Chapter 1 – Introduction

1. Definition of Economy - Economy is a system which provides living to the people.

For this objective to be fulfilled, it is necessary that every economy should undertake three economic
activities:

Vital Processes of an Economy

 Production
 Consumption
 Investment or Capital Formation.

2. The root of all economic problems is Scarcity , that is why its important to study economics.

Scarcity –
 Scarcity refers to the limitation of supply in relation to demand for a commodity. It
refers to the situation, when wants exceed the available resources.
 Scarcity of resources calls for economizing of resources.
 Economizing of resources refers to making optimum use of the available resources.
 There is a need to economize, as we have to satisfy our unlimited wants out of limited resources.

Limitation of resources -

 In addition to being scarce, resources also have alternate (different) uses.

 Alternate use of resources means that a resource can be put to more than one use.

ECONOMIC PROBLEM

Definition - Economic Problem is a problem of choice involving satisfaction of unlimited wants out of limited
resources having alternative uses.

Reasons for Economic Problem The 3 main reasons for existence of economic problems are:

(i) Scarcity of Resources: Resources (i.e. land, labour, capital, etc.) are limited in relation to their demand and
economy cannot produce all what people want. It is the basic reason for existence of economic problems in all
economies. Scarcity is universal and applies to all individuals, organisations and countries. There would have been no
problem, if resources were not scarce.

(ii) Unlimited Human Wants: Human wants are never ending, i.e. they can never be fully satisfied. As soon as one
want is satisfied, another new want emerges. Wants of the people are unlimited and keep on multiplying and cannot
be satisfied due to limited resources. Human wants also differ in priorities, i.e. all wants are not of equal intensity. For
every individual, some wants are more important and urgent as compared to others. Due to this reason, people
allocate their resources in order of preference to satisfy some of their wants. If all human wants had been of equal
importance, then it would have become impossible to make choices.

(iii) Alternate Uses: Resources are not only scarce, but they can also be put to various uses. It makes choice among
resources more important.
Features of Resources:

(i)They are scarce, i.e. their supply is limited in relation to demand.

(ii) They have alternative uses.

Features of Human wants:

(i) They are unlimited, i.e. they can never be fully satisfied.
(ii) (ii) They differ in priorities.

Economics
 Definition - Economics is a social science which studies the way a society chooses to use its limited
resources, which have alternate uses, to produce goods and services and to distribute them among different
groups of people.
 Economics is a social science - The term 'Science' stands for any systematic and organised body of
knowledge. Economics is also a science as it is a systematic and organised study of economic behaviour of
human beings. However, it is not an exact science like Physics and Chemistry as it deals with the study of
human behaviour. Therefore, it is known as social science.
 Economics studies human behaviour as a relationship between means (resources) and ends (human wants).
 Economics aims to ensure that the resources are used in the best possible manner.
 Positive economics studies the facts of life, i.e., it deals with 'things as they are'.
 Normative economics tells us 'what ought to be'. Normative Economics deals with what ought to be or how
the economic problems should be solved

Economics as a science

Positive science OR Positive Normative Science OR Normative

Economics Economics (Deals with what ought to be
(Deals with what are the economic or how the economic problems should
problems and how are they actually be solved)
solved)

Basis Positive Economics Normative Economics

Meaning It deals with what is or how the economic
problems are actually solved. It can be It deals with what ought to be or how
verified with actual data. the economic problems should be
solved.

Verification It can be verified with actual data. It cannot be verified with actual data

Purpose It aims to make real description of an It aims to determine the ideals.

economic activity.
 Suggestive It is based upon facts, and thus, not It is based upon individual opinion and
suggestive. therefore, it is suggestive in nature.

Value It does not give any value judgements, i.e it is It gives value judgements.
Judgements neutral between ends.

Examples 1. Prices in Indian Economy are rising. 1. India should take steps to
2. There is inequality of income in our control rising prices.
country . 2. . Income inequalities should be
reduced.

