Notes on Micro Economics (AAU EiABC)

Chapter 1: Introduction to Economics

1. An Introductory Remark
In this section, you will learn about the subject matter of Economics, the concept of human needs, the
nature of choice and scarcity of resources, elements of economic systems and the circular flow of
economic activities. In addition, you will learn about methods, types and levels of economic analysis
and you will differentiate the positive economic analysis from the normative one; microeconomics
from macroeconomics. Then, you will learn about the fundamental (basic) economic problems; what
to produce? How to produce?, and for whom to produce? You will also learn how economic system
differ one from the other based on how they solve the above problems.
Lastly, you will be introduced to the curve which is the production possibility from their (PPF).
Economics uses verbal explanation, mathematical equations and graphs. The PPF is the first curve
that you will encounter in this course.
For additional reading, you may use any standard text-book in economics or principles of economics,
or you may use the list of references given at the end of this course.

1.2. The Subject Matter of Economics

Definition:
Definition: Economics is an academic discipline, which studies about efficient allocation of scarce
resources so as to attain unlimited human needs.

Definition: A resource is anything, given by nature or produced by human efforts that can be used as
an input in production of output(s).

Consider the following example below. As the figure clearly illustrates, housing production requires
different types of inputs cement, labor, land, construction tools and machinery,... etc. These inputs are
called resources (factor inputs).
inputs).

Inputs
Land, Labor tools, Output
construction Apartments, Villas,
machinery, cement, Housing Production Business malls,
reinforcement bars, condominiums, etc
etc.

Most of the resources that are used to housing production might be used for production of other
outputs as well. For example, land can be used for planting a factory, for agricultural production etc.
Because the same resources can be used for different purposes, resources are often said to have
alternative uses.

There are four major types of resources that are essential for production. These are human, natural,
capital and entrepreneurial resources.

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1. Human Resources (HRs)
(HRs) - HRs are labor and labor related resources. These are subject to
exchange as we can sell or buy labor and the price for HRs is called Wage (or salary if the
employer is a public office). Manual labor, intellectual labor, skilled labor etc are few examples
of human labor. Labor is not a heterogeneous resource and that is why different people may earn
different amount of wage or salary for the same amount of time they spend on their respective
jobs.

2. Natural Resources (NRs) - These are resources that are given by nature. There are three types of
NRs: non-exhaustible, exhaustible and renewable NRs.

2.1 Non - Exhaustible are those whose supply cannot be affected human behavior. Some examples
of non - exhaustible NRs are air, wind energy, moon light, … etc. Almost all non - exhaustible
NRs are not scarce and thus they are not subject to trade and they are free to be used.

2.2 Exhaustible: which may end - up sometime in the future if utilized uneconomically. Few
examples are minerals like gold and petroleum. These are perishable, limited in stock and are
distributed unevenly on the globe and thus they are subject to [Link] call the price for
exhaustible NRs rent.

2.3. Renewable: whose quality and /or quantity may be degraded or depleted by unwise utilization
but may also be rehabilitated by human efforts (example: fertile soil). Currently some of the
renewable NRs are not subject to trade (example atmospheric air and oceans) because of unclear
ownership structure for such resources but we incur some hidden costs to keep their quality which
is costly. On the other hand, there are some renewable NRs that are subject to direct trade
(example: land and commercial forest). The price for such resources is known as rent.

3. Capital Resources (CRs). These are resources that are produced by human efforts either to
facilitate the overall economic performance of the country or to be used as inputs in production
of final goods and services. There are two types of CRs: physical and financial.
3.1 Physical CRs are those whose existence can be felt (tangible assets) and which are either
infrastructure (example: buildings, roads, bridges) or intermediate goods
(example :telecommunication networks). We call the price for physical CRs – rent

3.2 Financial CRs are monetary or money related resources (example: cash, savings, loans, current
and term accounts in banks, grants and funds) and what matters is their purchasing power. The
price for financial CRs is called interest

4. Entrepreneurial Resources (ERs). ERs refer to the sprit and inclination of some people to start,
organize and run businesses. ER is a particular type of human resource. An entrepreneur is an
individual who is a business innovator, who sees opportunity to make profit, who uses
unexploited raw materials, who takes risk with new product or process and who brings together
land, labor, and capital resources. Thus, entrepreneurship is a vital resource necessary for any
type of economic activities.

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As stated earlier, economics is only concerns about the scarce resources.

 Definitions: A resource is said to be scarce if its supply can be affected by the price system
and its total demand is greater than its total supply at zero price level.
We have said that scarce resources are not distributed evenly and also not a single nation or a social
group can have as much scarce resources as it may wishes. This is why economics studies about the
allocation of scarce resources.

