1.1.Brief Definitions
This chapter begins with examining what the science of economics is about. The subject matter of economics has grown so wide and vast that it is difficult to define it in a nutshell. Nonetheless, from time to time, economists have attempted to define economics. The various definitions can be categorized in to three of the wealth , the welfare and the scarcity definitions discussed below.
The wealth definition, pioneered by Adam Smith in his work “an enquiry in to the nature and causes of the wealth of nations”, puts economics as a science of wealth that enquires in to the factors that determine wealth of a country and its growth. It emphasizes the production, distribution and expansion of material wealth resulted from productive labor as the subject matter of economics. The wealth definition unduly limited the scope of economics that it neglected the immaterial services such as health, education, administration and arts from the definition of wealth and thus ignored their role for economic growth.
The welfare definition (by Alfred Marshal), in contrast, considers economics as the study of mankind in the ordinary business of life closely connected with material welfare. It deals with wealth implying that it studies man’s action in earning and spending wealth. Thus, wealth here is studied not as an end but as a means to the end of promoting human welfare. This definition again leaves immaterial services and ends out of the scope of economics.
The scarcity definition (by Robbins) regards economics as a science which studies human behavior as a relationship between unlimited ends and scarce resources with alternative uses. It studies human action regarding how he satisfies his wants (all goods and services) with scarce resources. This definition leaves macroeconomic issues such as determination of national income and employment, and the theory of economic growth and development untouched that are the major concerns of modern microeconomics.
Furthermore, professor Hennery smith has recently defined economics as “the study of how in a
Compiled by micro team
Microeconomics I Page 1

-civilized society one obtains the share of what other people have produced and of how the total product of society changes and is determined.” Although this recent definition explicitly embraces the crucial issues of distribution of income, determination of income and employment and theory of economic growth, it excludes the problems of pricing and resource allocation.
In conclusion, the whole subject matter of economics can hardly be inclusively put in few words.
Being started with the wealth aspect of Smith, its scope has remarkably grown touching new and varied issues owning to the dynamic economy that economic theories lay on. Accordingly, existing economic theories might not work anymore or may be inadequate to comprehend the constant changes. Economics can instead be better described by spelling out the problems economists raise as J.Viner stated it that economics is what economists do. Economists deal with various issues like pricing and resource allocation, distribution of national income, determination of employment and income, general price level and theory of economic growth and development.
1.2. Microeconomics and Macroeconomics
The modern view divides the subject matter of economics in to microeconomics and macroeconomics. The term microeconomics is derived from the Greek word mikros to mean
‘small’ and macroeconomics from makros meaning ‘large’. Microeconomics deals with the analysis of small individual units such as individual consumers, individual firms, and small groups of individual units like industries and markets. In particular, it analyses the theory of product pricing that include theories of demand and production and cost; theory of factor pricing and theory of economic welfare. Microeconomics also deals with some aggregates relating to a particular product, industry or particular market with regard to price, output or employment generation.
On the other side, macroeconomics analyses the economy as a whole and its large aggregates such as national output and income, aggregate employment, aggregate consumption, aggregate investment and the general price level of the economy. The theories of distribution and growth in national output are studied in macroeconomics. It thus analyses and establishes the functional relationship between these large aggregates. Unlike microeconomics, aggregates and subaggregates in macroeconomics relates to the whole economy with a great deal of products, markets and industries.
Compiled by micro team
Microeconomics I Page 2

But it is vital to note that micro and macro-economics are interdependent. Macroeconomic theories are derived from theories of individual behavior. The theories of aggregate consumption and investment are based on the behaviors of entrepreneurs and consumers. Likewise, some macroeconomic issues like profits and rates of interest are determined from macroeconomic theory.
1.3.The Fundamental Economic Fact- Scarcity
Economics especially deals with the achievement and use of material requirements to satisfy human wants. But human wants are without limit. Most of us, for instance, want more or better food and clothing, better education or health care, good houses and new television sets.
Economists say human wants are unlimited due to the facts that some human wants are recurring and others are hierarchal. The same needs reappear after being satisfied and needs emerge with higher order ones. For example, the need to eat recurs within a certain interval. Likewise, once you attain your Bachelor degree, you aspire to get better education like a master degree and then
PhD.
In contrast, the productive resources such as land and other natural resources, skilled labor, raw materials, capital equipments and entrepreneurship are limited in supply. Land resource includes land and other natural resources while labor refers to the physical or mental effort of people.
Capital represents the set of goods produced for use in the production other goods but not for direct consumption. Entrepreneur ability again is the sprite and effort to start, organize and run business. These resources are scarce since total amount of demand for them is greater than total supply at zero price level. These scarce resources result in scarce amount of goods and services.
Thus, human wants for goods and services remain ahead of resources and capacity to produce.
This gives rise to the problem of how to use scarce resources to achieve maximum possible fulfillment generally called
‘the fundamental economic problem’
. This problem of scarcity of resources relative to wants bases all economic problems and unanimously faces individuals, the society and all economic systems. Scarcity justifies existence of economics as a scientific study that otherwise would have been unnecessary. The problem can be felt well in poor countries where a lot of people live at a bare subsistence level. However, the developed countries also face
Compiled by micro team
Microeconomics I Page 3

