Introduction to Microeconomics

Lecture Note: One

Course Codes
BECO Y1 S1 - BECO 1103
BEEP Y1S1 - BECO 1102
BASC Y1 S1 - BECO 1103
BASE Y1S1 - BECO 1103

INTRODUCTION TO ECONOMICS
By the end this lesson the learner should be able to;
i) Define Economics
ii) Distinguish between microeconomics and macroeconomics
iii) State and explain the fundamental economic questions
iv) Explain the economic problem
v) State and explain the factors of production
vi) Describe the market systems
vii) Describe the methodology of economics
viii) Explain reasons for studying economics
ix) Explain the methodology of economics
x) Explain the basic tools for analysis: supply and demand, equilibrium, comparative statics
xi) Explain the basic economic concepts

1.0 BASIC ECONOMIC CONCEPTS

Economics essentially studies the way in which mankind provides for the material well-being. It’s
thus concerned with the way people apply their knowledge, skills and effort to the gift of nature in
order to satisfy their human material wants.

1.1 Definition of Economics

Economics is a social science which studies the allocation of scarce resources which have alternative
uses among competing and usually limitless wants of the consumers in the society.

1.2 Scarcity
Scarcity is one of the key economic concepts. In economics, it refers to the limited availability of
resources for human consumption. The world population needs are unlimited, whereas the resources
to meet the needs are limited. The limited feature of resources makes it more valuable and expensive.
Effective resource allocation techniques and integration of alternatives confront the scarcity issues.
Examples of scarce resources are oil and gold. Its scarcity will limit the human want for it.

1.3 Needs and wants. A need is something that is necessary to live and function. A want is
something that can improve the quality of life. Using these criteria, a need includes food, clothing,
shelter and medical care, while wants include everything else

1
1.4 Scope of Economics
The main branches of economics are:
i) Microeconomics which is the study of the smallest economic decisions making units of the
society. Microeconomics theory is a branch of economics that studies the behavior of individual
decision-making units such as consumers, resource owners and business firm as well as
individual markets in a free market economy. The aim of microeconomics is to explain the
determination of prices and quantities of individual goods and services. Microeconomics also
considers the impact of government regulation and taxation of individual markets. For example,
microeconomics analyses the forces that determine the prices and quantities of television sets
sold. Microeconomics can be considered as the ultimate cellular structure of economics.

The major areas of microeconomics are;

- demand and supply analysis
- market equilibrium
- consumer theory
- theory of the firm (production theory)
- market structure
- distribution theory

ii) Macroeconomics is the study of bigger and complex systems. Macroeconomic theory is the study
of the behavior of the economy as a whole whereby the relationship is considered between broad
economic aggregates such as national income, employment and prices. The economy is aggregated
into broadly homogenous categories and determinants of the behavior of these aggregates are
integrated to provide a model to the entire economy.

Activity 1: Illustration of the concept of macroeconomics by using two agents (e.g 2 consumers)
Price (Ksh) 100 80 60 40 20
Demand 1 5 10 15 20 25
Demand 2 8 14 20 26 32
(Graphs here)

Macroeconomics focuses on the economic stabilization whereby government policy is used to

moderate business cycles and encourages real economic growth. Macroeconomics became a separate
topic of discussion in the aftermath of John Maynard Keynes and the great depression. The line
between microeconomics and macroeconomics is, however, blurred and there are many areas of
overlap between the two. Key areas of macroeconomics are:
- national income
2
 - economic growth and development
- money and banking
- public finance
- unemployment
- inflation
- international trade

Usefulness of economics - economics provides an objective mode of analysis, with rigorous models
that are predictive of human behavior. Economics uses,
• Scientific approach
• Rational choice

Assumptions in Economics - economic models of human behavior are built upon assumptions; or
simplifications that permit rigorous analysis of real-world events, without irrelevant complications.
• model building - models are abstractions from reality - the best model is the one that best
describes reality and is the simplest.
• simplifications:
i) ceteris paribus - means all other things equal.
ii) There are problems with abstractions, based on assumptions. Too often, the models built
are inconsistent with observed reality - therefore they are faulty and require modification.
When a model is so complex that it cannot be easily communicated or its implications
easily understood - it is less useful

1.4 Rational choice theory - Rational behavior refers to a decision-making process that is based on
making choices that result in an optimal level of benefit or utility. Rational choice theory is an
economic theory that assumes rational behavior on the part of individuals

1.5 Marginal thinking - Marginalism is the insight that people make economic decisions over
specific units or increments of units, rather than making categorical, all-or-nothing decisions.
Thinking at the margin helps to explain various economic concepts, such as consumer behavior,
supply and demand, pricing decisions, and resource allocation. Marginality uses the concept of the
gradient or slope of a line or curve.

Marginal value = Slope = Change in vertical axis = 𝛿y/ 𝛿x, for continuous functions
Change in horizontal axis

Note on Concave and Convex functions

Convex curves curve downwards and concave curves curve upwards.