1.3. The Concept of Human Needs

Economists assert that human needs are unlimited mainly because of two reasons: First,First, some human
needs are recurring (they occur again and again), and secondly,
secondly, human needs are hierarchical (after
satisfying a given need another similar need of higher order may emerge). The hierarchy of needs
continue without any upper limit that is why it is said "human needs are unlimited". However, the
available resources are not sufficient to satisfy all these unlimited needs of human beings.

1.4. Scarcity and Choice

Since human needs are unlimited and resources are scarce, every one is obliged to make hard choices.
No one in this world is rich enough to fully satisfy all his or her ever-increasing needs. Thus, we have
to decide which of our needs should be satisfied first and which one next and which ones should be
canceled altogether. Scarcity is a basic fact of economic life and it necessitates choices. Resources
used to produce one output cannot simultaneously be used to produce something else and thus when
we choose to produce something we sacrifice the opportunity to produce some other good or services.
Note that not only individuals have to makes choices but also societies and nations as well.

1.5. Elements of Economic Systems

There are four major elements of a modern economic system: (1) Households, (2) Business Firms, (3)
Governments, and (4) Foreigners. Each element participates in economic activities in various ways
and this means that each element is making several important decisions concerning production,
distribution, exchange and consumption etc. Thus, they collectively determine allocation of scarce
resources. The general effects of decisions made by these elements determine the overall economic
performance of the country. That is why they are also known as " Major Decision - Maker",
Maker", and
because they have different roles in the economy, they are also referred to as " Major Economic
Actors or Agents".
Agents".

1.5.1 Households (or individuals)

The household is an important supplier of resources (labor, some of the most important natural
resources like land, financial capital resources through savings and entrepreneurial resources. The
household is also the major consumer of final goods and services produced by domestic business
firms. It also consumes some imported final goods and services produced by foreign business firms.
In addition, the household is a tax payer; i.e., it finances government expenditure.

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1.5.2 Business Firms
Business firms are major producers of goods and services, important job creators, important
consumers (inputs like raw materials, energy, telephone service, etc) and they participate in
international trade (they import goods and services produced by foreign business firms and export
their own products to foreigners). They are also important tax-payers.
1.5.3 Government
Government has many important economic roles. It produces peace and political stability,
which is a primary pre requisite for economic and social development. It coordinates various
economically and socially relevant activities better than the market. One obvious example of such a
social coordination is the monetary system.
system. Without the government, a stable modern monetary
system (e.g. Paper money) would have been impossible. In the absence of government intervention,
spontaneous market solutions to coordination problems tend to be of inferior quality and highly
unstable.

Government protects property rights and enforces contracts. In the absence of government, property
rights are not secured and contracts are not binding; thus, there will be less interest accumulating
capital and contractual transactions. Market economy demands for high degree of protection of
property rights and enforcement of contracts.

It finances or directly produces various types of public and worthy (merit) goods. Public goods are
goods and services whose consumption is joint; and excluding those who do not want to pay is
difficult or totally impossible. Therefore, once produced, any body can consume public goods
without paying. Some examples of public goods are peace, clean environment and atmosphere, radio
and public TV programs, streetlights, roads and other major infrastructure. Since it is difficult to
force consumers pay for the public goods they consumed, the private sector will under produce them
(i.e. market produces less than the necessary amount). On the other hand, worthy (Merit) goods are
whose consumption is always encouragable because they determine quality of life and equity. equity.
Examples of worthy (Merit) goods are education, health services, cultural, entertainments and
physical education centers. To be more specific, schools and research centers, hospitals and clinics,
theaters, museums, monuments, historical sites, libraries, stadiums, gymnasiums, parks, zoo-park and
the like are all examples of worthy (Merit) goods. Since the private sector under produces public
goods and because we need worthy goods more than the market produces, a government may help its
country's economy by financing or directly producing public and worthy (Merit) goods. That is why
good governments invest on production of clean environment and atmosphere (for example by
collecting trashes to keep cities clean), building roads, schools, research centers, stadiums,
gymnasiums, libraries, museums, parks, and several other types of infrastructure.

Government corrects market - failures. Market may fail for several reasons; for example, due to
monopoly, negative externalizes, business cycles, inflation and unemployment. In each cases, the
government can take some measures to correct the failures; for example, the government may:
 enact anti - trust (anti - monopoly) legislation to protect the market from being
dominated by monopoly(s);
 enact environmental protection policy and take measures to keep the environment
from pollution;

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  use its micro and macro regulatory tools to moderate business cycles. (Business cycles
are topics of macro economics);
 take monetary and fiscal measures to fight against inflation (again it’s a topic for
macroeconomics);
 take micro - and macro measures to fight against unemployment (again a topic for
macroeconomics)
 Generally, government can protect the market from being destabilized. This function
of the government is called stabilization function.
function.

