It appears from the PPC that a point such as say P, indicates that resources are underutilised. Movement
away from the point on the curve AF shows fuller utilisation of resources at present.
For instance, point O, indicates efficient utilisation of resources and point B indicates economic growth
and technological development.
The curve is the frontier line beyond which existing resources cannot produce. If the society is able to
increase the resources due to the economic growth, a new curve GH is formed. PPC is concave to the
origin. Since resources are limited and have alternative uses, we have to put them to the best possible
use to maximise output. For example, if a producer is able to earn ` 30,000 in cloth versus ` 20,000 in

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wheat, he will shift production resources to cloth. Thus, the opportunity cost of the cloth is wheat and
vice versa. That is why opportunity cost is called the cost of displaced or sacrificed or foregone or next
best alternative.

Economic Growth and

20 Technological Development
G A
18
B
16
C Efficient use of resources
14
12
O D
Cloth

10 Under utilisation of resources

8
6 E
4 P
2 F
0
H
0 1 2 3 4 5 6
Wheat

Figure 5: Production Possibility Curve

1.9.1 Objectives of Firms

Firms have the following objectives:
 Profit Maximisation: The theory of the firm states that the primary goal of the firm is to maximise
profits. Profits are maximised at the point where total revenue is greater than total costs. Profits are
defined as follows:
 Business or Accounting Profit: Total revenue minus the explicit or accounting costs of production.
 Economic Profit: Total revenue minus the explicit and implicit costs of production.
 Opportunity Cost: Implicit value of a resource in its best alternative use.
 Role of Profits:
 Profit is a signal that guides the allocation of society’s resources.
 High profits in an industry are a signal that buyers want more of what the industry produces.
 Low (or negative) profits in an industry are a signal that buyers want less of what the industry
produces.

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Profit
Maximisation

Sales
Profit Satisficing
Maximisation
FIRM
OBJECTIVES

Social
Survival
Responsibility

Figure 6: Business Firm’s Objectives

Alternative Objectives of the Firm:
1. Profit Satisficing: The owners of the business may want to maximise profits, however, the
managers have much less incentive to maximise profits because they do not get the same
rewards - dividends. Therefore, managers may generate an acceptable minimum level of profit to
keep the shareholders happy, but then maximise other objectives, such as increasing salaries and
wages, maintaining good interpersonal relationships and so on. This is the problem of ‘principal-
agent‘, which can be addressed by providing incentives to managers such as employee stock options,
bonus, perks and so on.
2. Revenue Maximisation: Firms often seek to increase their market share – even at the cost of lower
profit. Increased market share increases monopoly power and may enable the dictate prices and
make more profit in the long run. Also, managers prefer to work for bigger companies as it leads to
greater prestige and higher salaries.
3. Survival: In times of the downturn of the business cycle when there is an economic depression,
it may be important just to survive till recovery starts. Also, intense competition and predatory
pricing strategies may compel firms to revise their objectives from profit-seeking to prevent shut-
down of business.
4. Social Responsibility: Some firms may adopt social/environmental concerns as part of their
branding strategy. This can ultimately improve profitability since the brand image is enhanced
before the consumers. Others may adopt social/environmental concerns based on principles
alone – irrespective of brand image and ensuing profits.

1.9.2 Interface between Business and Economy

Every business has stakeholders viz., customers, suppliers, government, competitors, employees among
others which it influences and is in turn influenced by them. These stakeholders have varied expectations
and demand certain obligations from the firm. For instance, customers demand fair prices with good
quality. The government expects the firms to abide by all the laws of the land and pay taxes. Suppliers
expect to be paid on time and transparency is internal procedure. Competitors expect fair play and

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competitive pricing policies. All these stakeholders continually act and, in turn, are acted upon by the
firm.

Shareholders

Management Customers

Employees Business Firm Community

Government Competitors

Suppliers

Figure 7: A Firm’s Stakeholders

Conclusion 1.10 CONCLUSION

 Economics is concerned with the optimal allocation of scarce resources for the satisfaction of human
wants. Human beings have unlimited wants, but the means to satisfy these wants are limited. How,
economic agents optimally allocate these scarce resources among unlimited wants is the subject
matter of Economics.
 The nature of Economics is that it’s both positive and normative. Microeconomics is a branch
of economics that is concerned with the behavior of individual consumers, firms, industries,
commodities and prices. It studies how decisions made by economic agents affect the prices of
goods and services. The main objective of microeconomics is to maximise utility and minimise cost.
 Macroeconomics, on the other hands, studies the economy as a whole. The word macro is derived
from the Greek word makros meaning large. It studies aggregates and averages. For instance, it
studies Gross Domestic Product (GDP), total production, total consumption, total market demand
and supply, average price level, per capita income and so on.
 The central problem of Economics is: What to produce, how to produce, and how much to produce.
 Opportunity Cost refers to the cost of the displaced alternative or the sacrificed alternative or the
foregone alternative or the next best alternative. Since resources are scarce, we need to make a
choice. Choice involves sacrificing one use over the other.
 The Incremental concept involves estimating the impact of the alternative decision on costs and
revenues. It emphasises the changes in total cost and total revenue resulting from changes in prices,
products, procedures, investments or whichever other factors may be involved in the decisions. The

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marginal concept refers to the effect of an additional unit of good or service on revenues, costs and
profits.
 Time perspective states that an economic agent should carefully assess the impact of his decision
both from the perspective of short run as well as long run. Discounting Principle states that a rupee
received today is worth more than a rupee received tomorrow. This is because inflation can erode
the purchasing power of money so that the same rupee received tomorrow may buy less amount of
goods and services.
 Production Possibility Curve (PPC) is the locus of various combinations of two commodities which
can be produced with given level of resources and technology.