That doesn’t sound particularly mathematical, though…

• When f′′(x)>0, we have a portion of the graph where the gradient is increasing, so the graph is
convex at this section, i.e when the second derivative is positive, the function is convex
downward (concave upward)
• When f′′(x)<0, we have a portion of the graph where the gradient is decreasing, so the graph
is concave at this section, i.e when the second derivative is negative, the function is concave
downward (convex upward).

3
 An easy way to test for both is to connect two points on the curve with a straight line.
If the line is above the curve, the graph is convex.
If the line is below the curve, the graph is concave.
Or a graph is said to be concave up (convex or sometimes convex down) at a point if the tangent line
to the graph at that point lies below the graph in the vicinity of the point and concave down (convex
up) at a point if the tangent line lies above the graph in the vicinity of the point.

Illustration
i) The function x2

Its derivative is 2x (see Derivative Rules)

2x continually increases, so the function is concave upward.
Its second derivative is 2
Both give the correct answer.

ii) The function f(x) = 5x3 + 2x2 − 3x

Let's work out the second derivative:

• The derivative is f'(x) = 15x2 + 4x − 3 (using Power Rule)

• The second derivative is f''(x) = 30x + 4 (using Power Rule)

And 30x + 4 is negative up to x = −4/30 = −2/15, and positive from there onwards. So:

• f(x) is concave downward up to x = −2/15

4
 • f(x) is concave upward from x = −2/15 on

The point where it changes is called an inflection point (A point of inflexion is a point where the
gradient of the curve stops falling and starts rising, or vice versa, at the point of inflection f’’ (x) = 0)
Activity 2: Describe the slope of each of the following graphs

Panels e and f

5
Panels g, h, i and j

Panels k and l

Panel m

6
Economic principle: Rational people think at the margin

The third of Mankiw’s four principles of economics, states that” rational people think at the margin”:
Rational people systematically and purposefully do the best they can to achieve their objectives,
given the available opportunities

Gregory Mankiw’s Economic principles are as follows

i) People face trade-offs.
ii) The cost of something is what you give up getting it.
iii) Rational people think at the marginal cost and marginal revenue.
iv) People respond to incentives.
v) Trade can make everyone better off.
vi) Markets are usually a good way to organize economic activity.
vii) Governments can sometimes improve market outcomes.
viii) A country's standard of living depends on its ability to produce goods and services.
ix) Growth of money leads to inflation
x) Society faces a short-run tradeoff between Inflation and unemployment.

1.6 Incentives
Incentive refers to the factor that influences the consumer in the decision-making process. Two types
of incentives are intrinsic and extrinsic incentives. Intrinsic incentives originated in the consumer
without any outside pressure, whereas extrinsic incentives developed due to external rewards. For
example, the decrease in the price of a discretionary item is an incentive to purchase that item.

1.7 Economic Problems

1) The economizing problem involves the allocation of resources among competing wants. There is
an economizing problem because there are:
• unlimited wants
• limited resources

2) Factors of Production (Economic resources): Factors of production is an economic term that

describes the inputs used in the production of goods or services to make an economic profit. These
include any resource needed for the creation of a good or service. The factors of production
include;
i) Land - includes space (i.e., location), natural resources, and what is commonly thought of as
land. Land is paid rent. Land has the following features’
• Land is fixed in quantity. It is said that land has no supply price. That is, price of land
prevailing in the market cannot affect its supply; the price may behigh or low, its supply
remains the same.
• Land has original and indestructible properties.
• Land lacks mobility in the geographical sense.
• Land differs in fertility.

ii) Capital - are the physical assets used in production - i.e., plant and equipment. Capital is paid
interest. Capital has the following features,

7
 • Capital is a Passive Factor - Capital is a passive factor of production. This is so because
capital is ineffective without the cooperation of labor. A business cannot operate only with
capital. They need to invest equally in labor and land.
• Capital is Man-Made: Capital is a man-made thing. Its production and supply is controlled
by the efforts of man.
• Capital is not Indispensable: Capital is not an indispensable factor of production like labor
and land. This would mean that production can be possible even without capital.
• Capital has high mobility: Among all the factors of production, Capital has the highest
mobility. The land is immobile and labor has the least mobility, while capital has both
‘place mobility’ and ‘occupational mobility’.
• Capital is Elastic: The elasticity of capital is high when we talk about its supply. Its supply
can be adjusted quickly and easily depending on the demand. On the other hand, the
supply of land is fixed and the supply of labor can neither be increased or decreased
quickly.
• Capital Depreciates: Capital depreciates over time. For example, if a machine is used again
and again its efficiency goes down and it may not be suitable for further use due to
depreciation.
• Capital is Productive: Capital helps in increasing production. When labor is given adequate
capital, it effectively increases production. More capital leads to better efficiency and
increased productivity.
• Capital is Temporary in Nature: Capital is temporary. It cannot last forever. Therefore,
Capital needs to be reproduced and replenished from time to time. This makes capital a
short-term asset.
• Capital is Prospective: Capital is considered much prospective as the accumula-tion of
capital yields an income. The more we invest in the accumulation of capital, the greater is
the possibility of it providing aid to the business when it is needed.
• Capital is recalled as Past Savings: Capital goods become savings when production
exceeds consumption. For example, when a farmer does not consume or sell a part of his
crop production, it can be used as seeds in the future.