The government also redistributes wealth in such a way as to achieve more equitable (not necessarily
equal but equitable)
equitable) distribution of wealth. Good governments carry out this task by taxing the rich
and providing direct and indirect assistance to the poor.
1.5.4 Foreigners (foreign business firms and households)
Foreigners participate in economic activities in several ways. They may purchase commodities
produced by domestic firms (through export) and domestic households, business firms and
government may purchase commodities produced by foreign business firms (through import).
Foreigners may invest their capital in our economy and run business in our country and we may also
invest our capital in other countries. They may come to our country as tourists and we also can do the
same. Foreigners may save money in our banks and we can save our money in their banks. Generally,
capital entering into our economy from other countries is called capital inflow; and capital leaving
our country is called capital outflow.

There are other economic elements beyond the four major ones. Examples of these may include
multinational organizations like WTO, IMF the World Bank and the like.

1.6. The Circular Flow of Economic Activities

In the mid XVIII century, some French economists, physiocrats, observed that commodities and
money circulate in economy in similar way as blood circulates in the human body. Although the
analogy may not be appropriate, indeed resources and money circulates in opposite directions.
Consider the following diagram.

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 Flow of Payment for Resources

 iiFlow
. of Resources  i
.

iii.
Business Firmsiv. v. N Households
R
ix. vi. vii.
 viii
 .  

Flow of Final Products Fig. 1.2. Circular flow in a

closed economy

There are two flows in the above diagram. The inner flow is called real flow because it is a flow of
real things; i.e., factor inputs and final products.
products. The outer flow is called Nominal flow or
financial flow because it is a flow of purchasing power, i.e. money.
money.
The real flow shows that household supply factor inputs (human, natural, capital and entrepreneurial
resources) to the business firms; and businesses firm supply final products like automobiles,
Computers, prepared food etc. to the households. Analogously, the financial flow shows that payment
for factor inputs (wage, rent, interest and profit) flow from the business firms to the households, and
payments for final goods (consumption expenditures) flow from the households to the business firms.
However, the above model represents a closed system because:
(a) It involves only two elements of economic system, namely, the business firms and
household.
household.
(b) The households in the model spend all of their incomes on expenditure; i.e., they do not
save.
(c) Since there is no capital investment, the model - economy is a stagnated one; i.e., there is
no economic growth/recession
The following diagram illustrates how the above model can be modified to represent an open and
modern economy. The figure illustrates an open and modern economy. Here, households save part of
their income, they pay tax and thus some percentage of the household's income will not return back to
the business firms. Again, because now there is international trade, the household may purchase some
consumer goods produced by foreign business firms. Therefore, again some percentage of the
households' income will not return back to the domestic business firms; it goes to foreign business
firms. The sum of money that leaves the system (savings + net tax + import) is called leakage or
withdrawals.
withdrawals.

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 
Flow of Resources x. F
 xi.

xiii
 . xii.
xiv.

Households
Households
Business Firms

Injections xvi.

 xvii.  xv.

-Capital investment Flow of Final Products
-Government Leakage/
Expenditure xviii. Withdrawal
-Export
-Savings
-Net Tax
-Import

Fig 1.3 Circular flow in an open economy

On the other hand, in an open economy, some amount of money enters into the system from outside.
Since the open economy is a potentially growing economy there are capital investments (new
investments) thus money is injected into the system by investors. The government also injects a lot of
money into system in the form of recurrent or capital budget expenditure. And lastly, foreigners may
buy some products of the domestic business firms and when so happens they pay money to the
business firms - we call these exports. The sum of money that enters into the system from outside is
called as injection.

Here, except in a special case known as macroeconomics equilibrium the sum of injections is not
equal to the sum of leakage (withdrawals) which indicates that an open and modern economy is not a
stagnated economy; i.e., economic growths and recession (economic deterioration) are possible.
1.7. Method, Types and Levels of Economic Analysis
1.7.1 Methods of Economic Analyses:
The five important steps in conducting economic research are: (1) defining the problem; (2)
collecting data concerning the problem; (3) constructing statements of hypotheses; (4) constructing a
conclusion (theory), and (5) empirical verification of the conclusion (theory)

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1. Defining the Problem(s). The primary task of the researcher is to clearly define the problem(s) he
or she wants to investigate. That is, before starting the actual investigation, the researcher should
clearly understand the nature and scope of the problem(s). This preparatory stage is vital because
a poorly defined problem will lead to incorrect and/or ambigious conclusions. As it is often said
"a well defined problem is half - solved". A well defined problem is the one which, in addition to
clearly explaining the problem, sets explicit boundaries and conditions.

