Introductory Microeconomics

Course: 101

Nature, Scope, and Basic Concepts of

Economics
Course Teacher: Dr. A. R.
Sarker
Professor
Department of Economics
The University of Rajshahi
learning objectives

Specific issues you will learn in this chapter:

•Definition of economics
•Major themes of economics
•Opportunity costs and economic efficiency
• Economic systems
• Basic economic problems and their answers
•Decisions making agents
•Methods in economics
•Major branches and schools of economics
What is economics?

Xenophon had invented the term

‘economics” in the fourth century BCE
( Before the Common Era)

The English term ‘economics’ is derived

from the Greek word ‘Oikonomia’…meaning
is managing a household with limited funds.

However, economists are far from unanimous

about the definition of their subject.
What is economics? -major definitions

 Adam Smith in this book “ An Inquiry into

the Nature and Causes of the Wealth of
Nations” (1776) defined economics as a
science of wealth.

He explained how a nation’s wealth is

created.
What is economics? -major definitions
 Smith argued that the keys to the “wealth
of nations” were production and exchange,
not the artificial acquisition of gold and silver
at the expense of other nations.

The wealth of a country consists, not its gold

and silver only, but in its lands, houses, and
consumable goods of all different kinds.
Wealth should be measured according to how
well people are lodged, clothed, and fed, not
according to the number of bags of gold in the
What is economics? -major definitions

Three ingredients to wealth and prosperity

1. Freedom: giving people economic
freedom to do what they wish with
little interference from the state
2. Competition: individuals have the
right to compete in the production and
exchange of goods and services.
3. Justice: the actions of individuals must
be just and honest, according to the
rules of society.
What is economics? -major definitions

Three ingredients to wealth and prosperity

These ingredients would lead to a natural
harmony of interest between the
participants/stakeholders.
His doctrine of self-interest/the invisible
hand: “ By pursuing his own self-
interest, every individual is led by an
invisible hand to promote the public
interest.
 What is economics? -major definitions

 Alfred Marshall in his book “Principles of

Economics” (1890) defines economics as follows:
“Political Economy or Economics is a study of
mankind in the ordinary business of life; it examines
that part of individual and social action which is most
closely connected with the attainment & with the use
of material requisites of well-being”

Economics is a study of wealth and a part of the

study of man.
What is economics? -major definitions

 Lionel Robbins in his book “ An Essay on

the Nature and Significance of Economic
Science” in 1932 defined economics as
follows:
“Economics is a science which studies
human behaviour as a relationship between
ends and scarce means which have alternative
uses.”
(Ends refer to human wants and means are
resources)
What is economics? -major definitions
The subject of economics is too broad.
According to Jacob Viner, “ Economics is
what economists do”
A good definition of economics:
Economics is the study of choice under the
condition of scarcity.
It is a social science. It is social because it
involves people and their behavior. It is a
science because it uses a scientific approach in
investigation of choices.
An ‘imperialist’ social science
What is economics? Basic themes
1. Scarcity
The condition in which wants are forever
greater than the available supply of time,
goods, and resources.

Scarcity exists simply because it is human

nature for people to want more than they can
have, which forces people to make choices.
What is economics? Basic themes
2. Choice

Choice and scarcity go together.

Individuals, businesses, and societies must

choose among alternatives
 What is economics? Basic themes
3. Specialization
Economics studies why participants in the
economy (people, business, countries)
specialize in tasks to which they are
particularly suited.
According to Adam Smith, specialization
creates wealth. Without specialization, we
could not enjoy the high living standards.
Division of labour was Adam Smith’s term for
specialization.
 What is economics? Basic themes
4. Exchange/trade
 Exchange complements specialization.
Specialized producers cannot meet their
own consumption needs from their own
production.
Exchange is all around us.
A country like America exchanges its
wheat for TV sets made in Japan.
•
Scarcity and Resources
What does Scarcity force us to do?
• It forces us to make choices/ economic decisions
(where to work, what to produce, how much to sell)
• What are Resources?
– The basic categories of inputs used to produce
goods and services
• What are the three categories of Resources?
• What is Entrepreneurship?
– Entrepreneurship organizes resources to produce goods
and services
Opportunity costs and efficiency
Efficiency denotes the most effective use
of a society’s resources in satisfying
people’s wants and needs.