iii) Labour - labor is the skills, abilities, knowledge (called human capital) and the effort exerted
by people in production. Labor is paid wages. Labour has the following features’
• Labour cannot be separated from the labourer. Hence, a labourer has to sell his labour in
person.
• Labour is highly perishable. A labourer cannot preserve his labour and deliver it in the
future. A day without work in a worker’s life is lost forever.
• Labourer has a weak bargaining power. As labour is perishable, it has no reserve price.
Hence, labourers have to accept low wages rather than being idle or unemployed.
• The supply of labour changes slowly. Supply of labour cannot be curtailed immediately,
even if wages fall. This is due to the fact that labourers must earn their subsistence,
somehow. Conversely, increase in labour supply depends on new births and a long period
of training.
• Labour is not so mobile as capital due to differences in language, environment, habits, etc
in different localities.
iv) Entrepreneurship - entrepreneurial talent - (risk taker) the economic agent who creates the
enterprise. Entrepreneurial talent is paid profits. Characteristics of Entrepreneurship as a
Factor of Production

8
 • Innovation and Creativity: Entrepreneurs are known for their ability to innovate and think
creatively. They identify new opportunities and develop innovative solutions to meet
market demands. By introducing new products, services, or processes, entrepreneurs
contribute to economic growth and facilitate technological advancements. Their creative
thinking allows them to identify gaps in the market and develop unique solutions, leading
to greater efficiency and productivity.
• Risk-Taking and Initiative: Entrepreneurs are willing to take risks and bear uncertainties
associated with their business ventures. They have the initiative to convert their ideas into
action, despite the potential for failure. This risk-taking behavior is essential for economic
progress as it encourages experimentation, investment, and the creation of new businesses.
Entrepreneurs are not deterred by setbacks and are willing to learn from failures, adapt,
and persevere to achieve their goals.
• Resource Mobilization: Entrepreneurs possess the ability to mobilize and allocate
resources efficiently. They identify and acquire the necessary inputs such as capital, labor,
and materials required for their business operations. Through effective resource
management, entrepreneurs optimize the utilization of these inputs, leading to higher
productivity and profitability. They are skilled at attracting investors, securing funding,
and building networks to support their entrepreneurial endeavors.
• Vision and Leadership: Entrepreneurs have a clear vision of their goals and aspirations.
They possess the ability to inspire and lead their teams towards the realization of this
vision. Through effective leadership, entrepreneurs motivate their employees, foster a
positive work environment, and drive innovation within their organizations. Their vision
and leadership skills enable them to navigate through challenges, make strategic decisions,
and adapt to changing market conditions.

3) Full employment is often described as the level of employment at which virtually anyone who
wants to work can find employment at the prevailing wage. One might assume that if everyone
who wants a job has one, then the unemployment level would be zero. However, full production
or 100% capacity utilization cannot be maintained for a prolonged period without labor and
capital breaking-down. Full employment also means that all available labor resources are being
used in the most efficient way possible. Underemployment then means the utilization of a
resource in a manner, which is less than what is consistent with full employment.

4) Fundamental Economic Questions: In order to solve the problem of scarcity, societies must make
choices. The basic economic questions are the main or basic choices that all societies must
answer. These choices are influenced or guided by the rules or parameters set by each society.
These rules or parameters compose the economic system.

Because of scarcity every society or economic system must answer these three (3) basic questions:
i) What to produce?
• What should be produced in a world with limited resources?
• Examples: Using limited resources, should a local government build a new school or improve
roads? Using limited resources, should a farmer grow wheat, cotton, or corn? Using limited
resources, should an automobile manufacturer produce driverless cars?
ii) How to produce?
• What resources should be used?
• Examples: How should we obtain oil? How much pollution should be allowed? How should
we produce steel – using union or nonunion workers? Using recycled steel or iron ore?
9
 iii) Who consumes what is produced?
• Who acquires the product? How is it distributed?
• Examples: Who gets a flu vaccine? Where are new schools built? Who should clothes be
produced for (what demographic group / generation)?

5) Efficiency: The goal in answering the three fundamental economic questions is efficiency.
Efficiency is the goal of all economic decisions to solve the problem of scarcity. Thus, the aim of
each society is to answer the above questions efficiently. Efficiency is one of the important things
to keep in mind when deciding how to produce something. Efficiency means producing with a
minimum of expense, effort and waste.