The technique usually used by economists to set boundaries and conditions of the problem is
called statements of assumptions. There are three groups of assumptions in economic analysis:
fundamental, definitional and procedural.
a) Fundamental assumptions are integral and permanent parts of the problem itself.
Therefore, they cannot be dropped at any stage in the course of the whole analysis. For
example, the assumptions that economic resources are scarce and that decision - makers
are rational are fundamental assumptions in any economic problems. Without the scarcity
assumption, the problem of choice would not exist and, consequently, there will not be
any economic problem to be investigated. Like wise, without the assumption of rationality
(i.e., if we assume that people and organizations behave irrationally and unpredictably),
no body of principles would be possible because behavior would no longer be directed
toward identifiable objectives. In fact, the researcher need not waste time and energy in
explaining the common fundamental assumptions of economics as a whole like the
assumptions of scarcity, rationality, or utility maximization because these are too common
and well known assumption in economics. However, while defining the problem, the
researcher should take time and clearly state (and also justify) all the uncommon
assumptions he or she believes are fundamentals, integral and permanent parts of the
problem.
b) Definitional assumption set the boundaries of the problem under investigation. The
purpose of definitional assumption is to give a precise and unambiguous understanding of
the problem at hand. For example, say, the researcher wants to investigate the major
causes of unemployment in Ethiopia. At the very beginning the researcher should clearly
define what he or she meant by "unemployment" under the given investigation. He or she
should list all the criteria that quality a person as an unemployed under the given
investigation; there should not be any ambiguity concerning who is, or who is not,
considered to be unemployed according to the given definition. How long a person should
be unemployed before being counted as an "unemployed" in this research? Do peasants
during non - peak periods (i.e., during seasons in which there isn't much to do for
peasants) are counted as unemployed? Do students seeking jobs during vacations are
considered to be unemployed during these periods? … etc. The definitional assumptions
should solve such ambiguities.

c) Procedural assumptions define the type of techniques to be used in the analysis of the
problem. They are often temporary and thus can be changed as the analysis proceeds from
simplified to more complex and realistic settings. For example, one may start with a
closed economy model and then proceed the analysis into an open-economy model to
consider the impacts of international trade. Like wise, one may initially exclude all non-
economic factors and then include some of them. :If all other factors that may affect this

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 relationship are kept constant" (ceteris paribus) is the most common procedural
assumption in economics.
2. Collecting Data:
Data: After precisely defining the problem(s) and clearly stating all the assumptions,
the researcher(s) starts collecting data. Close observation of the impacts of the problem to be
investigated will broaden the researchers' knowledge and may give new insights. For example,
one who wishes to investigate the major causes of unemployment in Ethiopia may start his or her
research by observing the behaviors of the unemployed people, talking to them, their families,
former employers and friends … etc may be very helpful. Besides broadening the researchers
own understanding of the problem, close observation may be a source of valuable data by itself.
Reading the outcomes of previously conducted researchers on the same and/or related problems is
another vital source of data. To a degree it is possible, the researcher should read all articles and
papers on related topics produced before him. Then, comes studying the history of the problem.
History is one of the important sources of data and information. Then comes analysis of the
available statistical data. Statistical data may be obtained from publications of the Federal and
Regional Statistical Offices, National Bank, Various Ministries, International Organizations or
NGOs. Data collected from various sources should be analyzed thoroughly. If the researcher is
not satisfied with the data he or she collected from various sources, or if the collected data is not
reliable, or if the collected data is not sufficient to formulate any relevant hypothesis, then the
researcher should conduct his or her own experiment. However, the researcher should always
aware of the fact that the way how experiments are conducted in social science is very different
from that of in natural sciences. In social sciences experiments, the researcher deals with human
behavior within incessantly changing social, economic, political and psychological environment
and thus social experiments can be easily biased.
3. Hypothesis:
Hypothesis: After a successful accomplishment of the tasks discussed above, the researcher
enters into constructing statements of hypothesis. A hypothesis is a yet-to-be- proved scientific
preposition. Each hypothesis should be logically consistent and within the boundaries set by the
assumption. A Tautology (a preposition which is always true under any conditions) or a
contradiction (a preposition which is always false under any conditions) cannot be considered to
be a scientific hypothesis. All logically inconsistent statements of hypothesis should be canceled
out and all those that violate the assumptions should be dropped. Then, the rest will be tested
against the already collected data. Only one or few of the initial statements of hypothesis will
survive such tests.
3. Conclusion (theory): The statement of hypothesis that passed all the above tests is called the
conclusion or the outcome of the analysis. If the research is theoretical, the concluding statement
may be called a theory. A theory can be formulated in various ways: as a verbal statement, in
terms of mathematical formula, statistical relationships, graphs or diagrams. Note that not all
theories are correct or applicable.
4. Verification of the conclusion (theory): The last stage of economic analysis (which often is an
independent research project on its own right) is to empirically verify and justify the relevance of
the finding of the research. Here, the objective is to convince others that the conclusions of the
research are relevant and applicable in real economic life. To do so, the researches should check
his or her conclusions (theory) based on real world data collected from different places and time.
1.7.2 Types of Economic Analyses:

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There are two major types of economic analyses: Positive and Normative.

1. Positive Analysis describes what is going on in the economy. The objective of positive analysis
is to study how an economic system ( for example, market economy, centrally planned
economy, the agricultural or industrial sector etc) functions and the relationship between
different variables. Therefore positive analysis is value neutral. It does not judge a system as
good or bad, better or worse. It just tries to show facts. That is why sometimes-positive analysis
is also known as pure economics.
economics.
2. Normative Analysis, on other hand, describes what should be done or what should be done in
order to attain pre-established goals. The objective of normative analysis is to tell policy makers
what to do and what not to do in order to achieve the required outcomes. Normative analysis,
therefore, is value loaded because what is good for the analyst or the policy maker may not be
equally good for others. Thus normative analysis is highly influenced by politics, ideology and
ethics.
Although it is true that positive and normative economic analysis substantially differ one from the
other they may overlap. This is because the outcomes of positive analysis may have some policy
implications even though the researcher's objective may not to offer any policy advice. Likewise,
normative analysis uses findings of positive analyses to justify its arguments. Therefore, overlaps
between positive and normative analyses are often observable.
1.7.3 Logical Reasoning
Economic analysis is based on logic - the science and art of reasoning. As mentioned above, any
logically inconsistent, tautologic or contradictory statements cannot be considered to be scientific
hypotheses. Generally, there are two ways of logical reasoning: inductive and deductive.
1. Inductive Reasoning is a logical method of reaching at a correct general statement or theory
based on several independent and specific correct statements. In short, it is a logical way of
transforming repeated particular truth into a general truth. We use inductive reasoning to
translate the common outcomes of several independent researches on the same topic into an
acceptable general theory. For example, assume that a group of scholars has conducted
researchers on "factors causing unemployment" in different countries, say, in USA, Mexico,
Brazil, Greet Britain, France, Sweden, Poland, Russia, Albania, North and South Korea, China,
Kenya, Nigeria and South Africa. These countries differ one from the other in several respects:
geographic location, level of technology, standard of living and quality of life of their citizens,
ethnic composition, political orientation, culture, language, religion … etc. thus, it is rational to
expect that some factors causing unemployment in one country may not cause unemployment in
another country. It is also possible that some major causes of unemployment in one country
may not even exist in another country. Nevertheless, few factors may be observed to exist and
cause unemployment in all countries investigated, these are common factors in the sample.
Since the sample is composed of very different countries, one can concluded that these common
factor many be considered as causes of unemployment. Such a finding can be accepted as a
general theory.
theory. Hence, in the above example, we have shown how repeatedly observed specific
truth can be translated into a general truth. Such method is called inductive reasoning.
A simpler example of inductive reasoning is given below:

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 Fact no. 1. Eagle is a bird and lays egg
Fact no. 2. Sparrow is a bird and lays egg
Fact no. 3. Dore is a bird and lays egg
Fact no. 4. Ostrich is a bird and lays egg
Fact no. 5. Peacock is a bird and lays egg
Fact no. 6. Vulture is a bird and lays egg
Fact no. 7. etc.
General Statement: Therefore, all birds lay eggs