MICROECONOMICS AND MACROECONOMICS

The subject matter of economics has been studied under two broad branches:

1. Microeconomics (Price Theory)

2. Macroeconomics (Income Theory)

1. Microeconomics (Price Theory)

1. Adam Smith is considered to be the founder of the field of microeconomics.

2. The term 'micro' has been derived from Greek word 'mikros' which means 'small'.
3. Microeconomics deals with analysis of behaviour and economic actions of small and individual units of the
economy, like a particular consumer, a firm or a small group of individual units.
4. The concept of microeconomics is very important as it supplies the foundation for most of our understanding
of functioning of economy.
5. Microeconomics is that part of economic theory, which studies the behaviour of individual units of an
economy. For example, Individual income, individual output, price of a commodity, etc. Its main tools are
Demand and Supply

2. Macroeconomics (Income Theory)

 The term macro ' has been derived from the Greek word 'makros' which means 'large'.
 Macroeconomics deals with overall performance of the economy.
 It is concerned with study of problems of the economy like inflation, unemployment, poverty, etc.
 Macroeconomics is that part of economic theory which studies the behaviour of aggregates of the economy
as a whole. For example, National income, aggregate output, aggregate consumption, etc. Its main tools are
Aggregate Demand and Aggregate Supply.

Basis Microeconomics Macroeconomics

Meaning Microeconomics is that part of Macroeconomics is that part of economic

economic theory which studies theory which studies the behaviour of
the behaviour of individual units aggregates of the economy as a whole.
of an economy.
 Tools Demand and Supply. Aggregate Demand & Aggregate Supply.

Basic Objective It aims to determine price of a It aims to determine income and

commodity or factors of employment level of the economy.
production.

Degree of It involves limited degree of It involves the highest degree of

Aggregation aggregation For example, aggregation. For example, aggregate
market demand is derived by demand is derived for the entire
aggregating individual demands economy.
of all buyers in the particular
market.

Basic Assumptions It assumes all the macro It assumes that all the micro variables,
variables to be constant, i.e., it like decisions of households and firms,
assumes that national income, prices of individual products, etc. are
consumption, savings, etc. are constant.
constant.

Other Name Theory' as it is primarily Microeconomics is also known as 'Price

concerned with determination Macroeconomics is also known as
of prices of commodities and 'Income and Employment Theory' as it is
factors of production. primarily concerned with determination
of level of income and employment.

Examples Individual income, individual National Income, National output.

output.

Interdependence of Micro and Macro Economics :

Microeconomics depends on Macroeconomics

 Law of demand came into existence from the analysis of the behaviour of a group (aggregate) of
people.
 Price of a commodity is influenced by the general price level prevailing in the economy.

Macroeconomics depends on Microeconomics

 National income of a country is nothing but the sum total of incomes of individual units of the country.
 Aggregate demand depends on demand of individual households of the economy.

Micro-Macro Paradoxes - It means, an act which is beneficial for an individual, may prove to be harmful for the
economy as a whole. Example: If an individual saves, his family will be benefitted, but if the whole economy starts
saving, it will result in contraction of demand, output, employment and income. As a result, the whole economy will
suffer.

Which is more Important - Microeconomics or Macroeconomics?

 Both, microeconomics and macroeconomics have a place of their own and none of them can be dispensed
with.
 Both approaches are supplementary to each other.
  The superiority of one approach over the other cannot be claimed.

CENTRAL PROBLEMS OF AN ECONOMY (Problems under Allocation of Resources)

 Resources are scares and human wants are unlimited

 Resources have alternate uses
 This leads to problem of allocation of resources to achieve maximum satisfaction .It leads to following
Central Problems, that are faced by every economy:
1. What to produce
2. How to produce
3. For whom to produce

These problems are called central problems because these are the most basic problems of an economy and all other
problems revolve around them. They are also called as problem of 'Allocation of Resources.

Allocation of Resources (Studied under Microeconomics)

Allocation of resources refers to the problem of assigning the scarce resources in such a manner so that maximum
wants of the society are fulfilled. As resources are limited in relation to the unlimited wants, it is important to
economize their use and utilise them in the most efficient manner.

The problem of allocation of resources is studied under 3 heads:

(1) What to produce;

(2) How to produce;

(3) For whom to produce.

1. What to Produce

 On the basis of the importance of various goods, an economy has to decide which goods should be produced
and in what quantities.
 The problem of 'What to produce' has two aspects:
 What possible commodities to produce: Consumer goods (rice, wheat, clothes, etc.) vs
capital goods (machinery, equipment, etc.) civil goods (bread, butter, etc.) vs war goods
(guns, tanks, etc.).
 How much to produce: After deciding the goods to be produced, economy has to decide the
quantity of each commodity, that is selected.