Types of efficiency
i) Economic efficiency – a state of affairs in which it is impossible to make any change that
satisfies one person’s wants more fully without causing some other person’s wants to be
satisfied less fully. In production economic efficiency involves producing a given output at
least cost. This usually involves a unique combination of inputs, the levels of these inputs
depending on their substitutability and complementarity, and also on their prices.

ii) Productive efficiency: a situation in which the economy, given available knowledge and
resources, could not produce any more of one good without sacrificing production of
another good.

iii) Allocative efficiency- a state of the economy in which production represents consumer
preferences. Production that is valued by society when supply meets demand (in allocative
efficiency all goods and services meet the needs and wants of society). Allocative efficiency
is measured using a concept known as Pareto Superiority (or Optimality)
▪ Pareto Optimal - is that allocation where no person could be made better off without
inflicting harm on another.
▪ Pareto Superior - is that allocation where the benefit received by one person is more than
the harm inflicted on another [cost – benefit approach]

iv) Technical efficiency: This means that a firm is producing the maximum output from given
quantities of inputs. Any production function assumes that a firm is operating at technical
efficiency. It follows from this that a given output may be produced in many ways, each one
of which may be technically efficient; in other words, that output is the maximum output
that can be produced from each different combination of inputs
v) Full employment - for a system to be economically efficient then full employment is also
required
6) Positive and Normative economics: Virtually every mainstream textbook in economics begins
with a brief discussion of the difference between positive and normative economics, made a
dogma by those who slavishly followed Lionel Robbins in his Essay on the Nature and
Significance of Economic Science (1932). Normative or welfare economics deals with what ought
to be rather than what is and involves prescriptive statements that may be based on value
judgments, i.e., normative economics offers prescriptions or recommendations based on personal
value judgements.

10
 Examples of Normative statements in Economics
• The government should implement strict wealth tax laws to decrease the uneven
distribution of wealth
• No individuals should be entitled to inheritances as it belongs to society
• Import duties should be increased on goods coming from nations with humble human
rights record
• Investors ought to be more socially responsible and stop investing in vice stocks
• Developing countries should only accept democracy when their entire population is
educated and liberated.
• The government should increase taxes on tobacco products in order to reduce smoking.
• It is wrong for people to discriminate against others based on their race or ethnicity.
• Higher education should be free for all students. Tuition fees should be abolished.

Positive economics deals with what is rather than what ought to be and involves descriptive
statements that are objective and scientifically verifiable explanations of the working of the
economy. The aim of positive economics is to explain how society makes decisions about
consumption, production, and exchange of goods. The purpose of this investigation is twofold: to
satisfy our curiosity about why the economy works as it does, and to have some basis for
predicting how the economy will respond to changes in circumstances. In positive economics, we
hope to act as detached scientists. Whatever our political persuasion, whatever our view about
what we would like to happen or what we would regard as “a good thing”, in the first instance we
have to be concerned with how the world actually works. At this stage, there is no scope for
personal value judgements. We are concerned with propositions of the form: if this is changed
then that will happen. In this regard, positive economics is similar to the natural sciences such as
physics, geology, or astronomy.

Examples of Positive statements in Economics

• Monopolies have proved to be inefficient
• The desired rate of return on gambling stocks are higher compared to others
• The relationship between wealth and demand is inverse in the case of inferior goods
• House prices reduce once the interest rate on loans get higher
• Car scrappage schemes can result in a fall in the prices of second-hand cars
• The average temperature in Nairobi City in July is 24 degrees Celsius.
• The demand for petrol and diesel is inversely related to the price of petrol and diesel
• The gross domestic product (GDP) of the Kenya increased by 1.5% in the second
quarter of 2023.
7) Trade-off and Opportunity Cost: Allocations of resources imply that decisions must be made,
which in turn involves choice. Scarcity and choice imply that if the resources available are not
enough to produce goods and services to satisfy all the wants then they are said to be scarce. As a
result, individuals and society cannot have all the things that they want. Since resources are
limited, choices have to be made. The choice to satisfy one want implies others are forgone.
Individuals have to make choices e.g., consumers with their limited income and unlimited wants
have to choose how they spend their income. A trade-off occurs when a decision leads to choosing
one thing over another. Every choice is costly; there is always the lost alternative – the
opportunity cost: opportunity cost - the next best alternative that must be foregone as a result of a
particular decision. Opportunity cost is based on the fact that resources being scarce have

11
 competing alternative uses. The choice to satisfy one alternative means that another is forgone.
The value of the second-best forgone alternative is the opportunity cost.

8) Production Possibility Frontier/Capacity (PPF/PPC): It provides a graphical illustration of the

problem of scarcity and choice which is the basic economic problem. The curve shows what a
country produces with existing supply of land, capital and entrepreneurship ability. With limited
supply of economic resources, a country has a wide variety of options and variety of goods and
services it can produce.

Assume a simple hypothetical economy where a country produces two types of goods i.e.,
agriculture and manufactured goods. The two extreme possibilities are:

• The country commits all its resources to the production of agriculture and none to
manufacturing.
• All the resources are put to manufacture and none to agriculture.

These two extreme cases are unlikely and the country will most likely choose to produce goods of
both commodities. The opportunity cost of producing either of them is increasing with the law of
diminishing return.