1.11 GLOSSARY

 Capital: Manmade goods which are used in the further production of goods is called capital.
 Firm: It is an individual economic agent. It refers to any company that seeks to make a profit by
manufacturing or selling products or services to consumers. Several firms producing the same or
similar products are referred to as an industry.
 Economy: An economy is a set of inter-related production, consumption, and exchange activities
that determine how scarce resources are allocated. This involves production, consumption, and
distribution of goods and services which are used for fulfilment of the needs of individuals living in
an economy. This is also called an economic system.

1.12 CASE STUDY: CHOICE MAKING BETWEEN ENVIRONMENTAL QUALITY AND

ECONOMIC GROWTH
Case Objective
This case study highlights the choice that the Canadian citizens had to make between economic
development as promised by the Conservative Party and greater economic growth as promised by
the New Democratic Party (NDP).
The former Prime Minister of Canada, Stephen Harper, was the head of the Conservative Party. In
Canada’s parliamentary system, he had walked a political tightrope for five years. During that time
period, he worked as the leader of the minority government.
His opponents were upset by some of the policies. One such policy was a reduction in corporate tax
rates. In 2011, his opponents strived for a no-confidence vote in parliament. It passed the parliament
tremendously. It not only brought down Harper’s government, but also forced national elections for a
new parliament.
This political victory was momentary as the Conservative Party won the elections held in May 2011. This
party had appeared as the ruling party in Canada. This ruling party had allowed Mr. Harper to continue
practising the policy of deficit and tax reduction. This Conservative Party was opposed by the New
Democratic Party (NDP) and the moderate Liberal Party at that time. These opposition parties strived
for higher corporate tax returns and less deficit reduction as compared to the ruling party. In 2010, the
deficit had fallen by one-third under the rule of Mr. Harper. At that time, he had promised a surplus
budget by 2015. In 2011, the unemployment rate in Canada was 7.4% as compared to the US rate, which
was 9.1% in the month of May. In 2010, the GDP growth rate was 3.1% in Canada. In the first quarter
of 2011, the Bank of Canada planned for 4.2% of growth rate as compared to the US which planned for
1.8% of growth rate. In 2008, Canada was dealing with the state of recession. To deal with this state,

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Mr. Harper had made great efforts in 2010 and 2011. These efforts helped him in producing substantial
reductions in the deficit.
All his efforts made Canadians decide and make a choice that resulted in lower taxes and less spending.
But this issue was not considered to be prominent in the campaign held in 2011. With the development of
huge oil deposits in Alberta, Canada is at the third place in the world for oil reserves. The NDP promised
to reduce the greenhouse gas emissions in Canada, whereas Mr. Harper and the Conservative Party had
promised to work towards the development of Canada’s economic growth.
Source: https://2012books.lardbucket.org/books/macroeconomics-principles-v2.0/s04-economics-the-studyof-choice.html

Questions
1. What was the criterion for choice making in this case study?
(Hint: Economic growth and environment quality)
2. What was the aim of Mr. Harper?
(Hint: Reduction in tax and deficit and ultimately the growth of the economy)
3. Identify any ‘free’ election promises, which are promised to people during elections. Find out the
opportunity costs associated with them and identify who in the end actually paid for those things.
(Hint: Free healthcare, free transport, free water supply, etc.)
4. Do you think the free promises are actually free?
(Hint: Taxpayers have to pay for it)
5. Can you recall any desirable good or service for which you have to make choice?
(Hint: Luxury car, lavish house)

1.13 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. Economics can be defined in a few different ways. At its core, economics is the study of how
individuals, groups, and nations manage and use resources. What is Economics?
2. Microeconomics is one of the two branches of the study of economics, and is often considered as a
foundation on which the other branch is built. Write a short note on microeconomics.
3. Macroeconomics, another branch of economics, attempts to assess how well an economy is
performing and understand how performance can be improved. Define macroeconomics.
4. Scarcity is a basic economic problem that indicates the gap between limited resources and limitless
wants. Explain the problem of scarcity at length.
5. Opportunity cost is fundamental concept of economics that represent the potential benefits an
individual, investor or business misses out on when choosing one alternative over another. Discuss
opportunity cost as an economic problem in detail.

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1.14 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. Economics is a study of reconciling unlimited wants with limited resources. Basically, economics
attempts to study how humans make decisions in the face of scarcity. Refer to Section Meaning of
Economics
2. Microeconomics is the study of decisions made by people and businesses regarding the allocation of
resources, and prices at which they trade goods and services. Refer to Section Microeconomics and
Macroeconomics
3. Macroeconomics is the branch of economics that studies the economy as a whole. It analyses
aggregates of individuals, businesses, prices and outputs. Refer to Section Microeconomics and
Macroeconomics
4. To meet the infinite wants of the people by using scarce resources while trying to meet the people’s
desire to maximise gains, economies must try to achieve efficiency in production and distribution of
resources. Refer to Section Twin Principles of Scarcity - Trade-offs
5. Opportunity cost is defined as the next best alternative that is given up when you make a choice. It
is a subjective issue. Refer to Section Economic Principles - Opportunity cost

@ 1.15 POST-UNIT READING MATERIAL

 https://leverageedu.com/blog/nature-and-scope-of-economics/
 https://courses.lumenlearning.com/wmopen-microeconomics/chapter/microeconomics-and-
macroeconomics/
 https://www.managementstudyguide.com/principles-managerial-economics.htm

1.16 TOPICS FOR DISCUSSION FORUMS

 Write down on a paper how you would allocate your limited budget among your unlimited wants
choosing more important wants over less important wants. Discuss with your peers.

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