Note that exactly in the same way as in the first example, there are several dissimilar characteristics
between the birds listed above. Actually, each species of bird is unique in some ways. However,
"laying eggs" is a common feature of all birds and that fact is used to formulate the general statement.
Due to existence of exceptions, inducted conclusions run the risk of being proved incorrect.
2. Deductive reasoning is a logical way of arriving at a particular (specific) correct statement
starting from a correct general statement. In short, it is a logical way of transforming a general
truth into a particular truth. We use deductive reasoning to explain particular events based on an
established theory. For example, we know that there is an inverse relationship between price
and quantity demanded, ceteris paribus. Knowing this general theory, if you heard about an
increase in a unit price of certain commodity, say, petroleum, then you may reasonably
(logically) expect that the quantity demanded for that commodity will decline. Note that you
made such a conclusion based on the general truth or theory you knew, without conducting any
research. Once upon a time, Socrates, the famous Greek Philosopher, is said to have deductively
proven that he is mortal in the following way:
General truth: All human beings are mortal
Particular case: Socrates is a human being.
Conclusion: Therefore, Socrates is mortal
Economics, as any other social sciences, employs both inductive and deductive reasoning to arrive at
logically correct conclusions.
1.7.4 Levels of Economic Analysis
There are two level of economic analysis: microeconomics and macro economics.

Definition: Microeconomics is a branch of economics which studies about the behavior of elements
of economic systems (i.e., individuals or households, business firms, government, and foreigners),
how they chooses between alternatives and how their choices affect their own well - beings.
Microeconomics focuses on:
a) Price theories:
theories: Microeconomics studies about the behavior of prices of specific commodities
or services, wage of specific type of labor, rent of specific types of physical asset, profit
obtainable from specific type of entrepreneurial activity. It studies how prices behave under
different market structures (like in a perfectly competitive market economy or under purely
monopolized market, etc.)

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 b) Consumption theories.
theories. Microeconomics studies about how consumers make choices with
regard to their consumption decision in order to maximize their benefits (utility), subject to
the available budget.
c) Production theories: Microeconomics studies about how business firms make choices about
what to produce and sell in order to maximize profit and/or minimize cost of production.
d) Welfare theories: Microeconomics also studies about how government makes choice between
alternative projects to maximize welfare and/or minimize public expenditure.
Definition: Macroeconomics is a branch of economics which studies about the general effects of
decisions made by micro - agents (households, business firms, government and foreigner) and
decisions made by macro - agents (like the National Bank and Ministry of Finance).
Macroeconomics studies about aggregated effects only. Accordingly, major topics of
macroeconomics are: a) inflation, b) unemployment, c) some aspects of international trade, d) some
aspects of economic growth, and e) some aspects of distribution of national wealth.
The following table summarizes the major differences between microeconomics and
macroeconomics.
Criteria Microeconomics Macroeconomics
Economic actions of individual actors or General effects of all economic
small groups of actors like individuals, activities like Gross National
1. Objective of households, particular firms, and particular Product (GNP), Level of
analysis industries. Unemployment, and General
Price Index.
 To maximize consumers’ total utility  Full employment of labor and
subject to budget constraint all other productive resources
 To maximize business firms’ total profit  Price stability
subject to cost of production  Equitable distribution of
2. Objective of the  to provide maximum social welfare at national wealth
analysis minimum cost to the public finance  Creating favorable
 Efficient allocation of the available environment for rapid
resources economic growth
 Creating favorable balance of
payment
3. Basis of Price mechanism with the help of demand Manipulation mechanism with the
analysis and supply forces help of government intervention
on money creation and public
budget management
Types of Short-run partial equilibrium which is static. General equilibrium in dynamics;
equilibrium that is under continuous change

1.8. Fundamental (Basic) Economic Problems and Alternative Economic Systems

Any economic system has to determine how the following three fundamental economic problems
should be solved. Among other things, economic systems differ one from the others based on how
they address and solve the problems.

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1. What to produce? Since economic resources are scarce and the same resources can be used in
production of different outputs, decisions have to made to determine what and how much of what
should be produced. Due to scarcity of resources we cannot produce all outputs in sufficient
amounts we wish to produce. Therefore, we have to make a hard choice of sacrificing some
outputs; that is, we have to prioritize our needs. Who and how such decisions are made in a
society is determined by the type of the economics system. The “what to produce?” is a choice
between alternative combinations of outputs. Who determines how much food, industrial
products, defense, education, health service, etc. should be produced, given the limited stock of
resources?

2. How to produce? This problem refers to a choice between alternative technologies of

production. Once the possible and required combinations of outputs are determined, the system
has to determine the most suitable way of producing them. There might be different ways and
techniques of producing the same type of output but different production techniques require
different technologies which may or may not be available in the country. Furthermore, different
technologies require different types of labor and other inputs and therefore the cost of production
is seriously affected by the type of technology used. That is a choice between alternative
technologies is one of the fundamental economic problems that determines the economic system.

3. For whom to produce? This problem refers to a choice between alternative ways of distributing
the final products. Here, the system determines who should get how much of the total product. In
some economic systems, for example, few people are too rich while the majority are very poor;
while in other, wealth is distributed in more equitable way. How and why such differences came
in to being? Who determines commodity prices, wage, profit, rate of interest, and rate of profit?