Activity 3: Illustration of the PPF/C curve with constant/Increasing opportunity cost

Agriculture 0 50 100 150 200
Manufacturing 600 450 300 150 0
(PPF/PPC here)

The PPF is a locus of all combination point which represents goods and services that a country can
produce if all resources are utilized fully and efficiently. Points on the curve such as A, B and C show
maximum possible combined output of the two commodities. The economy can produce any
combination inside the curve such as point Q where it means some resources are unemployed. The
resources in such a case will produce more commodities by moving either to point B or point A. The
points outside the curve are not attainable with the country’s present productive capacity. The country
can only achieve this if its productive capacity has been increased and this will cause the curve to shift
to the right as shown by the dotted curve. A country’s productive capacity can increase if there is
advancement in technology or if there is a discovery of new resources. The PPF/C is concave to the
original indicating the concept of increasing opportunity costs

12
Assumptions necessary to represent production possibilities in a simple production possibilities curve
model:
i) Efficiency
ii) Fixed resources
iii) Fixed technology
iv) Two products
Law of Increasing Opportunity Costs is illustrated in the above production possibilities curve. Notice
- as we obtain more manufactured products (shift to the right along the manufacturing axis) we have
to give up large amounts of Agricultural products (downward shift along Agricultural axis)
9) Economic Growth can also be illustrated with a production possibilities curve.
• The only way this can happen is for there to be more resources or better technology.
• Growth will change the potential output of the economy, hence the shift of the entire curve
The dashed line in the above model shows a shift to the right of the of the curve which is called
economic growth.
10) Economic System: An economic system comprises various entities forming a social structure
that enables a production system, allocation of resources, and exchange of products and services
within a community. Capitalism, communism, socialism, and market economy are types of economic
systems.
Economic Systems rarely exist in a pure form. The use on a specific economic system is how the
basic economic questions are answered. Economic systems provide the rules or a framework for
choices. They are chosen because society thinks it is the best way to meet the needs and wants of it
citizens.
The following classification of systems is based on the dominant characteristics of those systems:
a) Pure capitalism (Market system) - private ownership of productive capacity, very limited
government involvement, and motivated by self-interest.
i) laissez faire - government hands-off; markets relied-upon to perform allocations.
ii) costs of freedom - poverty, inequity and several social ills are associated with the lack
of protection afforded by government.

In a free market economy, firms and households act in self-interest to determine how resources
get allocated, what goods get produced and who buys the goods. In other words, consumers and
producers, through demand and supply, answer the basic economic questions. This is opposite to
how a command economy works, where the central government answer them in their interest.
• There is no government intervention in a pure market economy (“laissez-faire “). However,
no truly free market economy exists in the world. For example, while America is a capitalist
nation, our government still regulates (or attempts to control) fair trade, government
programs, business monopolies, etc.
• In this type of economy, there is a separation of the government and the market. This
separation prevents the government from becoming too powerful and keeps their interests
aligned with that of the markets.
b) Command - government makes the decisions - with force of law (and sometimes martial
force)
13
• Often associated with dictatorships

Generally, in a command economic system, a large part of the economic system is controlled
by a centralized power. For example, in the USSR most decisions were made by the central
government. This type of economy was the core of the communist philosophy.
• Since the government is such a central feature of the economy, it is often involved in
everything from planning to redistributing resources: deciding the answers to the basic
economic questions of what to produce, how to produce, and who gets to acquire the
product. A command economy is capable of creating a healthy supply of its resources,
and it rewards its people with affordable prices. This capability also means that the
government usually owns all the significant industries like utilities, aviation, and
railroad.
• In a command economy, it is theoretically possible for the government to create enough
jobs and provide goods and services at an affordable rate. However, in reality, most
command economies tend to focus on the most valuable resources like oil.
• China, Cuba, and the Democratic People’s Republic of Korea (DPRK; North Korea) are
examples of command economies. However, due to changes beginning with the
creation of Special Economic Zones in 1979, China has amounts of private ownership,
and therefore elements of a market economy or capitalism.

c) Traditional - based on social mores or ethics or other non-market, non-legislative bases

• Christmas gift giving is tradition

The traditional economic system is the most traditional and ancient types of economies in the
world. Vast portions of the world still function under a traditional economic system. These
areas tend to be rural, second- or third-world, and closely tied to the land, usually through
farming. In general, in this type of economic system, a surplus would be rare, therefore the
members of this economy would not have the ability to trade their excess for another person’s
excess. As a result, less will be enjoyed by each member than could be, and in economics,
there quality of life would not be very high. Each member of a traditional economy has a
more specific and pronounced role, and therefore the basic economic questions are answered
according to the designations of the society, usually tradition and custom. These societies
tend to be very close-knit and socially satisfied. However, they do lack access to technology
and advanced medicine.

d) Socialism - maximizes individual welfare based on perceived needs, not contributions;

generally concerned more with perceived equity than efficiency
e) Communism - everyone shares equally in the output of society (according to their needs),
generally no private holdings of productive resources
• The former Soviet Union espoused communism, but also was mostly command
• Utopian movement in the U.S.
f) Mixed system - contains elements of more than one system - U.S. economy is a mixed system
(capitalism, command, and socialism are the major elements, with some communism and
tradition)
• All of the high income, industrialized economies are mixed economies.
Thus, a mixed economy is a combination of different types of economic systems. This
economic system is a cross between a market economy and command economy. In the most
common types of mixed economies, the market is more or less free of government ownership
14
 except for a few key areas like transportation or sensitive industries like defense and railroad.
Hence, consumers and producers answer the basic economic questions through supply and
demand, while the government may also answer them.
• However, the government is also usually involved in the regulation of private businesses.
The idea behind a mixed economy was to use the best of both worlds – incorporate policies
that are socialist and capitalist.
• To a certain extent, most countries are mixed economic system. For example, the United
States, India and France are mixed economies.

