Chapter-1

Basic Concepts of
Economics
What is Economics?

Economics is the study of how societies choose to

use scarce productive resources that have
alternative uses, to produce commodities of various
kinds, and to distribute them among different
groups.
Scarcity

Concerns of economics exist because goods are scarce and

society must use its resources efficiently.
Production is never high enough to meet everyone’s
demand.
Wants are unlimited.
Efficiency

Economic efficiency requires that an economy produce

the highest combination of quantity and quality of goods
and services given its technology and scarce resources.
An economy is producing efficiently when no individual’s
economic welfare can be improved unless someone else is
made worse off.
Free Goods vs Economic Goods

A free good is a good that is not scarce, and

therefore needs no conscious effort to be obtained.
E.g.: air

An economic good is a good that is useful to people

but scarce in relation to its demand so that human
effort is required to obtain it. E.g.: food, clothes
Free Goods vs Economic Goods
Free Goods Economic Goods

Air Food
Subject-Matter of Economics

The subject matter of economics is sub-divided into

two core branches, Microeconomics and
Macroeconomics.
• Microeconomics is concerned with the behavior of
individual entities such as markets, firms, and
households.
• Macroeconomics views the performance of the
economy as a whole.
Microeconomics
• Micro-economics, also known as Price Theory, focuses on individual
consumer and firm behavior. It analyzes the composition, allocation, and total
production of an economy.
• It examines demand, income, and employment of the individual or industry,
rather than that of the entire economy, It focuses on specific product prices,
demand, and income levels.
• It studies the flow of economic resources or factors of production from
resource owners to business firms and goods and services from business firms
to households.
• It plays a significant role in the study of economic theory, explaining the
functioning of a free enterprise economy, the distribution of goods and
services, and the conditions of efficiency in consumption and production.
Macroeconomics

• Macro-economics examines the entire economy, analyzing

aggregates and averages like income, output, employment,
consumption, savings, investment, demand, supply, and
price level, and identifying fluctuations.
• The old assumption of full employment is no longer valid,
and it's crucial to investigate how these aggregates are
determined and their determinants.
• Macro-economics deals with how an economy grows.
Fallacies of Economics
Some common fallacies encountered in economic reasoning are as
follows:
• The post hoc fallacy: The post hoc fallacy occurs when we
assume that, because one event occurred before another event,
the first event caused the second event.
• Failure to hold other things constant: Economists often fail hold
other things constant when thinking about an issue.
• The fallacy of composition: When one assumes that what holds
true for part of a system also holds true for the whole, one is
committing the fallacy of composition.
Positive Economics vs Normative Economics
Positive economics describes the facts of an economy
that can be backed by analysis and empirical evidence.
• Do teachers earn more than janitors in the United States?
• Do higher interest rates slow the economy and lower
inflation?
Normative economics involve ethics and values rather
than facts. It has no right or wrong answers.
• Should unemployment be raised to ensure that price
inflation does not become too rapid?
Positive Economics vs Normative Economics
Indicate whether each of the statements is positive or
normative:
1. Forex reserves rise by $1.51 billion in a week.
2. The economic disparity undermines the spirit of the
Liberation War.
3. The Consumer Price Index (CPI) rose 9.02% in FY23.

1. 2.
3.
Positive Economics vs Normative Economics
Indicate whether each of the statements is positive or
normative:
1. Forex reserves rise by $1.51 billion in a week.
2. The economic disparity undermines the spirit of the
Liberation War.
3. The Consumer Price Index (CPI) rose 9.02% in FY23.

1. Positive 2. Normative
3. Positive
Cool Heads at the Service of Warm Hearts
The ultimate goal of economic science is to improve the living
conditions of people in their everyday lives.
Determining the best route to economic progress or an equitable
distribution of society’s output requires cool heads that objectively
weigh the costs and benefits of different approaches.
Governments must preserve incentives for people to work and to
save in order to maintain a healthy economy.
• Societies can support the unemployed for a while, but when
unemployment insurance pays too much for too long, people
may stop looking for work.
The Three Problems of Economic Organization

Every human society must ask three fundamental

economic questions:
• What commodities are produced and in what
quantities?
• How are goods produced?
• For whom are goods produced?
Market, Command and Mixed Economies
There are three different ways of organizing an economy:
• A market economy is one in which individuals and private firms make
the major decisions about production and consumption.
 The extreme case of a market economy, where the government
makes no economic decisions, is called a laissez-faire economy.
• A command economy is one in which the government makes all
important decisions about production and distribution.
• A mixed economy is one that has elements of both market and
command.
 All contemporary societies today are mixed economies.
Market Economy
In case of a market economy:
• Firms produce the commodities that yield the highest profits
(the what)
• They use techniques of production that are least costly (the
how)
• Consumption is determined by individuals’ decisions about
how to spend the wages and property incomes generated by
their labor and property ownership (the for whom)
Examples of market economies: United States, Japan
Command Economy
In case of a command economy:
• Government decides the commodities that are produced
(the what)
• Government decides the techniques of production (the
how)
• Government decides how goods produced are divided
among different households (the for whom)
Examples of command economies: USSR, North Korea
Mixed Economy
In case of a mixed economy:
• The market mechanism determines the types and quantities of
goods produced but the government may intervene (the what)
• Market forces dictate production methods, but the government can
regulate industries, enforce safety standards, and offer incentives to
encourage specific practices (the how)
• Goods and services are distributed based on a combination of
market transactions and government interventions (the for whom)
Examples of mixed economies: China, Norway, Singapore
Inputs and Outputs