Note that we confront the above three fundamental problems both at individual and societal levels. If
you want to do business, for example, you have to think about what type of product or service you
should produce, how you should produce it, and how you are going to distribute the benefits between
you and your workers, customers, relatives, and so on. All of your decisions are constrained by
scarcity of resources.

On the level of the society, the same problem appears. At any given time, the total stock of any
productive resource available to any country in the world is limited. Therefore, the system should
somehow decide, given the limited available resources, what and how to produce and how to
distribute the outputs.
However, when we analyze how the problems are solved at individual level, we are dealing with
microeconomics whereas, when we focus on how the problems are solved at the society level we are
dealing with the type of economic system in the country.
Assume, for example, an economy in which one person (or a group of persons) decides all the above
three problems in behave of the whole society. The person (or the group of persons) determines what
should be produced in the economy, the type of technology to be used and who should get how much.
Of course, such a system will be absolutely dictatorial. Although such an extreme case has never
existed, there have been economic systems with similar features.

13
On the other hand, assume an economic system in which no one (neither any individual nor any
particular group) bothers about solving the above three problems in behave of the society as a whole.
In such a system, each individual makes his or her own decision for himself or herself without any
concern about the effects of his or her decisions on the well-being of the society. Every individual
produces what he or she can and want to produce using the type of technology he or she believes to
be appropriate and he or she alone takes all the benefits (or the harms). Such a system will be
absolutely decentralized. There will not be any economic role for the government or monopoly. Such
an extreme case has never exited in history although there have been economic systems with similar
features.

The existing economic systems are in between the two extremes explained in the above examples.
The first extreme case discussed above may be associated with the economic system known as
Centrally Planned Economy or Command Economy; while the second extreme case may associated
with the Perfectly Competitive Market Economy.
In a centrally Planned economy, there is a unique decision making unit which hold absolute
monopoly of economic power and which is responsible for solving all the three fundamental
problems. The most likely such an entity, of course, is the government. The government through its
central planning agency collect data on the available resources, studies the society’s needs and
preferences in the light of its strategic goals and then decides what and how much of what should be
produced, what type of technology should be employed, and who should get how much. Then the
decisions are realized by giving explicit commands or directives to those who should implement it. In
order to carryout all these tasks, the government should own (nationalize) major economic resources
like land, infrastructure, factories and also it should fix or control prices, wage and interest rates.

What For
to whom to
produce produce
Central
Planning a diagrammatic
Agency representation of the pure
model of the centrally
planned economy
For
whom to
produce

Note that in the centrally planned economic system there is no room for the market; all major
economic decisions are made by the central planning agency.

In a perfectly competitive market economy, there is no single entity which makes decisions on
behave of the whole society regarding the three fundamental economic problems. Rather, market
forces like demand, supply, the free output and input prices, competition between buyers, competition
between sellers, etc solve the three problems simultaneously and automatically. Guided by the market
forces individual consumers and producer make their own decisions without being concerned about

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the social outcome. Therefore, at the society level, the decisions simply prevail. The famous British
economist, Adam Smith, described market forces as “the invisible hands of market”.
The following is a diagrammatic representation of the pure model of the perfectly competitive
market. Note that in this ideal model:
 there is no economic role for the government; i.e, there is no government intervention;
 there are many buyers and many sellers of homogenous products and therefore there are
no monopolies which implies that no single economic agent can affect the total volume of
a product or its price;
 economic agents are free to make economic choices;
 there are no barriers to enter into or exit from any market; movement between markets is
absolutely free.
 transaction and information costs are assumed to be unexisted

What to For
produce whom to
produce
a diagrammatic
representation of a
perfectly competitive
For market economy
whom to
produce

Note that the centrally planned economy and the perfectly competitive market economy are ideal
models. No country in the world has ever been 100 percent either centrally planned or perfectly
competitive. Even the most liberal economies there are some forms of government interventions. In
fact, there are many economic activities that are more efficiently carried out by the government than
the private agents; an obvious example might be issuance of currency. Further more, in any country
there are some monopolies. Of course, no where in the world it is absolutely free to enter into or exit
from any market; everywhere there are some types of business which require special permission.

