Unit – 1

Introduction
Overview of the Chapter:
 Meaning of microeconomics and macroeconomics
 Positive and normative economics
 What is an economy?
 Central problems of an economy: What, How and For whom to Produce
 Concepts of production possibility frontier
 Opportunity cost.

Economics : Meaning
The science of economics was born with the publication of Adam Smith’s An Inquiry into
the Nature and Causes of Wealth of Nations in the year 1776. Adam Smith is known as the
father of Economics. At its birth, the name of economics was ‘Political Economy’.
Towards the end of the 19th century there was a definite change from use of word
‘Political Economy’ to ‘Economics’.
The word ‘Economics’ was derived from two Greek words oikou (a house) and nomos (to
manage). Thus, the word economics was used to mean home management with limited
funds available in the most economical manner possible.

Micro Economics : The word ‘Micro’ is derived from the Greek word mikros meaning small.
Microeconomics deals with small segments of the society. Microeconomics is defined as the
study of behaviour of individual decision-making units, such as consumers, resource owners
and firms. It is also known as Price Theory since its major subject-matter deals with the
determination of price of commodities and factors.

Importance of Microeconomics
1. Microeconomics helps in formulating economic policies which enhance productive
efficiency and results in greater social welfare.
2. Microeconomics explains the working of a capitalist economy where individual units
(i.e., producers and consumers) are free to take their own decision.
3. Microeconomics describes how, in a free enterprise economy, individual units attain
equilibrium position.
4. It helps the government in formulating correct price policies.
5. It helps in efficient employment of resources by the entrepreneurs.
6. It helps business economist to make conditional predictions and business forecasts.
7. It is used to explain gains from trade, disequilibrium in the balance of payment position
and determination of international exchange rate.

Positive and Normative Science :

Economic Problem: The economic problem is the problem of choice or the

problem of economising, i.e., it is the problem of fuller and efficient utilisation of the
limited resources to satisfy maximum number of wants.
Causes of Economic Problems
1. Human Wants are Unlimited: Human beings have wants which are unlimited. Human
want to consume more of better goods and services has always been increasing. For
example, the housing need has risen from a small house to a luxury house, the need for
means of transportation has gone up from scooters to cars, etc. Human wants are endless.
They keep on increasing with rise in people's ability to satisfy them. They are attributed to (i)
people’s desire to raise their standard of living, comforts and efficiency; (ii) human tendency
to accumulate things beyond their present need, (iii) multiplicative nature of some wants
e.g. buying a car creates want for many other things - petrol, driver, car parking place, safety
locks, spare parts, insurance, etc. (iv) basic needs for food, water and clothing, (v) influence
of advertisements in modern times create new kinds of wants and demonstration effect.
Due to these reasons human wants continue to increase endlessly.

2. Resources are Limited: Scarcity of resources is the root cause of all economic problems.
All resources that are available to the people at any point of time for satisfying their wants
are scarce and limited. In economics, however, resources that are available to individuals,
households, firms and society at any point of time are traditionally natural resources (land).
Human resources (labour), capital resources (like machine, building, etc.) and
entrepreneurship are scarce. It implies that resources are scarce in relation to the demand
for resources. The scarcity of resources is the mother of all economic problems.

3. Resources have Alternative Uses: Resources are not only scarce in supply but they
have alternative uses. Same resources cannot be used for more than one purpose at a
time. For example, ₹100 can be put in various alternative purposes such as buying
petrol, notebook, ice-cream, burger, cold drink, etc. Similarly an area of land can be
used for farming or as a playground or for constructing school, college or hospital
building or for constructing residential building, etc. Economics as a social science analyses
how people (individuals and the whole society or economy) make their choices between
economic goals they want to achieve, between goods and services they want to produce
and between alternative uses of their resources which will maximise their gains.

