Nazlawi business college

Chapter 1
Introduction
WHAT ECONOMICS IS ALL ABOUT?
• Economics is about economizing; that is, about choice among alternative
uses of scarce resources. Choices are made by millions of individuals,
businesses, and government units. Economics examines how these
choices add up to an economic system, and how this system operates.
• Scarcity is central to economic theory. Economic analysis is fundamentally
about the maximization of something (leisure time, wealth, health,
happiness—all commonly reduced to the concept of utility) subject to
constraints. These constraints—or scarcity—inevitably define a tradeoff.
For example, one can have more money by working harder, but less time
(there are only so many hours in a day, so time is scarce).
Continue
• Economics as a subject came into being with the publication of very popular
book in 1776, “An Enquiry into the Nature and Causes of Wealth of Nations”,
written by Prof. Adam Smith. At that time it was called Political economy, which
remained operational at least up to the middle part of the 19th century. It is
since then that the economists developed tools and principles using inductive
and deductive reasoning. In fact, the ‘Wealth of Nations’ is a landmark in the
history of economic thought that separated economics from other social
sciences.
• The word ‘Economics’ was derived from the Greek words ‘Oikos’ (a house) and
‘Nem ein’ (to manage), which meant managing a household, using the limited
money or resources a household has.
• In short, economics is a social science concerned with the use of scarce
resources in an optimum manner and in attainment of desired level of income,
output, employment and economic growth.
Definitions of Economics
• On first encountering economics, you may want a definition.
• Economic is the study of those activities that involve the production and exchange
goods.
• Economic analyze movements in the overall economy-trends in prices, output,
unemployment.
• Economics is the science of choice. It studies how people choose to use scarce or
limited productive resources( land, labor, equipment, technical knowledge), to
produce various commodities (such as wheat, beef, roads, concerts), and to
distribute these goods to various members of society for their consumption.
• Economics is the study of commerce among nations. It helps explain why nations
export some goods and import others, and analyzes the effects of putting economic
barriers at national frontiers.
• Economic is the study of money, banking, capital and wealth.
• Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different group.
SUBJECT MATTER OF ECONOMICS
• The subject matter of economics is divided into two categories–
microeconomics and macroeconomics. Microeconomics, which deals
with individual agents, such as households and businesses, and
macroeconomics, which considers the economy as a whole, in which
case it considers aggregate supply and demand for money, capital and
commodities. Aspects receiving particular attention in economics are
resource allocation, production, distribution, trade, and competition.
Introduction to Microeconomics
• Microeconomics seeks to analyze the market form or other types of
mechanisms that establish relative prices amongst goods and services and/or
allocates society’s resources amongst their
• many alternative uses. In microeconomics, we study the following:
• 1. Theory of product pricing, which includes-
• (a) Theory of consumer behaviour.
• (b) Theory of production and costs.
• 2. Theory of factor pricing, which constitutes-
• (a) Theory of wages.
• (b) Theory of rent.
• (c) Theory of interest.
• (d) Theory of profits.
• 3. Theory of economic welfare.
THE FUNCTION OF MICROECONOMIC
THEORY
• Microeconomic theory, or price theory, studies the economic
behavior of individual decision-making units such as consumers,
resource owners, and business firms in a free-enterprise economy.
Explains