Guiding Principle of 'What to Produce': Allocate the resources in a manner which gives maximum

aggregate satisfaction

2. How to Produce
  This problem refers to selection of technique to be used for production of goods and services. By 'technique',
we mean which particular combination of inputs to be used. Generally, techniques are classified as:

 Labour intensive techniques (LIT) - In Labour intensive technique, more labour and less capital (in the
form of machines, etc.) is used.
 Capital intensive techniques (CIT)- In Capital intensive technique, there is more capital and less
labour utilisation.
 Availability of factors and their relative prices helps in determining the technique to be used.

Guiding Principle of 'How to Produce': Combine factors of production in such a manner so that maximum output is
produced at minimum cost, using least possible scarce resources.

3. For Whom to Produce

This problem relates to the distribution of produced goods and services among the individuals within the economy,
i.e. selection of the category of people who will ultimately consume the goods.

 Goods are produced for those people who have the paying capacity.
 The capacity of people to pay for goods depends upon their level of income.
 It means, this problem is concerned with distribution of income among the factors of production (land,
labour, capital and enterprise), who contribute in the production process.
 It must be noted that production is the result of combined efforts of factors of production. The output
emerging from production is distributed as factor income (rent, wages, interest and profit) on the basis of
their contribution in production.
 Problem of 'For Whom to Produce' is actually concerned with distribution of income.

The problem can be categorised under two main heads:

(i) Personal Distribution: It means how national income of an economy is distributed among different groups of
people.

(ii) Functional Distribution: It involves deciding the share of different factors of production in the total national
product of the country.

Guiding Principle of 'For whom to Produce': Ensure that urgent wants of each productive factor are fulfilled to the
maximum possible extent.

OPPORTUNITY COST

 Opportunity Cost is the cost of next best alternative foregone.

 The amount of other goods and services, that must be sacrificed to obtain more of any one good, is called
the opportunity cost of that good.

PRODUCTION POSSIBILITY FRONTIER (PPF)

As the choice of what to produce has infinite possibilities, the economists assumed a very basic economy with only
two goods .Economists have traditionally represented this range of choices by what they call a 'Production Possibility
Schedule' When this schedule is graphically represented it is called 'Production Possibility Frontier (PPF)' or
'Production Possibility Curve (PPC).

 Production Possibility Frontier (PPF) refers to graphical representation of possible combinations of two goods
that can be produced with given resources and technology.
 PPF is the locus of various possible combinations of two goods that can be produced with given resources
and technology.

PPF is also known by the following names:

• Production Possibility Curve

• Transformation Boundary
• Production Possibility Boundary
 Transformation Frontier
• Transformation Curve

Assumptions for PPF

Production possibility frontier is based on the following assumptions:

1. The amount of resources in an economy is fixed, but these resources can be transferred from one use to another;

2. With the help of given resources, only two goods can be produced;

3. The resources are fully and efficiently utilised;

4. Resources are not equally efficient in production of all products. So, when resources are transferred from
production of one good to another, the productivity decreases;

5. The level of technology is assumed to be constant.

Marginal Opportunity Cost (MOC)

• MOC refers to the number of units of a commodity sacrificed to gain one additional unit of another
commodity
• In case of PPF, MOC is always increasing, i.e. more and more units of a commodity have to be sacrificed to
gain an additional unit of another commodity.

MOC is always increasing - Increasing MOC operates because productivity and efficiency of factors of production
decrease as they are shifted from one use to another.
Marginal Rate of Transformation (MRT)

• MRT is the ratio of number of units of a commodity sacrificed to gain an additional unit of another
commodity.
• MRT measures the slope of Production Possibility Frontier.
• MRT increases because it is assumed that no resource is equally efficient in production of all goods. As
resources are transferred from one good to another, less and less efficient resources have to be employed.
This raises cost and raises MRT.

MRT= Units Sacrificed

Units Gained

Characteristics or Properties of PPF

1. PPF slopes Downwards:

• PPF shows all the maximum possible combination of two goods, which can be produced with
the available resources and technology.
• More of one good can be produced only by taking resources away from the production of
another good.
• There exists an inverse relationship between change in quantity of one commodity and
change in quantity of the other commodity, PPF slopes downwards from left to right.

2. PPF is Concave Shaped: PPF is concave shaped because of increasing marginal rate of transformation (MRT),
i.e. more and more units of one commodity are sacrificed to gain an additional unit of another commodity.