the problem of scarcity despite the enormous rise in the possession of goods and service because their present wants exceed their increased resources and capacity to produce.
The problem of scarcity of resources to satisfy human wants leads to the basic economic problem of choice as to what goods and services should be produced, how they should be produced , and for whom should they be produced. Hence, an economy has to solve these central economic problems if it is to meet its purpose. These problems are explained in some detail below. a.
What to produce
Scarcity implies the society cannot have all the goods and services that it would like to have.
This in turn compels to decide which goods and in what quantities are to be produced. The society would have to choose what consumer and capital goods and what amounts of consumer and capital goods should be produced. In particular, the society faces a range of goods and services such as cars, schools, houses, nuclear bombs, rice, machinery, lipsticks, and haircuts and must determine what amount of each chosen good or service should be produced. b.
How to produce
This economic problem implies what combination of resources (production technology) should be utilized to get the best out of the resources. Usually, there exist various alternative techniques of producing a commodity and the society has to opt among the alternative production techniques involving various degrees of capital and labor intensity that result in the most efficient outcome. c.
For whom to produce
Goods and services cannot be produced in sufficient quantities to satisfy all wants of all the people due to scarcity of resources. This requires the society to decide how the national output is to be distributed. It can be considered as sharing of national ‘Teff’ among the people constituting a society. In a free market economy, the problem of who should get and how much of the national output depends on money income. Greater money income implies greater purchase of amount of goods and services and greater inequality in money incomes leads to greater inequalities in the distribution of national output.
Compiled by micro team
Microeconomics I Page 4

Having explained the central economic problems, let’s proceed with how actually these problems are solved. There are two main methods of the market (price) mechanism and economic planning to solve the central problems. In the former, the free play of the forces of demand and supply decide what and how much, how and for whom should be produced. The demand for and supply of goods, services and factors of Production determine the price, quantity and distribution of inputs and goods and services among individuals of the society. In the later, the central planning authority decides what, how and for whom should be produced. In such an economy, capital and property are collectively owned, government organizes production and consumers lose freedom of consumption.
It is worth noting that no country in the world today solves the central problems through unfettered market mechanism. Governments in present capitalist countries intervene in the economy and play an active role in the production, distribution and investment decisions.
Besides, governments interfere through the adoption of proper monetary and fiscal policies and direct controls. Thus, the coexistence of market mechanism and government interference gives rise to a mixed economic system.
1.4. Production Possibility Curve (PPC)
The nature of the basic economic problems discussed above can better be understood with the help of a vital economic tool referred to as production possibility curve (frontier). PPC represents graphically alternative production possibilities facing an economy given its resource and current level of technology. An economy indeed faces the decision of what and how much of several different goods and services to produce and how resources should be allocated among different possible goods and services. But in order to simplify the analysis, it is assumed that two goods-wheat and cloth-are to be produced.
The analysis of the central economic problems using the PPC is based on the assumptions of: a.
Fixed amount of productive resources and alternative uses of these resources b.
Full employment and full use of existing production capacity c.
A given level of technology and a short period of analysis considered d.
Only two goods and some factors are better adapted to certain uses than others
Compiled by micro team
Microeconomics I Page 5

