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Chapter 1
IntroductionIntroductionIntroductionIntroductionIntroduction
1.1 A SIMPLE ECONOMY
Think of any society. People in the society need many goods and
services1
in their everyday life including food, clothing, shelter,
transport facilities like roads and railways, postal services and
various other services like that of teachers and doctors. In fact, the
list of goods and services that any individual2
needs is so large that
no individual in society, to begin with, has all the things she needs.
Every individual has some amount of only a few of the goods and
services that she would like to use. A family farm may own a plot of
land, some grains, farming implements, maybe a pair of bullocks
and also the labour services of the family members. A weaver may
have some yarn, some cotton and other instruments required for
weavingcloth.Theteacherinthelocalschoolhastheskillsrequired
to impart education to the students. Some others in society may
nothaveanyresource3
exceptingtheirownlabourservices.Eachof
these decision making units can produce some goods or services
by using the resources that it has and use part of the produce to
obtain the many other goods and services which it needs. For
example, the family farm can produce corn, use part of the produce
for consumption purposes and procure clothing, housing and
various services in exchange for the rest of the produce. Similarly,
theweavercangetthegoodsandservicesthatshewantsinexchange
for the cloth she produces in her yarn. The teacher can earn some
money by teaching students in the school and use the money for
obtaining the goods and services that she wants. The labourer also
can try to fulfill her needs by using whatever money she can earn by
working for someone else. Each individual can thus use her
resources to fulfill her needs. It goes without saying that no
individual has unlimited resources compared to her needs. The
amount of corn that the family farm can produce is limited by the
amountofresourcesithas,andhence,theamountofdifferentgoods
1
By goods we means physical, tangible objects used to satisfy people’s wants and needs. The
term ‘goods’ should be contrasted with the term ‘services’, which captures the intangible satisfaction
of wants and needs. As compared to food items and clothes, which are examples of goods, we can
think of the tasks that doctors and teachers perform for us as examples of services.
2
By individual, we mean an individual decision making unit. A decision making unit can be a
single person or a group like a household, a firm or any other organisation.
3
By resource, we mean those goods and services which are used to produce other goods and
services, e.g. land, labour, tools and machinery, etc.
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IntroductoryMicroeconomics
and services that it can procure in exchange of corn is also limited. As a result, the
family is forced to make a choice between the different goods and services that are
available. It can have more of a good or service only by giving up some amounts of
other goods or services. For example, if the family wants to have a bigger house, it
may have to give up the idea of having a few more acres of arable land. If it wants
more and better education for the children, it may have to give up some of the
luxuries of life. The same is the case with all other individuals in society. Everyone
faces scarcity of resources, and therefore, has to use the limited resources in the
best possible way to fulfill her needs.
In general, every individual in society is engaged in the production of some
goods or services and she wants a combination of many goods and services not
all of which are produced by her. Needless to say that there has to be some
compatibility between what people in society collectively want to have and what
they produce4
. For example, the total amount of corn produced by family farm
along with other farming units in a society must match the total amount of corn
that people in the society collectively want to consume. If people in the society
do not want as much corn as the farming units are capable of producing
collectively, a part of the resources of these units could have been used in the
production of some other good or services which is in high demand. On the
other hand, if people in the society want more corn compared to what the farming
units are producing collectively, the resources used in the production of some
other goods and services may be reallocated to the production of corn. Similar is
the case with all other goods or services. Just as the resources of an individual
are scarce, the resources of the society are also scarce in comparison to what the
people in the society might collectively want to have. The scarce resources of the
society have to be allocated properly in the production of different goods and
services in keeping with the likes and dislikes of the people of the society.
Any allocation5
of resources of the society would result in the production of a
particular combination of different goods and services. The goods and services
thus produced will have to be distributed among the individuals of the society.
Theallocationofthelimitedresourcesandthedistributionofthefinalmixofgoods
and services are two of the basic economic problems faced by the society.
In reality, any economy is much more complex compared to the society
discussed above. In the light of what we have learnt about the society, let us now
discuss the fundamental concerns of the discipline of economics some of which
we shall study throughout this book.
1.2 CENTRAL PROBLEMS OF AN ECONOMY
Production, exchange and consumption of goods and services are among the
basic economic activities of life. In the course of these basic economic activities,
every society has to face scarcity of resources and it is the scarcity of resources
that gives rise to the problem of choice. The scarce resources of an economy
have competing usages. In other words, every society has to decide on how to
use its scarce resources. The problems of an economy are very often summarised
as follows:
4
Here we assume that all the goods and services produced in a society are consumed by the people
in the society and that there is no scope of getting anything from outside the society. In reality, this
is not true. However, the general point that is being made here about the compatibility of production
and consumption of goods and services holds for any country or even for the entire world.
5
By an allocation of the resources, we mean how much of which resource is devoted to the
production of each of the goods and services.
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Introduction
What is produced and in what quantities?
Every society must decide on how much of each of the many possible goods and
services it will produce. Whether to produce more of food, clothing, housing or
to have more of luxury goods. Whether to have more agricultural goods or to
have industrial products and services. Whether to use more resources in education
and health or to use more resources in building military services. Whether to
have more of basic education or more of higher education. Whether to have
more of consumption goods or to have investment goods (like machine) which
will boost production and consumption tomorrow.