• Microeconomics has occupied a very important place in the study of economic theory. In fact, it is
the stepping–stone to economic theory. It has both theoretical and practical implications. Important
points of its significance are mentioned as under:
• 1. Microeconomics is of great help in the efficient management of the limited resources available in
a country.
• 2. Microeconomics is helpful in understanding the working of free enterprise economy where there
is no central control.
• 3. Microeconomics is utilized to explain the gains from international trade, balance of payments
disequilibrium and determination of foreign exchange rate.
• 4. It explains how through market mechanism goods and services produced in the community are
distributed.
• 5. It helps in the formulation of economic policies, which are meant for promoting efficiency in
production, and welfare of the people.
• 6. Microeconomics is the basis of welfare economics.
• 7. Microeconomics is used for constructing economic models for better understanding of the actual
economic phenomena.
THE PURPOSE OF THEORY
• The purpose of theory is to predict and explain. A theory is a hypothesis that has been
successfully tested. A hypothesis is tested not by the realism of its assumption(s) but by its
ability to predict accurately and explain, and also by showing that the outcome follows
logically and directly from the assumptions.
• EXAMPLE 1. From talking to friends and neighbors, from observations in the butcher shop,
and from our own behavior, we observe that when the price of a particular cut of meat
rises, we buy less of it. From this casual real-world observation, we could construct the
following general hypothesis: “If the price of a commodity rises, then the quantity
demanded of the commodity declines.” In order to test this hypothesis and arrive at a
theory of demand, we must go back to the real world to see whether this hypothesis is
indeed true for various commodities, for various people, and at different points in time.
Since these outcomes would follow logically and directly from the assumptions (i.e.,
consumers would want to substitute cheaper for more expensive commodities) we would
accept the hypothesis as a theory.
THE PROBLEM OF SCARCITY
• The word scarce is closely associated with the word limited or economic as
opposed to unlimited or free. Scarcity is the central fact of every society.
• EXAMPLE 2. Economic resources are the various types of labor, capital,
land, and entrepreneurship used in producing goods and services. Since the
resources of every society are limited or scarce, the ability of every society
to produce goods and services is also limited. Because of this scarcity, all
societies face the problems of what to produce, how to produce, for whom
to produce, how to ration the commodity over time, and how to provide for
the maintenance and growth of the system. In a free-enterprise economy
(i.e., one in which the government does not control economic activity), all
these problems are solved by the price mechanism
MARKETS, FUNCTIONS, AND EQUILIBRIUM
• A market is the place or context in which buyers and sellers buy and sell goods, services, and resources.
We have a market for each good, service, and resource bought and sold in the economy.
• A function shows the relationship between two or more variables. It indicates how the value of one
variable (the dependent variable) depends on and can be found by specifying the value of one or more
other (independent) variables.
• Equilibrium refers to the market condition which once achieved, tends to persist. Equilibrium results
from the balancing of market forces.
• EXAMPLE 4. The market demand function for a commodity gives the relationship between the quantity
demanded of the commodity per time period and the price of the commodity (while keeping everything
else constant). By substituting various hypothetical prices (the independent variable) into the demand
function, we get the corresponding quantities demanded of the commodity per time period (the
dependent variable). The market supply function for a commodity is an analogous concept—except that
we now deal with the quantity supplied rather than the quantity demanded of the commodity.
• EXAMPLE 5. The market equilibrium for a commodity occurs when the forces of market demand and
market supply for the commodity are in balance. The particular price and quantity at which this occurs
tend to persist in time and are referred to as the equilibrium price and the equilibrium quantity of the
commodity.
COMPARATIVE STATICS AND
DYNAMICS
• Comparative statics studies and compares two or more equilibrium positions,
without regard to the transitional period and process involved in the adjustment.
• Dynamics, on the other hand, deals with the time path and the process of
adjustment itself. In this book we deal almost exclusively with comparative
statics.
• EXAMPLE 6. Starting from a position of equilibrium, if the market demand for a
commodity, its supply, or both vary, the original equilibrium will be disturbed and
a new equilibrium usually will eventually be reached. Comparative statics studies
and compares the values of the variables involved in the analysis at these two
equilibrium positions, while dynamic analysis studies how these variables change
over time as one equilibrium position evolves into another.
PARTIAL EQUILIBRIUM AND GENERAL
EQUILIBRIUM ANALYSIS
• Partial equilibrium analysis is the study of the behavior of individual decision-making units and
the working of individual markets, viewed in isolation.
• General equilibrium analysis, on the other hand, studies the behavior of all individual decision-
making units and all individual markets, simultaneously.
• General equilibrium analysis studies how the price of every good, service, and factors depends
on the price of every other good, service, and factors. Thus, a change in any price will affect
every other price in the system.
• EXAMPLE 7. The change in the equilibrium condition of the commodity in Example 5 was
examined only in terms of what happens in the market of that particular commodity. That is,
we abstracted from all other markets by implicitly keeping everything else constant (the
“ceteris paribus” assumption). We were then dealing with partial equilibrium analysis. However,
when the equilibrium condition for this commodity changes, it will affect to a greater or lesser
degree and directly or indirectly the market for every other commodity, service, and factor.
POSITIVE ECONOMICS AND
NORMATIVE ECONOMICS
• Positive economics deals with or studies what is, or how the economic problems facing
a society are actually solved.
• Normative economics, on the other hand, deals with or studies what ought to be, or
how the economic problems facing the society should be solved. This book deals
primarily with positive economics.
• EXAMPLE 8. Suppose that a firm pollutes the air in the process of producing its output.
If we study how much additional cleaning cost is imposed on the community by this
pollution, we are dealing with positive economics. Suppose that the firm threatens to
move out rather than pay for installing antipollution equipment. The community must
then decide whether it will allow the firm to continue to operate and pollute, pay for
the antipollution equipment itself, or just force the firm out with a resulting loss of
jobs. In reaching these decisions, the community is dealing with normative economics.
Glossary
• Dynamics: The study of the time path and process of adjustment to disequilibrium.
• Equilibrium :The market condition which once achieved tends to persist.
• Function :The relationship between two or more variables.
• General equilibrium analysis :The study of the behavior of individual decision-making units and all individual
markets simultaneously.
• Hypothesis: An “if-then” statement usually obtained from a causal observation of the real world.
• Market: The place or context in which buyers and sellers buy and sell goods, services, and resources.
• Microeconomic theory or price theory :The study of the economic behavior of individual decision-making units
such as consumers, resource owners, and business firms in a free-enterprise economy.
• Normative economics: The study of what ought to be, or how the economic problems facing the society should
be solved.
• Partial equilibrium analysis: The study of the behavior of individual decision-making units and the working of
individual markets, viewed in isolation.
• Positive economics :The study of what is, or how the economic problems facing a society are actually solved.
• Scarce: Limited, or economic (as opposed to unlimited, or free).
• Theory :A hypothesis that has been successfully tested.
 Review Questions