The table below shows a hypothetical economy with various production possibilities between cloth and wheat for a given amount of productive resources and technology.
Table 1.1
Production possibility schedule
A
B
C
D
E
F
Production possibilities Cloth (in thousand meters)
0
1
2
3
4
5
Wheat (in thousand quintals)
15
14
12
9
5
0
The production possibilities A, B, C, D, E and F in the table above indicate the combination of the amounts of cloth and wheat produced given the current amount of resources and level of technology. For instance, production possibility ‘A’ shows that 15 thousand quintals of wheat is produced if all the given resources are employed for the production of wheat.
Y Y
15 A B
Wheat 14 C H wheat
12 D
9 U E
5 PPC
0
PPC
2
PPC
0
PPC
1
0 1 2 3 4 5 F X X
Cloth cloth
Figure 1.1: Production possibility curve (frontier) Figure1.2. Shift in PPC
Compiled by micro team
Microeconomics I Page 6

With ‘B’, the economy can produce 14 thousand quintals of wheat and one thousand meters of cloth and similar combinations can be formulated for the other production possibilities above.
The alternative production possibilities can be illustrated graphically by plotting the data in table
1.1. The curve AF is called the production possibility curve (frontier) - PPC. Points on the PPC like A, B, C, D and F are technically efficient in that the economy fully utilizes and employs its resources. The combined output of the two goods can neither lie at U where there exist underutilization or underemployment nor at H which lies beyond the capacity of the economy to produce. However, resource underutilization or inefficiency due to unemployment, underemployment or the like could allow production of more of the two or either of the two goods.
As we move from production possibility A to F, we give up some units of wheat so as to have some more units of cloth and vice-versa. Some resources are drawn away from wheat production and devoted to production of cloth. Hence, it is always must to give up something of one good to obtain some more of another with full-employment economy and full-use of production capacity.
This reveals that resource scarcity prevents an economy from producing more of both goods.
Besides, as we move from A to B, B to C, C to D and further D to E and E to F, the amount of wheat given up for having extra unit of cloth goes on increasing. In particular, the cost of extra one thousand meters of cloth as we move from A to B, B to C, C to D ,D to E and E to F is 1 thousand, 2 thousand, 3 thousand, 4 thousand and 5 thousand respectively. The successive rise in the amount of wheat sacrificed in order to have one more unit of cloth is called the principle of increasing opportunity cost and this makes the PPC concave to the origin. The rise in opportunity cost (or concavity of the PPC) is related the fact that economic resources are not completely suited to alternative uses that a given resource is more suited to the production of one good than another often called specificity of resources. Opportunity cost here is defined as the ratio of the amount of good given up to the amount of other good gained or the value of the next best alternative sacrificed.
Despite the assumptions to draw the PPC, the change in the supply of resources and change in technology in the long run shifts the PPC outward such as from PPC
0 to PPC
1
or PPC
2
in figure
1.2. Hence, the growth in economy due to change in capital, human or natural resource and
Compiled by micro team
Microeconomics I Page 7

technology shifts the PPC outward while the deterioration in growth from lower amount of productive resources and inferior technology shifts the production possibility curve to the left.
It is worth noting that the movement from one PPC to another should be distinguished from the movement from a point inside the PPC to a point on it. Despite the increase in output in both cases, the former involves increase in resources or productive capacity while the latter results in fuller employment or efficient utilization of resources. Beside, the former is about theory of economic growth where as the latter is associated to the short-run macroeconomic theory.
1.5. Micro economic theory and the price system
1.5.1.
the circular flow of economic activity
Micro economic theory –studies the economic behavior of individual decision making units such as individual consumers (resource owners), and business firms, and the operation of individual markets in a free enterprise economy. Micro economics focuses attention on two broad categories’ of economic units: Households and business firms and it examine the operation of two types of markets; the market for goods and services & the market for economic resources.
Expenditure of firms’ market
Flow of resources flow of resources
Firm
Household
Product
Flow of goods and services goods and services market
Revenue of firms’ consumption expenditure
Figure 1.4 the circular flow of economic activity.
Compiled by micro team
Microeconomics I Page 8