11) Circular Flow of Economic Activity: The circular flow model in economics primarily portrays
how money flows through different units in an economy. It connects the sources and sinks of factors
of production, consumer & producer expenditures, and goods & services. For example, resources
move from household to firm, and goods and services flow from firms to households.

Circular flow is a macroeconomics term and tries to study the central questions of economies.
Amongst these questions, the main question is how economies create wealth. In an economy, all
factors of production undergo a production flow/cycle; in the process of which it generates wealth in
the form of making payments to the factor of production, known as factor payments. Thus, the
economic wealth of nations is created by generating this flow and producing commodities (goods and
services), which are then consumed by consumers who spend their income on these goods and
services.

Circular Flow in a Two-Sector Economy

In the circular flow of an economy in a two-sector model without the financial market, it is assumed
that no savings are made in the economy. It means that the households spend their entire income on
the purchase of goods and services and every firm spends all the receipts from the sale of goods and
services to make factor payments.

However, it does not happen in the actual world, i.e., households do not spend their entire income on
the consumption of goods and services. Instead, they save a part of their income for the future. In the
15
same way, the firms save some part of their receipts for the expansion of business or various other
reasons. Besides, the firms also borrow money from outside to finance their expansion plans. All of
these savings and borrowings happening in the economy are channelised through the financial
market. Therefore, in a two-sector economy, the savings made by households accumulated in the
financial market are used by the firms for investment purposes.

Financial Market refers to those institutions like insurance companies, banks, etc., which transacts
loanable funds in the economy.

Circular Flow in a Three-Sector Economy

The government also plays a crucial role in the economic development of a country. Therefore, the
circular flow of income in a three-sector economy includes households, firms, and the government
sector. The government of a country acts as both a firm and a consumer. As a firm or producer, the
government produces goods and services for the economy. However, as a consumer, it spends money
on the consumption of goods and services produced by the firms. Besides the flows of circular
income in the two-sector economy with a financial market, the additional flows due to the inclusion
of the Government are:

1. Between Households and Government: The money from the government to households flows in an
economy in two forms. First, in the form of transfer payments, such as old age pensions,
scholarships, etc. Second, in the form of factor payments for hiring factor services of the households.
This money flows back from households to the government in the form of direct taxes, such as
interest tax, income tax, etc.

2. Between Firms and Government: The money from firms to the government flows in an economy
in the form of direct and indirect taxes. However, the money from the government to the firms flows
into an economy in the form of subsidies. In this case, the government grants subsidies to the firms
and makes payments to the firms for the purchase of goods and services produced by them.

16
The financial market also plays an important role in a three-sector economy, as the government saves
a part of their earned income and deposits the same in the financial market. Besides, the government
also borrows money from the financial market so it can meet its expenditures.
Circular Flow in a four-Sector Economy

1. Household Sector: The household sector of an economy provides factor services to the firms,
government, and the foreign sector for which it received factor payments in return. Besides factor
payments, the households also receive transfer payments like old age pensions, scholarships, etc.,
from the government and foreign sector. The household sector spends its earned income on Payments
for goods and services purchased from firms, payments for imports, and tax payments to the
government.

2. Firms: The firms receive revenue for the sale of goods and services from the government,
households, and foreign sectors. They also receive subsidies from the government to produce goods
and services. Besides, the firms make payments for taxes to the government, factor services to the
households, and imports to the foreign sector.

3. Government: The government receives revenue for the sale of goods and services, fees, taxes, etc.,
from the firms, households, and the foreign sector. It also makes factor payments to households and
spends its revenue on transfer payments and subsidies.

4. Foreign Sector: The foreign sector receives revenue for the export of goods and services from
firms, households, and the government. It also makes payments to firms and the government for the
import of goods and services, and households for the factor services.

17
The financial market also plays an important role in a four-sector economy as the savings made by
the households, firms, and the government gets accumulated here and this money is invested by the
financial market in the form of loans to firms, households, and the government. The inflows of
money in the financial market in a four-sector economy are equal to the outflows of money, which
makes the circular flow of income continuous and complete

1.8 Why Study Economics?

It is useful to study economics for the following reasons
i) Economics provides the underlying principles of optimal resource allocation and thus enables
individuals and firms to make economically rational decisions. Thus, for example the preparation of
budgets involves knowledge of demand and elasticity analysis. The making of price policy
decisions draws heavily on the concept of elasticity in economics. Additionally, the theory of
production in economics is concerned with the principles that facilitate the optical combination
factors of production.