How are these goods produced?
Every society has to decide on how much of which of the resources to use in the
production of each of the different goods and services. Whether to use more
labour or more machines. Which of the available technologies to adopt in the
production of each of the goods?
For whom are these goods produced?
Who gets how much of the goods that are produced in the economy? How should
the produce of the economy be distributed among the individuals in the economy?
Who gets more and who gets less? Whether or not to ensure a minimum amount
of consumption for everyone in the economy. Whether or not elementary education
and basic health services should be available freely for everyone in the economy.
Thus, every economy faces the problem of allocating the scarce resources to
the production of different possible goods and services and of distributing the
produced goods and services among the individuals within the economy. The
allocation of scarce resources and the distribution of the final goods and
services are the central problems of any economy.
Production Possibility Frontier
Just as individuals face scarcity of resources, the resources of an economy
as a whole are always limited in comparison to what the people in the
economy collectively want to have. The scarce resources have alternative
usages and every society has to decide on how much of each of the resources
to use in the production of different goods and services. In other words,
every society has to determine how to allocate its scarce resources to different
goods and services.
An allocation of the scarce resource of the economy gives rise to a
particular combination of different goods and services. Given the total amount
of resources, it is possible to allocate the resources in many different ways
and, thereby achieving different mixes of all possible goods and services. The
collection of all possible combinations of the goods and services that can be
produced from a given amount of resources and a given stock of technological
knowledge is called the production possibility set of the economy.
EXAMPLE 1
Consider an economy which
can produce corn or cotton
by using its resources.
Table 1.1 gives some of the
combinations of corn and
cotton that the economy can
produce.
Table1.1: Production Possibilities
Possibilities Corn Cotton
A 0 10
B 1 9
C 2 7
D 3 4
E 4 0
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If all the resources are used in the production of corn, the maximum
amount of corn that can be produced is 4 units and if all resources are
used in the production of cotton, at the most, 10 units of cotton can be
produced. The economy can also produce1 unit of corn and 9 units of
cotton or 2 units of corn and 7 units of cotton or 3 units of corn and 4
units of cotton. There can be many other possibilities. The figure illustrates
the production possibilities of the economy. Any point on or below the
curve represents a combination of corn and cotton that can be produced
with the economy’s resources. The curve gives the maximum amount of
corn that can be produced in the economy for any given amount of cotton
and vice-versa. This curve is called the production possibility frontier.
The production possibility frontier
gives the combinations of corn and
cotton that can be produced when
the resources of the economy are fully
utilised. Note that a point lying
strictly below the production
possibility frontier represents a
combination of corn and cotton
that will be produced when all or
some of the resources are either
underemployed or are utilised in a
wasteful fashion.
If more of the scarce resources are used in the production of corn,
less resources are available for the production of cotton and vice versa.
Therefore, if we want to have more of one of the goods, we will have
less of the other good. Thus, there is always a cost of having a little
more of one good in terms of the amount of the other good that has to
be forgone. This is known as the opportunity costa
of an additional
unit of the goods.
Every economy has to choose one of the many possibilities that it
has. In other words, one of the central problems of the economy is to
choose from one of the many production possibilities.
a
Note that the concept of opportunity cost is applicable to the individual as well as the
society. The concept is very important and is widely used in economics. Because of its
importance in economics, sometimes, opportunity cost is also called the economic cost.
1.3 ORGANISATION OF ECONOMIC ACTIVITIES
Basic problems can be solved either by the free interaction of the individuals
pursuing their own objectives as is done in the market or in a planned manner
by some central authority like the government.
1.3.1 The Centrally Planned Economy
In a centrally planned economy, the government or the central authority plans
all the important activities in the economy. All important decisions regarding
production, exchange and consumption of goods and services are made by the
government. The central authority may try to achieve a particular allocation of
resources and a consequent distribution of the final combination of goods and
services which is thought to be desirable for society as a whole. For example, if it
is found that a good or service which is very important for the prosperity and
Cotton
A
B
C
D
E
O Corn
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Introduction
well-being of the economy as a whole, e.g. education or health service, is not
produced in adequate amount by the individuals on their own, the government
might try to induce the individuals to produce adequate amount of such a good
or service or, alternatively, the government may itself decide to produce the good
or service in question. In a different context, if some people in the economy get
so little a share of the final mix of goods and services produced in the economy
that their survival is at stake, then the central authority may intervene and try
to achieve an equitable distribution of the final mix of goods and services.
1.3.2 The Market Economy
In contrast to a centrally planned economy, in a market economy, all economic
activities are organised through the market. A market, as studied in economics,
is an institution6
which organises the free interaction of individuals pursuing
their respective economic activities. In other words, a market is a set of
arrangements where economic agents can freely exchange their endowments or
products with each other. It is important to note that the term ‘market’ as used
in economics is quite different from the common sense understanding of a
market. In particular, it has nothing as such to do with the marketplace as you
might tend to think of. For buying and selling commodities, individuals may or
may not meet each other in an actual physical location. Interaction between
buyers and sellers can take place in a variety of situations such as a village-
chowk or a super bazaar in a city, or alternatively, buyers and sellers can interact
with each other through telephone or internet and conduct the exchange of
commodities. The arrangements which allow people to buy and sell commodities
freely are the defining features of a market.