Economic efficiency requires that an

economy produces the highest
combination of quantity and quality of
goods and services given its technology
and scarce resources.
 Opportunity costs and efficiency
Opportunity costs
 In a world of scarcity, choosing one
thing means giving up something else.
The opportunity cost of a decision or
choice that one makes is the value of
the highest valued alternative that could
have been chosen but was instead
forgone.
 The Production Possibility Curve
• What is a PPC/PPF?
• - A graphical device that is used for economic analysis
of production decisions
– A curve that shows the maximum combinations of
two outputs that an economy can produce, given its
available resources and technology
( Technology: The body of knowledge and skills applied to
how goods are produced)
• Assumptions
 Fixed resources, Fully employed resources, Technology
unchanged
 The PPF

(Unattain
able)
Inefficient
Production Possibilities 2.1 LEARNING OBJECTIVE

Frontiers Use a production possibilities

frontier to analyze opportunity costs
and trade-offs.

and Opportunity
Increasing Marginal OpportunityCosts
Costs

FIGURE 2-2
Increasing Marginal
Opportunity Costs
As the economy moves down the
production possibilities frontier, it
experiences increasing marginal
opportunity costs because
increasing automobile production
by a given quantity requires larger
and larger decreases in tank
production.
For example, to increase automobile
production from 0 to 200—moving
from point A to point B—the
economy has to give up only 50
tanks.
But to increase automobile
production by another 200 vehicles
— moving from point B to point C
—the economy has to give up 150
tanks.
 The PPC/PPF
• Efficient point
– Any combination of goods for which currently
available resources do not allow an increase in
the production of one good without a reduction
in the production of the other.
• Inefficient point
– Any combination of goods for which currently
available resources enable an increase in the
production of one good without a reduction in
the production of the other.
Multiple choice questions
What is the
opportunity
cost ( what
you
sacrifice) of
producing
400 aircraft
carriers?
 Multiple choice questions
• Which graph best represents an increase in the
economy’s resources?
More economic resources and
technological change (economic
growth) Technological change in
automobile industry
Applications of PPC
Application of PPC
Application of PPC
 Decision making agents
• Individuals
– Individuals are the basic units of a society
– the individual here will be understood as
making decisions for his or her family or
household
• Business firms
– Business firms are artificial units
– Every firm is ultimately owned by or operated
for the benefit of one or more individuals.
 Decision making agents
• Governments
– Governments are also economic decision-
makers
– Governments set the legal framework
within which the entire economy works
– Unlike firms and individuals,
governments have the legal right to take
property without consent (as by taxation)
 Decision making agents
• Other agents
– Trade unions and cartels (organization of
sellers)
– Voluntary associations such as clubs,
foundations, and religious institutions
(through which individuals combine for
collective consumption choices)
 Objects of Choice and Economic
Activities
The objects of economic choice are called
commodities or goods
Consumption is the ultimate economic
activity
Production by individuals and firms is a
second economic activity
The third main economic activity is exchange
– Trade neither creates nor destroys goods
and services,
Inputs and Output Markets : The Circular-
Flow Diagram
• The circular-flow diagram is a
visual model of the economy
that shows how dollars flow
through markets among
households and firms.
• Flow of economic activity
Figure 1 The Circular Flow

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell Goods and
Goods
•Households buy services
and services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Copyright © 2004 South-Western

Figure 1 The Circular Flow
Figure 1 The Circular Flow
 The Circular-Flow Diagram-flow of
economic actibity
• Firms
– Produce and sell goods and services
– Hire and use factors of production

• Households
– Buy and consume goods and services
– Own and sell factors of production
 Our First Model: The Circular-Flow
Diagram
• Markets for Goods and Services
– Firms sell
– Households buy

• Markets for Factors of Production

– Households sell
– Firms buy
Three problems of every economy
What to produce?
– What commodities are produced (and in what
quantities)?
– Should society devote its limited resources to
producing civilian or military goods; luxuries
or necessities?
– Should more agricultural or more industrial
goods be produced?
Three problems of every economy
How to produce ?
Once the decision is made on what to produce, society must
determine what combinations of the factors of production
will used.
How are goods produced?
A trade-off between using more workers and using more
machines
Will coal, petroleum, or nuclear power be used to produce
electricity?
Will bulldozers or workers with shovels dig dams?
Three problems of every economy
For whom to produce?
 For whom are goods produced?
 Who gets to eat the fruit of economic activity?
 Will society’s output be divided fairly equally?
 Will differences in wealth be allowed to pass
from one generation to the next?
 What role will government play in determining
for whom?
 Should government intercede to change the
way the economy is distributing its output?
Three problems of every economy
For whom to produce?
 Who will receive goods and services
produces?
 It depends mostly on how income is
distributed
 Individuals with the highest income have
ability to buy the most goods and
services.
 Answering the problems
• Answers depend on the type of the
economic system:
The set of organizational arrangements
and institutions that are established to
solve the economic problems is called
an economic system.
[ Forms of ownership, state interference in the economy, pricing
and competition etc. ]