ii) A study of economics enables individuals and organizations to appreciate the constraints imposed
by the economic environment within which any entity operates. Thus, an individual or firm is
more fully enabled to appreciate the implications of the annual budget considering how for
example the increased liberation of the economy will affect a particular business entity and the
economy in general. Additionally, the student of economics is able to appreciate the
effects of such economic variables as inflation, exchange rates, interest rates money supply and so
on.
iii) The area of development economics is fundamentally concerned with the reasons why societies
develop and means of accelerating development. It is vital for individuals as citizens to appreciate
the parameters that determine the development process so that they contribute more fully to
facilitate and contribute to solving the economic problems that characterize their society.
iv) Economics is an analytical subject and its study can help develop logical reasoning which is never
superfluous.

vi) Career Prospects: An education in economics can improve one’s employability in a variety of
industries. According to research, analytical thinking and complex problem-solving skills top the
list of transferable skills that employers will find increasingly important in the future, both of
which can be gained by studying economics. In addition, many careers require knowledge of
economic concepts, models, and relationships. Some possible career paths for economics students
include finance, banking, insurance, politics, healthcare administration, local and national
government, think-tanks, large multinational companies, financial consultancies, accountancy
firms, local authorities and non-governmental organizations.

1.9 The Methodology of Economics

Scientific Method - A logical problem-solving approach used by scientists. The usual methods of
scientific studies — deduction and induction, are available to the economist.
Both methods come from science, viz., Logic. The deductive method involves reasoning from a few
fundamental pro-positions, the truth of which is assumed - Deductive reasoning uses available
information, knowledge, or facts to construe a valid conclusion (top-down approach). Deduction
means reasoning or inference from the general to the particular or from the universal to the individual

18
The inductive method involves collection of facts, drawing conclusions from them and testing the
conclusions by other facts - Inductive reasoning makes a generalization from specific observations
and facts (bottom-up approach). Induction “is the process of reasoning from a part to the whole, from
particulars to generals or from the individual to the universal.

Six steps in the Scientific method

i) State the Problem or Question to be answered
ii) Make some related Observations
iii) Form a Hypothesis
iv) Test the Hypothesis (figure out a way to get some evidence)
v) Get some Results
vi) Make a Conclusion

a) Theories: A useful insight into the methodology applied in economics can be gained by distinction
between positive and normative economics. This enables one to appreciate the limitations and
scope of economics.

Economics makes use of the scientific methods to develop theories. Scientific inquiry is generally
confined to positive questions. One of the major objectives of sciences is to develop theories. A
theory is a general or unifying principle that describes and explains the relationship between things
observed in the world around us. A scientific theory does two things: it describes or explains
relationships between phenomena that we observe, and it makes testable predictions. Theories are
indispensable to any science, and over time they tend to be gradually improved, meaning that they fit
existing observations better and make more accurate forecasts. When a theory is initially developed it
is usually on the basis of casual observation, and is sometimes called a hypothesis. This then needs to
be tested and in order to do this an empirical study is required. An empirical study is one which
involves real-world observations. Such studies can be either experimental or observational: the
former involve a situation where the investigator can control the relevant variables to isolate the
variables under investigation and keep other factors constant.

A ‘good’ theory has the following characteristics:

i) It explains existing observations well.
ii) It makes accurate forecasts.
iii) It involves mensuration, meaning that the variables involved can be measured reliably and
accurately.
iv) It has general application, meaning that it can be applied in a large number of different
situations, not just a very limited number of cases.
v) It has elegance, meaning that the theory rests on a minimum number of assumptions.

Theory is used to refer to more general statements about economic relationships

b) Models: Because economics is a difficult subject area, involving complex interactions

among many people and variables, the pedagogical approach to learning the subject generally
involves initially making many assumptions about behaviour and relationships in order to build
simple models. A model in general terms is a representation of a system, which is simplified in
order to illustrate the important features and relationships involved.

19
 Economic models often involve diagrams, graphs or equations. Basic analysis is then performed
with these models, and conclusions drawn. This again relates to the neoclassical approach.
Another reason for using models is that it provides this very useful starting point, by making
necessary assumptions.

Thus, models refer to more particular statements, especially those that take the form of graphs or
equations.

1.10 Tools of analysis

i) Constrained Optimization
In mathematical optimization, constrained optimization (in some contexts called constraint
optimization) is the process of optimizing an objective function with respect to some variables in the
presence of constraints on those variables. Constrained optimization may be used to minimize cost
functions while maximizing output by defining functions that describe how inputs, such as land,
labor and capital, vary in value and determine total output, as well as total cost

ii) Demand and supply

The concepts of demand and supply are among the most important in all economics. They are of
course not the only tools of analysis in the economist’s armoury, but they allow us to identify and
understand the relevant factors in analysing many economic situations
a) Demand
Demand is one of the most fundamental concepts of economics and it is the backbone of a market
economy. In ordinary language, demand refers to the purchases made by a consumer. It is term as
desire or want for something's. Cigarettes harmful to persons, is demanded by one whose want it
satisfies (Goods are demanded, because they have utility). But a nonsmoker may not have any
demand for it, since he does not have a desire for its consumption.