Economic Problem:
1. Allocation of Resources
What Goods to Produce and How Much to Produce?
Due to limited resources, every economy has to decide what goods to produce and in
what quantities. If the means were unlimited, then it would lead to a stage of salvation.
But the means are limited and the economy must decide the efficient allocation of scarce
resources so that both output and output-mix are optimum. An economy has to make a
choice of the wants which are important for the economy as a whole. For example, if the
economy decides to produce more cloth, it is bound to reduce the production of food.
The reason is that resources used to produce food and cloth are limited and given. An
economy cannot produce more of both food and cloth. Thus, an economy has to decide
what goods it would produce on the basis of availability of technology, cost of production,
cost of supplying and demand for the commodity.

(b) How to Produce?

It is the question of choice of technique of production. Since resources are scarce, an
inefficient technique of production, which would lead to wastage and high cost, cannot be
applied. A technique of production which would maximise output or minimise cost should
be used.
We generally consider two types of techniques of production: labour-intensive and
capital-intensive techniques. In labour-intensive technique, more labour and less capital is
used. In capital-intensive technique, more capital and less labour is used.
For example, it is always technically possible to produce a given amount of wheat or rice
with more of labour and less of capital (i.e. with labour intensive technology) or with more
of capital and less of labour (i.e. with capital intensive technology). The same is true for
most commodities. Thus, every economy has to choose the most efficient technique of
producing a commodity.

(c) For Whom to Produce?

This is the question of how to distribute the product among the various sections of the
society. National product is the total output generated by the firms. Goods and services are
produced in the economy for those who have the ability (i.e. capacity) to buy them.
Ability or capacity or purchasing power of people depends on their income. More income
means more capacity to buy. The total output ultimately flows to the households in the
form of income, i.e., their wages, rent, profits or interest. This raises the problem of
distribution of national product among different households. Who should get how much is
thus the problem? Thus, guiding principle of this problem is output of the economy be
distributed among different sections of the society in such a way that all of them get a
minimum level of consumption.

Production Possibility Curve/ Production possibility frontier/ Production possibility

boundary/ Transformation Curve / Transformation frontier/ Transformation Boundary
Production possibility curve refers to locus of points which depicts all the different possible
combinations of two goods that can be produced from a given amount of resources and a
given level of technology when the resources are all fully and efficiently employed.
Assumptions
(a) Economy produces only two goods, X and Y. (Examples of goods X and Y can be gun
and butter, wheat and sugar cane, cricket bats and tennis rackets or anything else.)
(b) Amount of resources available in an economy are given and fixed.
(c) Resources are not specific, i.e., they can be shifted from the production of one good
to the other good.
(d ) Resources are fully employed, i.e., there is no wastage of resources. Resources are
not lying idle.
(e) State of technology in an economy is given and remains unchanged.
(f ) Resources are efficiently employed (efficiency in production means output per
unit of an input).
Production Possibility Schedule and Curve
PP schedule refers to tabular presentation of different possible combinations of two goods
that an economy can produce with given resources and available technology.
It shows that, with given resources, an economy can produce either zero unit of X and 21
units of Y or 1 of X and 20 of Y or 2 units of X and 18 units of Y or 3 units of X and 15 units of
Y or 4 of X and 11 of Y or 5 of X and 6 of Y or 6 units of X and zero units of Y.
Features of Production Possibility Curve
Two features of production possibility curve are:
(a) PPC slopes downward. A production possibility curve slopes downward from left to right
because under the condition of full employment of resources, production of one good can
be increased only after sacrificing production of some quantity of the other good. It is so
because resources are scarce. Due to this, production of both goods cannot be increased at
the same time. That is why PPC slopes downward.
(b) PPC is concave to the origin. A production possibility curve is concave to the point of
origin because of increasing marginal rate of transformation (MRT) or increasing marginal
opportunity cost (MOC). Slope of PPC is defined as the quantity of good Y given up in
exchange for additional unit of good X.

Marginal opportunity cost is opportunity cost of good X gained in terms of good Y

given up. It is also called Marginal Rate of Transformation (MRT). Concave shape of PPC
means that slope of PPC increase which implies that MRT increases. It means that for
producing an additional unit of a good, sacrifice of units of other good (i.e. opportunity cost)
goes on increasing. It is because resources are not equally efficient for the production of
both goods. Thus, if resources are transferred from production of one good to another, cost
increases i.e., MRT or MOC increases. It is called law of increasing opportunity cost.
Shifts in Production Possibility Curve
PPC will shift to the right when:
(a) New stock of resources are discovered.
(b) There is an advancement in technology. For example: Government policy of ‘Make in
India’.
Look at this example: When training institutes come up, they provide training which
raises efficiency of workers. PPC shifts outside.
PPC will shift to the left when:

(a) Resources are destroyed because of national calamity like earthquake, fire, war, etc.
For example: When maggi product was destroyed.
(b) There is use of outdated technology.