• 1. A theory is
(a) an assumption,
(b) an “if-then” proposition,
(c) a hypothesis, or
(d) a validated hypothesis.
• 2. A hypothesis is tested by
(a) the realism of its assumption(s),
(b) the lack of realism of its assumption(s),
(c) its ability to predict accurately an outcome that follows logically from
the assumption(s), or
(d) none of the above.
2
• 3. The meaning of the word “economic” is most closely associated with the
word
(a) free,
(b) scarce,
(c) unlimited, or
(d) unrestricted.
• 4. Microeconomic theory studies how a free-enterprise economy determines
(a) the price of goods,
(b) (b) the price of services,
(c) the price of economic resources, or
(d) all of the above.
3

• 6. A market
(a) necessarily refers to a meeting place between buyers and sellers,
(b) does not necessarily refer to a meeting place between buyers and sellers,
(c) extends over the entire nation, or
(d) extends over a city.
• 7. A function refers to
(a) the demand for a commodity,
(b) the supply of a commodity,
(c) the demand and supply of a commodity, service, or resource, or
(d) the relationship between one dependent variable and one or more independent variables.
• 8. The market equilibrium for a commodity is determined by
(a) the market demand for the commodity,
(b) the market supply of the commodity,
(c) the balancing of the forces of demand and supply for the commodity, or
(d) any of the above.
4

• 9. Which of the following is incorrect?

(a) Microeconomics is concerned primarily with the problem of what, how, and for whom to
produce.
(b) Microeconomics is concerned primarily with the economic behavior of individual decision-making
units when at equilibrium.
(c) Microeconomics is concerned primarily with the time path and process by which one equilibrium
position evolves into another.
(d ) Microeconomics is concerned primarily with comparative statics rather than dynamics.
• 10. Which of the following statements is most closely associated with general equilibrium analysis?
(a) Everything depends on everything else.
(b) Ceteris paribus.
(c) The equilibrium price of a good or service depends on the balancing of the forces of demand and
supply for that good or service.
(d ) The equilibrium price of a factor depends on the balancing of the forces of demand and supply
for that factor.
5
• 11. Which aspect of taxation involves normative economics?
(a) the incidence of (i.e., who actually pays for) the tax,
(b) the effect of the tax on incentives to work,
(c) the “fairness” of the tax, or
(d) all of the above.
• 12. Microeconomics deals primarily with
(a) comparative statics, general equilibrium, and positive economics,
(b) comparative statics, partial equilibrium, and normative economics,
(c) dynamics, partial equilibrium, and positive economics, or
(d ) comparative statics, partial equilibrium, and positive economics.