In the economic sense demand refers to the quantities that people are or would be willing to buy at
different prices during a given time period, assuming that other factors affecting these quantities
remain the same.

It is worth noting that this definition incorporates three important concepts:

• It involves three parameters – price, quantity and time.
• It refers to quantities in the plural, therefore a whole relationship, not a single quantity.
• It involves the ceteris paribus (other things being equal) assumption, which is a very common
one in making statements in economics.

In economics Demand = Desire + ability to pay +willingness to pay for it

There is generally an inverse relationship between the quantity demanded and the price charged, and
this is customarily shown in the downward-sloping demand curve, although the relationship can
equally be expressed in terms of a function or equation.

20
 Activity 4: Drawing of the demand from demand Schedules

Schedule 1 Demand Curve 1

Price (Ksh) 100 80 60 40 20
Quantity (Units) 5 10 15 20 25

Schedule 2 Demand Curve 2

Price (Ksh) 1 3 6 9 12 15
Quantity (Units) 900 100 25 11 6 4

Graphs are much more useful for analysis, and indeed most analysis in introductory microeconomics
involves the use of graphs. Graphs relating to the above demand schedules are shown. It can be seen
that the demand relationship in first case is both inverse and linear, and in the second case it is inverse
and nonlinear. At this stage both of these characteristics are assumed, but later on both of these
assumptions will have to be examined. Again, the difference between the concepts of demand and
quantity demanded is illustrated: the former relates to the whole demand curve whereas the latter
relates to a single point on the curve. Although graphical analysis is very useful in economics its main
disadvantage is that it essentially involves a two-dimensional framework. Thus, it is mainly limited to
examining two-variable relationships. Demand relationships often involve many variables and
although the effects of these can be shown on a graph, they are difficult to measure.

21
 b) Supply
In the economic sense supply refers to the quantities that people are or would be willing to sell at
different prices during a given time period, assuming that other factors affecting these quantities
remain the same. When talking about the supply of products it is often the costs of production that
are most important in determining the supply relationship, and generally there is a direct relationship
between the quantity supplied and the price offered, with more being supplied the higher the price.
However, in factor markets, in particular the labour market, supply is more complex. The availability
of people with the relevant skills, the pleasantness of the work and the opportunity cost involved are
all important factors.

Activity 5: Drawing of the supply curves from supply schedules

Supply Schedule 1 Supply Curve 1

Price (Ksh) 100 80 60 40 20
Quantity (Units) 25 20 15 10 5

Supply Schedule 2 Supply Curve 2

Price (Ksh) 1 4 9 16 25 36
Quantity (Units) 10 20 30 40 50 60

iii) The Equilibrium Concept

In microeconomics, economic equilibrium may also be defined as the price at which supply equals
demand for a product, in other words where the hypothetical supply and demand curves intersect.
In demand (supply) analysis it is logical to treat the quantity demanded (supplied) as depending on
the price, and other variables if we want to include these in the equation on the righthand sides. Thus
all the independent variables in the situation should be on the righthand side of the equation. For
purposes of equilibrium analysis, price is put on the vertical axis and quantity on the horizontal axis.
22
Alfred Marshall1 was the first economist to develop this method, at the end of the nineteenth century.
However, the purpose of his analysis was different; he wanted to show how equilibrium prices were
determined in markets, in terms of the interaction of both demand and supply. Thus, he wanted to
show how much consumers were prepared to pay for certain quantities, and compare this with the
prices that suppliers wanted to receive in order to put such quantities onto the market. In this context
it is logical to treat price as a dependent variable; both price and quantity are simultaneously
determined by demand and supply, but Marshall and other neoclassical economists were primarily
concerned with price determination, since the price mechanism was seen as the key to allocating
resources in the economy

Activity 6: Illustration and discussion of equilibrium concept

iv) Comparative Statics

Comparative static analysis (comparative statics) compares the different equilibrium values
of the endogenous variables induced by changes in the values of exogenous variables and
parameters (given a specific model) i.e tests the way the equilibrium changes in response to
interventions or exogenous changes to the environment.

Comparative statics provides tools which can predict the changes in consumer demand
caused by changes in excise taxes, tariffs, and subsidies. The change in national income
due to changes in consumer investment, government spending, and interest rates can also
be predicted. The change in the market price of some specific commodity due to changes
in weather conditions, price of production inputs, and the availability of transport.

These kinds of predictions require the first derivatives of endogenous variables with respect
to (wrt) exogenous variables and parameters, using some plausible model.

****End of Lecture Note 1***

23
Review Questions:
i) Define economics
ii) Differentiate between microeconomics and macroeconomics
iii) Explain the rational principle of economics
iv) Differentiate between needs and wants
v) Explain the concept of opportunity cost
vi) What is “thinking at the margin”?
vii) Distinguish amongst economic, allocative, productive and technical efficiency
viii) Briefly discuss the classification of the world economic systems
ix) With the aid of a diagram explain the circular flow of economic activity for a four-sector
economy
x) What is a Production Possibility Frontier/Curve
xi) Define demand
xii) Define supply
xiii) Explain equilibrium concept
xiv) What are comparative statics

24