Households and firms (businesses are the two major decision making units of the economic system. Now let us use their interactions by using the circular flow model). The inner loop shows the flow of economic resources from households to business firms and the flow goods and services, from business firms to households represents production flow. The outer loop shows the flow of money incomes from business firms to households and the flow of consumption expenditures from households to business firms, this represents financial flow. However, the above model represents a closed and traditional economy because: a) It involves only two elements of the economic system, namely, the business firms and household. But it excludes the other two major elements, the government and foreigners. b) The households in the model spend all of their incomes on consumption and do not save. c) Since there is no capital investment, the model–economy is a stagnated one; i.e. there is no economic growth because the total product is consumed in the same period.
1.6
Methods of Economic Analysis
Every branch of knowledge derives hypotheses, generalizations, principles, laws and theories.
Each scientific study adopts a certain methodology to develop these theories and generalizations.
Every scientific theory is based upon a set of assumptions called premises or postulates. From the postulates, testable hypotheses are driven through the process of logical reasoning. A hypothesis is then established as a scientific theory if its predictions coincide with the direct observation of facts or through statistical methods of interpretation. Hence, the crucial test of a theory is that whether the explanations and predictions are consistent or not with empirical evidence. A distinction could be made between generalizations (laws) and theories.
Generalizations are statements of relationship between variables with no explanation about the described relations. Theories, on the other hand, provide an explanation of the sated relation that logically bases the generalization.
Like other scientific studies, generalizations in economics are derived through either the deductive or inductive methods.
1.6.1 Deductive method
The deductive method is an abstract, analytical or a priori approach that involves the principal steps of:
Compiled by micro team
Microeconomics I Page 9

a) Perception of the problem: a scientific theorist must have a clear idea of the problem and identify the significant variables and interrelationships. b) Precise definition of technical terms and making of assumptions: the next step in the deductive approach is the precise definition of technical terms and clear statement of the postulates. The postulates are based on observations or retrospect and could be behavioral relating to economic agents and variables or pertaining to the production technology and resources availability. The actual economic world is quite complex in which numerous factors play a part and act and interact. Hence, we introduce premises to identify the most significant factors having a bearing on the problem. Theories then are maps of the real world economic phenomenon and not perfect pictures. The crucial test of an economic theory is that whether the explanations and predictions are consistent or not with empirical evidence or the facts in the real world. c) Deducing hypothesis: then follows the deducing of a testable hypothesis describing the relation between variables affecting a phenomenon from the premises taken using logical reasoning. The logical deduction is carried out with the aid of words, symbolic logic, graphic technique or formal mathematics. d) Testing of hypothesis: economics relies on uncontrolled experiences and observations to verify hypothesis. The need to depend on uncontrolled experiences raises the size of observations and complicates analysis and interpretation. Despite this, there exist many well-established generalizations in economics such as the laws of demand and supply.
Predictions by hypotheses may not accord with historical sequence of events and forecasting of future events. The statistical (econometric) method may be used to verify hypothesis. If the predictions by a certain hypothesis are consistent with the direct observation of facts or result of statistical methods, it stands established as a scientific theory otherwise rejected. The rejection of a hypothesis implies an error either in logical deduction or adoption of too unrealistic assumptions.
The deductive method has some merits that useful mathematical techniques can be used; detailed collection and analysis of data may not be required; and vital due to impracticability of controlled experiment. However, it requires a high level competence in logic and theoretical abstraction and advanced model with no application can be developed.
Compiled by micro team
Microeconomics I Page 10

1.6.2
Inductive Method
The inductive (empirical) method derives theories based on experience or observations. The experimentation, observation or econometric methods can be used to derive economic principles. Experimentation has limited application in economics in that the behavior of man is changeable and unmanageable, man cannot tolerate experimentation and an economic phenomenon is the result of multiplicity of factors. The steps involved in the inductive approach include identification of the problem, defining technical terms and variables, collection of data and doing preliminary thinking about the possible functional relationship, processing of data and development of a theory to reined and tested further. The method of induction should be supported with theories developed by deductive logic, requires sufficient data and good knowledge of statistical methods.
1.7
Positive Economics and Normative Economics
It is worth distinguishing between normative and positive economics. Positive economics is a body of systematized knowledge about what it is. It describes theories and laws to explain observed economic phenomenon. In the other hand, normative economics relates to what should the economic phenomenon be. In positive microeconomics, we explain the determination of relative prices and resource allocation while normative economics emphasizes what should the relative prices and resources allocation look like. Given the profit maximization assumption, positive economics states that monopolist will fix a price which will equate marginal cost with marginal revenue but the question what price should or ought to be fixed so that maximum social welfare is achieved lies within the purview of normative economics.
Despite the above distinction, the modern viewpoint is that both approaches are needed for the proper development of scientific economic theories. Modern economists first derive economic hypothesis through deduction and utilize statistical methods to for empirical test.
Compiled by micro team
Microeconomics I Page 11