For the smooth functioning of any system, it is imperative that there is
coordination in the activities of the different constituent parts of the system.
Otherwise, there can be chaos. You may wonder as to what are the forces which
bring the coordination between the activities of millions of isolated individuals
in a market system.
In a market system, all goods or services come with a price (which is mutually
agreed upon by the buyers and sellers) at which the exchanges take place. The
price reflects, on an average, the society’s valuation of the good or service in
question. If the buyers demand more of a certain good, the price of that good
will rise. This will send a signal to the producer of that good to the effect that the
society as a whole wants more of that good than is currently being produced
and the producers of the good, in their turn, are likely to increase their production.
In this way, prices of goods and services send important information to all the
individuals across the market and help achieve coordination in a market system.
Thus, in a market system, the central problems regarding how much and what
to produce are solved through the coordination of economic activities brought
about by the price signals.
In reality, all economies are mixed economies where some important
decisions are taken by the government and the economic activities are by and
large conducted through the market. The only difference is in terms of the
extent of the role of the government in deciding the course of economic activities.
In the United States of America, the role of the government is minimal. The
closest example of a centrally planned economy is the Soviet Union for the
major part of the twentieth century. In India, since Independence, the
government has played a major role in planning economic activities. However,
6
An institution is usually defined as an organisation with some purpose.
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the role of the government in the Indian economy has been reduced considerably
in the last couple of decades.
1.4 POSITIVE AND NORMATIVE ECONOMICS
It was mentioned earlier that in principle there are more than one ways of
solving the central problems of an economy. These different mechanisms in
general are likely to give rise to different solutions to those problems, thereby
resulting in different allocations of the resources and also different distributions
of the final mix of goods and services produced in the economy. Therefore, it is
important to understand which of these alternative mechanisms is more
desirable for the economy as a whole. In economics, we try to analyse the
different mechanisms and figure out the outcomes which are likely to result
under each of these mechanisms. We also try to evaluate the mechanisms by
studying how desirable the outcomes resulting from them are. Often a
distinction is made between positive economic analysis and normative
economic analysis depending on whether we are trying to figure out how a
particular mechanism functions or we are trying to evaluate it. In positive
economic analysis, we study how the different mechanisms function, and in
normative economics, we try to understand whether these mechanisms are
desirable or not. However, this distinction between positive and normative
economic analysis is not a very sharp one. The positive and the normative
issues involved in the study of the central economic problems are very closely
related to each other and a proper understanding of one is not possible in
isolation to the other.
1.5 MICROECONOMICS AND MACROECONOMICS
Traditionally, the subject matter of economics has been studied under two broad
branches: Microeconomics and Macroeconomics. In microeconomics, we study
the behaviour of individual economic agents in the markets for different goods
and services and try to figure out how prices and quantities of goods and services
are determined through the interaction of individuals in these markets. In
macroeconomics, on the other hand, we try to get an understanding of the
economy as a whole by focusing our attention on aggregate measures such as
total output, employment and aggregate price level. Here, we are interested in
finding out how the levels of these aggregate measures are determined and how
the levels of these aggregate measures change over time. Some of the important
questions that are studied in microeconomics are as follows: What is the level of
total output in the economy? How is the total output determined? How does the
total output grow over time? Are the resources of the economy (eg labour) fully
employed? What are the reasons behind the unemployment of resources? Why
do prices rise? Thus, instead of studying the different markets as is done in
microeconomics, in macroeconomics, we try to study the behaviour of aggregate
or macro measures of the performance of the economy.
1.6 PLAN OF THE BOOK
This book is meant to introduce you to the basic ideas in microeconomics. In
this book, we will focus on the behaviour of the individual consumers and
producers of a single commodity and try to analyse how the price and the
quantity is determined in the market for a single commodity. In Chapter 2, we
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Introduction
KKKKKeyConceptseyConceptseyConceptseyConceptseyConcepts
Consumption Production Exchange
Scarcity Production possibilities Opportunity cost
Market Market economy Centrally planned economy
Mixed economy Positive analysis Normative analysis
Microeconomics Macroeconomics
?
? 1. Discuss the central problems of an economy.
2. What do you mean by the production possibilities of an economy?
3. What is a production possibility frontier?
4. Discuss the subject matter of economics.
5. Distinguish between a centrally planned economy and a market economy.
6. What do you understand by positive economic analysis?
7. What do you understand by normative economic analysis?
8. Distinguish between microeconomics and macroeconomics.
ExercisesExercisesExercisesExercisesExercises
shall study the consumer’s behaviour. Chapter 3 deals with basic ideas of
production and cost. In Chapter 4, we study the producer’s behaviour. In Chapter
5, we shall study how price and quantity is determined in a perfectly competitive
market for a commodity. Chapter 6 studies some other forms of market.
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