Opportunity Cost
In economic analysis, the concept of opportunity cost is widely used. Opportunity cost is
defined as the cost of alternative opportunity given up or surrendered. For example, on
a piece of land both wheat and sugarcane can be grown with the same resources. If wheat
is grown then opportunity cost of producing wheat is the quantity of sugarcane given up. It
is clear that question of opportunity cost arises whenever resources have alternative uses.
These resources are not always physical resources, they may be monetary resources or
time. For example, the opportunity cost of spending in a restaurant, may be a book that you
could have purchased by spending the same amount. Also, opportunity cost of time devoted
to studies, effort or work is the leisure or play that could have been enjoyed. In terms of
production possibility curve, the slope of the curve at every point measures the opportunity
cost of producing more units of good X in terms of good Y given up.

Marginal Opportunity Cost

Production possibility curve is also called transformation curve because looking at it, it
appears as if one good is being transformed into another. A movement along PPC implies
that more of good X is produced by sacrificing the production of a certain amount of good Y.
PPC is also called opportunity cost curve because slope of the curve at each and every point
measures opportunity cost of one commodity in terms of alternative commodity given up.
The rate of this sacrifice is called the Marginal Opportunity Cost.

Marginal Rate of Transformation (MRT).

It is defined as the ratio of number of units of good sacrificed to produce one additional unit
of other good. MRT measures the slope of PP curve. MRT = slope of PPC. Actually MRT is the
rate at which the transfer of resources from production of one good to production of other
good takes place.

Different shapes of PPC and its reasons:

Notes for important and hots based question:

Allocation of Resources—What to Produce and How Much to Produce?
What to Produce ?
All points on the production possibility curve, PP' shows what to produce and how much to
produce. All points on the curve are efficient and attainable. For example, if the economy
chooses point B as the production combination (Fig. 1.4), then 2 units of good X and 18 units
of good Y can be produced. On the other hand, if the economy is operating at point C, then
3 units of good X and 15 units of good Y are produced. Thus, depending upon the nation’s
policy it can choose any point on the curve, which will solve the problem of what to produce
and how much to produce.
How to Produce ?
It relates to technique to be used in production. The problem is to choose that technique of
production which will maximise production or minimise cost. Only efficient technology
should be chosen. All points on the production possibility curve imply that the most efficient
technology is employed.
For Whom to Produce ?
Production possibility curve fails to explain how distribution of national product takes
place. Each point on the curve shows the amount of the two goods produced by an
economy. It has to be analysed which section of the society is demanding which good. If
the rich sections of the society are getting more goods then it shows unequal distribution
of income and wealth in an economy. If poor people are getting more goods then it implies
more equitable distribution of income.
Full Utilisation of Resources
This problem is solved by all points on the production possibility curve. Each point on the
curve PP' shows full utilisation of resources. Any point inside the curve like point F shows
that resources are unemployed or underutilised or are lying idle. In other words, resources
are not being used efficiently. By increasing the use of resources, production can be
increased. Example, in India, most of machines and plants are underutilised. Another
example is: underutilisation of people who are willing to work. Massive unemployment
prevailing in India will lead to a point inside PPC. This will be true because PPC is drawn
on the assumption that resources are fully employed. When there is massive unemployment
it will reduce production possibilities and lead to a point inside PPC showing underutilisation
of resources.
Economic Efficiency
All points on the production possibility curve PP' are economically efficient in production.
The aim of an economy, which wants to be economically efficient, is to be on the production
possibility curve. Any point beyond the boundary of the curve is unattainable.
Economic Growth
With discovery of new stock of resources or an advancement in technology, the productive
capacity of an economy increases. The economy can produce more good X or more good Y
or more of both goods.