The way in which the means of production

and distribution of goods are organized
 Answering the problems
• Types of economic system: socialist,
capitalist, and mixed
• Centrally planned economy/centralized
economy/socialist/communist
– An economy in which government decides
how economic resources will be allocated
– Government decides what to produce, how to
produce them and who would receive them
Examples: Former Soviet Union, Cuba, North
Korea
 Answering the problems
• Market economy/ free-enterprise economy
– An economy in which government does not
control economic activity ( ME relies
primarily on firms)
– An economy in which the decisions of
households and firms interacting in markets
allocate resources
– Markets, rather than the government, is the
determining factor
– All problems are solved by the price
mechanism
 Answering the problems
• Mixed economy
– An economy in which most economic
decisions result from the interaction of buyers
and sellers in markets, but in which the
government plays a significant role in the
allocation of resources
– Social security system/ safety nets
– Public goods: roads, street lighting, and
national defense, education and health services
, protection of the environment
 Answering the problems
• Answers to what to produce
– In a free-enterprise economy, the “what to produce” problem is solved by
the price mechanism
– In a mixed economy such as ours, the government (through taxes,
subsidies, etc.) modifies and, in some instances (through direct controls),
replaces the operation of the price mechanism in its function of
determining what to produce
– In a completely centralized economy, the dictator, or more likely a
planning committee appointed by the dictator or the party, determines
what to produce
 Answering the problems
• Answers to how to produce
– In a free-enterprise economy, the “how to
produce” problem is solved by the price
mechanism
– In a mixed-enterprise economy, the operation of the
price mechanism in solving the “how to produce”
problem is modified and sometimes replaced by a
government action
– In a centralized economy, this problem is solved by a
planning committee.
 Answering the problems
• Answers to “ for whom to produce” ?
– In market economy, the problem of “for whom to
produce” is also solved by the price mechanism

– In the name of equity and fairness, governments usually

modify the workings of the price mechanism by taking
from the rich (through taxation) and redistributing to
the poor (through subsidies and welfare payments)

– They also raise taxes in order to provide for certain

“public” goods, such as education, law and other, and
defense.
 The Scope of Economics-Branches
Microeconomics—mikros -“small”
The microeconomics is concerned with the
behaviour of individual actors/agents/units of the
economy: households, business firms, and
governments.
Microeconomic Questions
How many jobs will open up in the ICT industry?
What will happen to the cigarette price over next five years?
How would phone companies be affected by a tax on
imported cell phones?
The Scope of Economics- branches
Macroeconomics-makros “large”
-It studies economy as a whole.
-The economic behavior of aggregates—income,
employment, output, and so on—on a national scale
GDP, GNP, CPI, the unemployment rate, and the
government surplus and deficit.
Questions
What are the determinants of inflation?
What is the relationship between the money supply and
inflation?
The Scope of Economics- branches
Which of the following topics would fall under
microeconomics? Which under macroeconomics?
The price of fish
The interest rate
Employment in the ICT industry
The general price level
The national unemployment rate
Unemployment in Rajshahi city
The number of new homes built in Bangladesh
The price of tomatoes
 Methodology in Economics
Economists rely heavily on economic theories
to explain how the economy works.

Logical theories explain how the economy

works by showing how the facts fit together in
a coherent manner.

To predict and explain the economic behaviour

of individual consumers, business firms and the
operation of individual markets economists use
theories or models.
 Methodology in Economics
Theories
A theory is simply a plausible and coherent
explanation of how certain facts are related.

A theory is a partially verified statement concerning

the relationship among variables

A theory is a conceptualization or description, of a

phenomenon that attempts to integrate all that we
know about the phenomenon into a concise statement
or question.
 Methodology in Economics
Hypothesis
A prediction about the variables being studied
An educated and testable guess about the answer to
research questions

An hypothesis can either be supported or refuted on

the basis of data

Example: If people exercise for 30 minutes per day at

least three days per week, then their cholesterol levels
will be reduced
 Positive Versus Normative
Analysis
• Positive statements are statements that
attempt to describe the world as it is.
– Called descriptive analysis
• Normative statements are statements
about how the world should be.
– Called prescriptive analysis
– Also called policy economics
 Why do we study economics?
•There are four main reasons to study economics:
• to learn a way of thinking,
• to understand society,
• to understand global affairs, and
• to be an informed voter.
 Why do we study economics?
•There are four main reasons to study economics:
• to learn a way of thinking,
• to understand society,
• to understand global affairs, and
• to be an informed voter.