Inputs are commodities or services that are used to

produce goods and services.

Outputs are the various useful goods or services that

result from the production process and are either
consumed or employed in further production.
Factors of Production
Another term for inputs is factors of production. These can be
classified into three broad categories:
• Land or, more generally, natural resource represents the gift of
nature to our societies. E.g.: Land, copper, iron ore and sand.
• Labor consists of the human time spent in production such as
working in factories, writing software and teaching in schools.
• Capital resources form the durable goods of an economy, produced
in order to produce yet other goods. Capital goods include
machines, roads and buildings
Factors of Production

Capital
Land

Labor
The Production Possibility Frontier (PPF)

The production-possibility frontier (or PPF) shows

the maximum quantity of goods that can be
efficiently produced by an economy, given its
technological knowledge and the quantity of
available inputs.
PPF Example
Consider an economy that produces only two economic goods:
guns and butter. Suppose that our economy decides to throw all its
energy into producing butter. There is a maximum amount of butter
that can be produced per year. Suppose 5 million pounds of butter
is the maximum amount that can be produced with the existing
technology and resources.
At the other extreme, imagine that all resources are instead
devoted to the production of guns. Again, because of resource
limitations, the economy can produce only a limited quantity of
guns. In this case, assume that the economy can produce 15,000
guns of a certain kind if no butter is produced.
Table 1-1
Figure 1-1
Figure 1-2
Opportunity Cost

In a world of scarcity, choosing one thing means giving up

something else. The opportunity cost of a decision is the
value of the good or service forgone.
In the previous figure, if the country decided to increase its
gun purchases from 9000 guns at D to 12000 units at C, 1
million pounds of butter would need to be foregone.
Hence, the opportunity cost of the 3000 extra guns would
be 1 million pounds of butter.
Figure 1-3
(a) Before development, the
nation is poor. It must devote
almost all its resources to
food and enjoys few
comforts. (b) Growth of
inputs and technological
change shift out the PPF.
With economic growth, a
nation moves from A to B,
expanding its food
consumption little compared
with its increased
consumption of luxuries. It
can increase its consumption
of both goods if it desires.
Figure 1-4
(a) A poor frontier society
lives from hand to mouth,
with little left over for public
goods like clean air or public
health. (b) A modern
urbanized economy is more
prosperous and chooses to
spend more of its higher
income on public goods and
government services (roads,
environmental protection,
and education).
Example 1-5
A nation can produce either current-consumption goods
(pizzas and concerts) or investment goods (pizza ovens and
concert halls). Three countries (Country A, Country B and
Country C) start out evenly but have different investment
rates. Country 1 does not invest for the future. Country 2
abstains modestly from consumption. Country 3 sacrifices a
great deal of current consumption and invests heavily. Draw
two PPFs, one showing the current consumption scenario and
the other showing the future consumption scenario.
Figure 1-5
Country 1 does not invest for the
future and remains at A1. Country
2 abstains modestly from
consumption and invests at A2.
Country 3 sacrifices a great deal
of current consumption and
invests heavily. In the following
years, countries that invest more
heavily forge ahead. Thus thrifty
Country 3 has shifted its PPF far
out, while Country 1’s PPF has not
moved at all. Countries that
invest heavily can have both
higher investment and
consumption in the future.
Productive Efficiency
Productive efficiency occurs when an economy cannot
produce more of one good without producing less of another
good; this implies that the economy is on its production-
possibility frontier.
When there are unemployed resources, the economy is not on
its production-possibility frontier but, rather, somewhere
inside it.
• Factors such as environmental degradation and business
cycles cause the economy to move inside its PPF
Any point outside the PPF is considered infeasible.
Business Cycle

Historically, one source of inefficiency occurs during

business cycle recessions.
The economy moved inside the PPF during the
Great Depression and the 2007-2008 Financial
Crisis.
Panics, bank failures, bankruptcies, and reduced
spending move the economy inside its PPF.
Environmental Degradation

Markets may sometimes fail to reflect

true scarcities, as with environmental
degradation.
Because businesses do not face
correct prices, the economy moves
from point B to point C. Private goods
are increased, but public goods (like
clean air and water) are significantly
decreased.