Therefore, all existing economic systems are mixed. Every existing economic system has some
features of the perfectly competitive market economy and some features of the centrally planned
economy. However, that all existing economic systems are mixed does not imply that all are identical
or even similar. Some exiting economic systems are close to CPE while others are close to PCME.
For example, the economic systems of Hong Kong, Singapore, USA, Great Britain and Japan are
closer to the PCME model than the CPE model. On the other hand, the economic systems of former
socialist countries were closer to the CPE model than the PCME model. CPE and PCME are two
extreme parameters (like asymptotes in mathematics) between which all countries of the world are
located. Economies that are near to PCME model are commonly refereed to as free market
economies or simply as market economies. Economies that are near to CPE model are commonly
refereed to as command economies or restricted (unfree) economies. Countries A, B and C in the
diagram below may reasonably described as command or highly restricted economies while countries
X, Y and Z may be described as (free) market economies.

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              
CPE A B C X Y Z PCME

Fig. 1.6.
1.9. The Production Possibility Frontier
Definition: The Production Possibility Frontier (PPF) [which is also known as Production
Possibility Curve (PPC) or as Product Transformation Curve (PTC)](PTC)] is a curve that connects all
combination of output that are possible to produce using the available total amount of resources and
technology. The PPF addresses the “what to produce?” problem. It shows what the society can
produce using the existing technology and resources. In other words, it shows the current maximum
capacity of the economy. The PPF is also helpful to understand important concepts like efficiency,
full-employment, opportunity costs, allocation of resources and economic growth.

The PPF is based on the following assumptions:

1. The time period is short. PPF is a short-run and static analysis. In order to analyze the long run
implications, a series of PPFs should be drown in a time series.
2. The available total amount of factor inputs is fixed. This assumption is valid because at a given
time (for example, today) the total amount land, labor, capital, entrepreneurial skill available in
a country is fixed.
3. Inputs can be reallocated in such a way so as to produce more of one (or a few) product(s) than
the other. This because most resources are multipurpose.
4. The production technique (the technology) is given and constant. This assumption is valued
because change of production technology is seldom instantaneous; it takes time and investment.
5. There are only two broadly classified outputs to be produced. This assumption is introduced to
simplify the problem of drawing multidimensional graphs in a plain. When the analysis is on a
table, this assumption can be dropped.
6. It is possible that some inputs are more suitable for production of some outputs than others. For
example, unskilled labor may be more suitable for agricultural production than for production
of electronic devices.

Given the above assumption, a hypothetical PPF is constructed in a table and a graph below.

Possibility Output Output

Y A xxix. X Y
20 xxvi.A B 0
xxx. 20
16 xxvii.B C1 I 16
14 xxviii. D
C 2 14
10 D xxxi. 3E 10
HE 4 6
4 F 5 F 4
G 6 0
G xxxii.
12 X 3 5

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According to the definition given above, PPF connects all possible maximum combinations of
outputs that can be produced by using the given amount of total inputs and technology. Therefore, an
economy, which performs on its PPF, is said to technically efficient because that economy fully
utilizes all its inputs and technology. Thus, points A, B, C, D, E, F, G, and any other points on the
PPF in the above diagram represent full employment output combinations. In other word, if any
economy is technically efficient, (i.e. if it performs on its PPF) there is no unemployment of
resources (labor and other resources). Such an economy cannot increase one of its outputs without
sacrificing some of the other outputs. For example, in moving from possibility B to D the economy
increase 2 units of output X but sacrifices 6 units if output Y. This discussion leads us to an important
economic concept known as Opportunity Cost. Cost.

Definitions:
On the PPF, opportunity cost equals to the value of all outputs that should be given-up in order to
increase one of the outputs by one unit.
Value given - up
Opportunity Costs 
Value gained
Example:
1. Given the PPF discussed above, calculate the opportunity cost of shifting production from
opportunity D to F.
Answer:
Value given - up 10 - 4
Opportunity Costs  OC of shifting D to F  3 Y per X
Value gained 5-3

This means that in shifting production from D to F, 3 Ys should be sacrificed to increase X by one
unit.
An economy that performs inside its PPF is said to be technically inefficient.
inefficient. For example, an economy that
produces combination H in the above diagram is inefficient because it underutilized the available resources
and technology. Therefore there is unemployment of resources and under utilization of the available
technology if an economy performs below its PPF. On the other hand, points outside the PPF, like I in the
above diagram, represent combination of outputs that are impossible to produce because the available
resources and technology are not sufficient to produce such a combination of outputs. Point I is beyond the
current capacity of the economy. Such point are said to be unattainable, under the given condition. The PPF
is constant only in the short-run. In the long-run new resources or better technology may be discovered and the
PPF may shift to the right. A right-ward shift of the PPF represent economic growth; while a left-ward shift of
the PPF represent Economic recession.


 xxxiii.

17
Economic Growth Economic Recession
xxxiv.
xxxiv.
Eco
1.8 1.9

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