Where will the economy operate on PPF

• PPF does not show the point at which the economy will actually operate. It only shows the maximum
available possibilities, which an economy can produce.
• Economy can either operate on PPF or inside PPF, known as 'Attainable Combinations'.
• Economy cannot operate outside PPF, known as 'Unattainable Combinations'.

The exact point of operation depends on how well the resources of the economy are used.

1. Economy will operate on PPF (any point on PPF) only when resources are fully and efficiently utilised.

2. Economy will operate at any point inside PPF if resources are not fully and efficiently utilised.

3. Economy cannot operate at any point outside PPF as it is unattainable with the available productive capacity.

PPF and MRT relationship

 • The slope of PPF is a measure of the MRT. PPF is always concave in shape.
• Since the slope of a concave curve increases as we move downwards along the curve, the MRT also rises as
we move downwards along the curve.

PPF as a straight line - PPF can be a straight line if we assume that MRT is constant, i.e. same amount of a commodity
is sacrificed to gain an additional unit of another commodity. It is possible only when we assume that all the
resources are equally efficient in production of all goods.

PPF can be convex curve – This will happen if MRT is decreasing, i.e. less and less units of a commodity are sacrificed
to gain an additional unit of another commodity. In such case, PPF will be a convex shaped curve. But this is not
possible as MRT is always increasing.

PPF and opportunity cost

• If all the resources of the economy are fully and efficiently utilised, then more of one good can be produced
only by taking resources away from the production of another good, The lost production of such other good
is the opportunity cost of the first.
• In case resources are fully but not efficiently utilised then economy will operate inside the PPF and not on
the PPF.

PPF as Transformation Curve

Slope of PPF indicates the ease or difficulty in transforming one good into another. As we move up /down on PPF
there is transformation of one good into other . Because of this reason, PPF is known as "Transformation Curve".

Change in PPF

PPF is based on the assumption, that resources of an economy are fixed. However, in this changing world, the
productive capacity of an economy is constantly changing due to increase or decrease in resources. Such changes in
resource lead to change in PPF.

The change in PPF indicates either an increase or a decrease in the productive capacity of the economy.

The change in PPF can be of two types:

1. Shift in PPF: PPF will shift when there is change in productive capacity (resources or technology) with respect to
both the goods.

2. Rotation of PPF: PPF will rotate when there is change in productive capacity (resources or technology) with
respect to only one good.

Shift in PPF
(i) Rightward Shift in PPF: When there is "Advancement or Upgradation of Technology" or/and "Growth of Resources"
in respect to both the goods, then PPF will shift to the right.

(ii) Leftward Shift in PPF: PPF will shift towards left, when there is a techno- logical degradation and/or decrease in
resources with respect to both the goods

Examples –

Quality of Resources increases

(i) "Skill Development of Human Resources" due to establishment of Educational

Institutes or schemes like Pradhan Mantri Kaushal Vikas Yojana;
(ii) (ii) "Improved Hygienic Environment" due to 'Clean India Mission' (Swachh Bharat
Mission).

Quality of Resources decreases

(i) Destruction of resources in an earthquake will reduce the productive capacity

Rotation of PPF

(i) Rotation for commodity on the X-axis:

a. Rightwards Rotation - When there is a technological improvement of an increase in resources for

production of the commodity on the X-axis then PPF will rotate rightwards .

b. Leftwards Rotation- When there is technological degradation or decrease in resources for

production of PPF will rotate to the left

(ii) Rotation for commodity on the Y-axis:

a. Rightwards Rotation - When there is a technological improvement of an increase in resources for

production of the commodity on the X-axis then PPF will rotate rightwards .

b. Leftwards Rotation- When there is technological degradation or decrease in resources for

production of PPF will rotate to the left

Overview of PPE

1. PPF slopes downwards, as an increase in production of one good requires decrease in production of the other.

2. PPF is concave shaped due to increasing MRT.

3. PPF shows transformation of one good into another, not physically, but by diverting resources from one use to the
other.

4. PPF shows the maximum available possibilities. The exact point of operation depends on how well the resources of
the economy are used.

5. If the economy operates on PPF it means resources are fully & efficiently utilised.
6. If the economy operates at any point inside PPF it means resources are not fully and efficiently utilised.

7. Economy cannot operate at any point outside PPF as it is unattainable with the available productive capacity.

8. An outward shift in PPF means, that the economy can produce more of both the commodities, which was not
possible earlier.